Stakeholders and Corporate Governance Key Issues

ASPECTS OF CONTROL :
STAKEHOLDERS
&
CORPORATE GOVERNANCE
MSC ACCOUNTANCY & FINANCE :
CORPORATE GOVERNANCE
& OPERATIONS RISK ANALYSIS AND CONTROL
Stephen Ong
BSc(Hons) Econs (LSE),
MBA International
Business(Bradford)
Visiting Fellow, Birmingham City University
Visiting Professor, Shenzhen University

• Discussion : Agency
problems and Large Family
Business Groups
1
• Stakeholders
• Management Control Systems
• Role of Boards
2
• Case Presentation: GM3
Today’s Overview

Casestudy 2 : General Motors
1. Read and prepare the Casestudy on General
Motors (Monks & Minow (2011)) for
discussion next class. Identify the corporate
governance issues faced.
2. In groups of four members you are required
to:
– Allocate responsibility to – a non executive
director, a CEO, a Health and Safety
Manager and a Risk Manager
– Analyse the scenario’s in the case study
and discuss which are the most critical
risks that the organisation faces.
– Plot the resulting risk analysis on an
appropriate risk map.
– Decide what is your groups response.

IMPACTONBUSINESS
Critical
4
4 8 12 16
Unacceptable level of risk exposure,
which requires extensive management
Major
3
3 6 9 12
Moderate
2
2 4 6 8
4 – 8: Risk management measures need
to be put in place and monitored
Minor
1
1 2 3 4
Almost
Never
1
Unlikely
2
Likely
3
Almost
Certain
4
1 – 3: Acceptable level of risk subject to
regular monitoring
LIKELIHOOD OF OCCURING

High
Medium
Low
Low Medium High
S
I
G
N
I
F
I
C
A
N
C
E
PROBABILITY
Requires close monitoring Manage and monitor Significant focus and action
Accept but monitor
Management effort worthwhile
Manage and monitor
Accept risks
Accept but periodically review Accept but monitor

1. Open Discussion
• Morck, Randall and Yeung, Bernard (2003)
Agency problems in large Family Business
Groups, Entrepreneurship: Theory and
Practice, Summer 2003. Vol. 27, No. 4: pp.
367 – 382

Corporate Governance Research in
Accounting & Auditing

Learning outcomes
• Consider appropriate ways to express the strategic purpose of
an organisation in terms of statements of purpose, values,
vision, mission or objectives.
• Identify the components of the governance chain of an
organisation.
• Understand differences in governance structures and the
advantages and disadvantages of these.
• Identify differences in the corporate responsibility stances taken
by organisations and how ethical issues relate to strategic
purpose.
• Undertake stakeholder analysis as a means of identifying the
influence of different stakeholder groups in terms of their
power and interest.

Influences on strategic purpose
Figure 4.1 Influences on strategic purpose

Who are the stakeholders?
Stakeholders are those individuals or groups who
depend on an organisation to fulfil their own
goals and on whom, in turn, the organisation
depends.

Mission statements
• A mission statement aims to provide employees
and stakeholders with clarity about the overriding
purpose of the organisation
• A mission statement should answer the
questions:
‘What business are we in?’
‘How do we make a difference?’
‘Why do we do this?’

Vision statements
• A vision statement is concerned with the
desired future state of the organisation; an
aspiration that will enthuse, gain commitment
and stretch performance.
• A vision statement should answer the question
: ‘What do we want to achieve?’

Statement of corporate values
• A statement of corporate values should
communicate the underlying and enduring core
‘principles’ that guide an organisation’s strategy
and define the way that the organisation should
operate.
• Such core values should remain intact whatever the
circumstances and constraints faced by the
organisation.

Objectives
• Objectives are statements of specific outcomes
that are to be achieved.
• Objectives are frequently expressed in:
financial terms (e.g. desired profit levels)
market terms (e.g. desired market share)
and increasingly
social terms (e.g. corporate social responsibility
targets)

Issues in setting objectives
• Do objectives need to be specific and quantified
targets?
• The need to identify core objectives that are crucial
for survival.
• The need for a hierarchy of objectives that cascade
down the organisation and define specific
objectives at each level.

