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Corporate Governance


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Corporate Governance

  1. 1. Corporate Governance <ul><li>Corporate governance is </li></ul><ul><ul><li>a relationship among stakeholders that is used to determine and control the strategic direction and performance of organizations </li></ul></ul><ul><ul><li>concerned with identifying ways to ensure that strategic decisions are made effectively </li></ul></ul><ul><ul><li>used in corporations to establish order between the firm’s owners and its top-level managers </li></ul></ul>
  2. 2. Corporate Governance Mechanisms <ul><li>Board of Directors </li></ul>Internal Governance Mechanisms Managerial Incentive Compensation Ownership Concentration External Governance Mechanisms Market for Corporate Control
  3. 3. Separation of Ownership and Managerial Control <ul><li>Basis of the modern corporation </li></ul><ul><ul><li>shareholders purchase stock, becoming residual claimants </li></ul></ul><ul><ul><li>shareholders reduce risk by holding diversified portfolios </li></ul></ul><ul><ul><li>professional managers are contracted to provide decision-making </li></ul></ul><ul><li>Modern public corporation form leads to efficient specialization of tasks </li></ul><ul><ul><li>risk bearing by shareholders </li></ul></ul><ul><ul><li>strategy development and decision-making by managers </li></ul></ul>
  4. 4. Agency Relationship: Owners and Managers <ul><li>Firm owners </li></ul>Shareholders (Principals)
  5. 5. Agency Relationship: Owners and Managers <ul><li>Decision makers </li></ul><ul><li>Firm owners </li></ul>Managers (Agents) Shareholders (Principals)
  6. 6. Agency Relationship: Owners and Managers <ul><li>Risk bearing specialist (principal) pays compensation to a managerial decision-making specialist (agent) </li></ul><ul><li>Decision makers </li></ul><ul><li>Firm owners </li></ul>An Agency Relationship Managers (Agents) Shareholders (Principals)
  7. 7. Agency Theory Problem <ul><li>The agency problem occurs when: </li></ul><ul><ul><li>the desires or goals of the principal and agent conflict and it is difficult or expensive for the principal to verify that the agent has behaved inappropriately </li></ul></ul><ul><li>Solution: </li></ul><ul><ul><li>principals engage in incentive-based performance contracts </li></ul></ul><ul><ul><li>monitoring mechanisms such as the board of directors </li></ul></ul><ul><ul><li>enforcement mechanisms such as the managerial labor market to mitigate the agency problem </li></ul></ul>
  8. 8. Manager and Shareholder Risk and Diversification Risk Diversification Dominant Business Unrelated Businesses Related Constrained Related Linked Managerial (employment) risk profile Shareholder (business) risk profile B S A M
  9. 9. Governance Mechanisms <ul><li>Insiders </li></ul><ul><li>The firm’s CEO and other top-level managers </li></ul><ul><li>Affiliated Outsiders </li></ul><ul><li>Individuals not involved with day-to-day operations, but who have a relationship with the company </li></ul><ul><li>Independent Outsiders </li></ul><ul><li>Individuals who are independent of the firm’s day-to-day operations and other relationships </li></ul>Board of Directors
  10. 10. Governance Mechanisms <ul><li>Role of the Board of Directors </li></ul><ul><li>Monitor – Are managers acting in shareholders best interests </li></ul><ul><li>Evaluate & Influence – examine proposals, decisions actions, provide feedback and offer direction </li></ul><ul><li>Initiate & Determine – delineate corporate mission, specify strategic options, make decisions </li></ul>Board of Directors
  11. 11. Governance Mechanisms <ul><li>Salary, bonuses, long term incentive compensation </li></ul><ul><li>Executive decisions are complex and non-routine </li></ul><ul><li>Many factors intervene making it difficult to establish how managerial decisions are directly responsible for outcomes </li></ul>Board of Directors Executive Compensation
  12. 12. Governance Mechanisms <ul><li>Stock ownership (long-term incentive compensation) makes managers more susceptible to market changes which are partially beyond their control </li></ul><ul><li>Incentive systems do not guarantee that managers make the “right” decisions, but do increase the likelihood that managers will do the things for which they are rewarded </li></ul>Board of Directors Executive Compensation