Corporate governance
Corporate governance is concerned with the
structures and systems of control by which
managers are held accountable to those who
have a legitimate stake in an organisation.

The growing importance of
governance
• The separation of ownership and management
control – defining different roles in governance.
• Corporate failures and scandals (e.g. Enron) –
focussing attention on governance issues.
• Increased accountability to wider stakeholder
interests and the need for corporate social
responsibility (e.g. green issues).

The governance chain
Figure 4.2 The chain of corporate governance: typical reporting structures
Source: Adapted from David Pitt-Watson, Hermes Fund Management

The principal-agent model
• Governance can be seen in terms of the
principal agent model
• Principals pay agents to act on their
behalf (e.g. beneficiaries/trustees pay
investment managers to manage funds,
Boards of Directors pay executives to run
a company).
• Agents may act in their own self interest.

Issues in governance (1)
• The key challenge is to align the interests
of agents with those of the principals.
• Misalignment of incentives and control –
e.g. beneficiaries may require long term
growth but executives may be seeking
short term profit.
• Responsibility to whom – should
executives pursue solely shareholder aims
or serve a wider constituency of
stakeholders?

Issues in governance (2)
• Who are the shareholders – should boards respond
to the demands of institutional investment
managers or the needs of the ultimate
beneficiaries?
• The role of institutional investors – should they
actively intervene in strategy?
• Establishing the specific role of the board – in
particular the role of non-executive directors.
• Scrutiny and control – statutory requirements and
voluntary codes to regulate boards.

Different governance systems
Table 4.1 Benefits and disadvantages of governance systems

The role of boards
• Operate ‘independently’ of the
management – the role of non-executives
is crucial.
• Be competent to scrutinise the activities of
managers.
• Have time to do their job properly.
• Behave appropriately given expectations
for trust, role fluidity, collective
responsibility, and performance.

Corporate social responsibility
Corporate social responsibility (CSR) is the
commitment by organisations to ‘behave
ethically and contribute to economic
development while improving the quality
of life of the workforce and their families
as well as the local community and society
at large’.1
1 World Business Council for Sustainable Development.

Corporate social responsibility stances
Table 4.2 Corporate social responsibility stances

Questions of corporate social
responsibility – internal aspects (1)
Table 4.3 Some questions of corporate social responsibility

Questions of corporate social
responsibility – external aspects (2)
Table 4.3 Some questions of corporate social responsibility (Continued)

The ethics of individuals and
managers
Ethical issues have to be faced at the individual
level :
• The responsibility of an individual who believes
that the strategy of the organisation is
unethical – resign, ignore it or take action.
• ‘Whistle-blowing’ - divulging information to
the authorities or media about an organisation if
wrong doing is suspected.

32
External Influences are important
Private sector
“Many of the failures in the last 18 months can be traced back to
poor strategies & business models, which investors had
approved or not challenged”
Hector Sants ,CEO, FSA, Feb09
Public Sector
“One of the worst NHS hospital care scandals – in which up to 1,200
patients died – could happen again, campaigners warned yesterday.
As a full public inquiry opened into the appalling standards of care
at the Mid-Staffordshire NHS Foundation Trust”, Julie Bailey said
“little had changed at the hospital and complaints were still being
routinely ignored.”
Source: http://www.dailymail.co.uk/news/article-1327766/Mid-Staffordshire-NHS-hospital-scandal-left-1-200-dead-happen-again.html#ixzz1bDNTl0QJ

Stakeholders (a reminder)
Organization
Suppliers Customers
Public Authorities
Staff Directors
Stakeholders are – groups of people who are affected by what the company does,
therefore they should be able to influence what the company does.
Investors

Stakeholders of a large organisation
Figure 4.3 Stakeholders of a large organisation
Source: Adapted from R.E. Freeman, Strategic Management: A Stakeholder Approach, Pitman, 1984. Copyright 1984 by R. Edward Freeman.