  13. 13. CEO Pay and Performance Firm Performance CEO Pay <ul><li>Classic pay for </li></ul><ul><li>performance </li></ul><ul><li>relationship </li></ul><ul><li>Unfortunately, this </li></ul><ul><li>relationship is weak </li></ul><ul><li>The stronger </li></ul><ul><li>relationship is with </li></ul><ul><li>firm size </li></ul>
  14. 14. CEO Pay and Firm Size Firm Size CEO Pay <ul><li>Relationship between </li></ul><ul><li>pay and firm size is </li></ul><ul><li>curvilinear. </li></ul><ul><li>CEO pay increases at </li></ul><ul><li>a decreasing rate </li></ul>
  15. 15. Relationship Between Firm performance and Firm Size Firm Size Firm Performance <ul><li>Relationship between </li></ul><ul><li>firm performance and </li></ul><ul><li>firm size is curvilinear . </li></ul><ul><li>Beyond some point, as </li></ul><ul><li>size increases, firm </li></ul><ul><li>performance declines </li></ul><ul><li>BUT… </li></ul><ul><li>From the graph of CEO </li></ul><ul><li>pay vs. firm size, pay </li></ul><ul><li>doesn’t decline </li></ul>
  16. 16. Relationship Between Firm performance and Equity Ownership Managerial Ownership in % Firm Value <ul><li>Relationship between </li></ul><ul><li>firm performance </li></ul><ul><li>(Tobin’s Q) and </li></ul><ul><li>managerial ownership </li></ul><ul><li>is curvilinear . </li></ul><ul><li>Beyond some point, as </li></ul><ul><li>ownership increases, </li></ul><ul><li>firm value declines </li></ul>
  17. 17. Governance Mechanisms <ul><li>Large block shareholders (often institutional owners) have a strong incentive to monitor management closely </li></ul><ul><li>Exit vs. Voice – Cannot costlessly exit due to equity stake (transaction costs) so they press for change (exercise voice) </li></ul><ul><li>They may also obtain Board seats which enhances their ability to monitor effectively (although financial institutions are legally forbidden from directly holding board seats) </li></ul>Ownership Concentration Executive Compensation Board of Directors
  18. 18. Governance Mechanisms <ul><li>Types of institutional investors </li></ul><ul><li>- Mutual funds, pension funds, </li></ul><ul><li>foundations, churches, universities, </li></ul><ul><li>insurance companies </li></ul><ul><li>Pressure-resistant versus pressure-sensitive </li></ul><ul><li>- Mutual and pension funds are </li></ul><ul><li>pressure resistant </li></ul><ul><li>Are Institutional investors the same? </li></ul><ul><li>- Short vs. long term </li></ul><ul><li>Components of voice: </li></ul><ul><li>- Pension fund hit lists </li></ul><ul><li>- Shareholder liability suits </li></ul><ul><li>- Investor alliances </li></ul><ul><li>- Proxy contests </li></ul>Ownership Concentration Executive Compensation Board of Directors
  19. 19. Governance Mechanisms <ul><li>Firms face the risk of takeover when they are operated inefficiently </li></ul><ul><li>Many firms begin to operate more efficiently as a result of the “threat” of takeover, even though the actual incidence of hostile takeovers is relatively small </li></ul><ul><li>Changes in regulations have made hostile takeovers difficult </li></ul><ul><li>Acts as an important source of discipline over managerial incompetence and waste </li></ul>Ownership Concentration Board of Directors Executive Compensation Market for Corporate Control
  20. 20. Managerial Defense Tactics <ul><li>Designed to fend off the takeover attempt </li></ul><ul><li>Increase the costs of making the acquisitions </li></ul><ul><li>Causes incumbent management to become entrenched while reducing the chances of introducing a new management team </li></ul><ul><li>May require asset restructuring </li></ul><ul><li>Institutional investors oppose the use of defense tactics </li></ul>
  21. 21. Takeover Defenses: <ul><li>Poison pills </li></ul><ul><li>Leveraged recapitalizations </li></ul><ul><li>Greenmail </li></ul><ul><li>Litigation </li></ul>Financial Mechanisms
  22. 22. Takeover Defenses: <ul><li>Scorched earth defense </li></ul><ul><li>Crown jewel sales </li></ul><ul><li>Pac-man defense </li></ul><ul><li>Poison pills </li></ul><ul><li>Leveraged recapitalizations </li></ul><ul><li>Greenmail </li></ul><ul><li>Litigation </li></ul>Asset-Based Mechanisms Financial Mechanisms
  23. 23. Takeover Defenses: <ul><li>Scorched earth defense </li></ul><ul><li>Crown jewel sales </li></ul><ul><li>Pac-man defense </li></ul><ul><li>Poison pills </li></ul><ul><li>Leveraged recapitalizations </li></ul><ul><li>Greenmail </li></ul><ul><li>Litigation </li></ul><ul><li>White knight defense </li></ul><ul><li>Other bidder (competitive bid situation) </li></ul>Asset-Based Mechanisms Financial Mechanisms Third Party Mechanisms