Stakeholders
Typical stakeholders
• Primary stakeholder - for companies = shareholders?
- Public sector and charities = customers, patients,
students etc
• Secondary stakeholders?
– Management and staff
– Suppliers
– Customers
– Community groups
– Interest groups – direct action (WWF, Greenpeace, Friends of Earth)
These secondary stakeholders usually have –
- no financial stake,
- no rights at corporate AGMs,
- no fiduciary rights over management ,or
- no reporting rights over EA.
Their influence is therefore often indirect

Stakeholder governance matters
therefore reflect
• CG guidance shows that decisions should also include
the interests of these groups? - King III especially
• Companies Act 2006 (Business Review), OECD CG
guide (2004) take into account these issues
• Most companies place profit above stakeholder needs
(Mallin: p56)
– foreign investment ,
– international outsourcing
• Stakeholder mapping – balance of interest versus
power?
• Stakeholder satisfaction

Companies Act 2006
Effective from Oct 1 2007
Aligns UK Law with EU Accounts Modernization Directive (2005)
The Business Review (S417):
• A statement of business in previous financial year
• A fair review of performance in previous financial year & the year end
financial position
• Includes environmental, employment, social & community issues
• Includes discussion of methods & measure of financial & non-financial
performance
• A fair projection of the business’s prospects , including an analysis of key
events (risks) that are likely to affect the company.
• Not a prescriptive checklist – just broad guidelines for
content/process which can be modified to suit company
• But, the EAs should check to see if the review accords with
evidence from the accounts.

Companies Act 2006(Business Review)
The business review must contain—
(a) a fair review of the company’s business, and
(b) a description of the principal risks and uncertainties facing the company.
The review required is a balanced and comprehensive analysis of—
(a) the development and performance of the company’s business during the financial year, and
(b) the position of the company’s business at the end of that year, consistent with the size and
complexity of the business.
In the case of a quoted company the business review must, to the extent necessary for an
understanding of the development, performance or position of the company’s business,
include—
(a) the main trends and factors likely to affect the future development, performance and position
of the company’s business; and
(b) information about— (i) environmental matters (including the impact of the company’s business
on the environment), (ii) the company’s employees, and (iii) social and community issues,
including information about any policies of the company in relation to those matters and the
effectiveness of those policies; and
(c) subject to subsection (11), information about persons with whom the company has contractual
or other arrangements which are essential to the business of the company.
If the review does not contain information of each kind mentioned in paragraphs (b)(i), (ii) and
(iii) and (c), it must state which of those kinds of information it does not contain.
The review must, to the extent necessary for an understanding of the development, performance
or position of the company’s business, include—
(a) analysis using financial key performance indicators, and (b) where appropriate, analysis using
other key performance indicators, including information relating to environmental matters and employee
matters

Stakeholder conflicts of expectations
Table 4.4 Some common conflicts of expectations

Stakeholder mapping
Stakeholder mapping identifies stakeholder
expectations and power and helps in
understanding political priorities.

Stakeholder mapping: the
power/interest matrix
Figure 4.4 Stakeholder mapping: the power/interest matrix
Source: Adapted from A. Mendelow, Proceedings of the Second International Conference on Information Systems, Cambridge, MA, 1986

Stakeholder mapping issues
• Determining purpose and strategy – whose
expectations need to be prioritised?
• Do the actual levels of interest and power
reflect the corporate governance framework?
• Who are the key blockers and facilitators of
strategy?
• Is it desirable to try to reposition certain
stakeholders?
• Can the level of interest or power of key
stakeholders be maintained?
• Will stakeholder positions shift according to the
issue/strategy being considered.

Power
Power is the ability of individuals or groups to
persuade, induce or coerce others into following
certain courses of action.

Sources of power
Table 4.5 Sources and indicators of power

Indicators of power
Table 4.5 Sources and indicators of power (Continued)

Summary (1)
• An important managerial task is to decide how the
organisation should express its strategic purpose
through statements of mission, vision, values or
objectives.
• The purpose of an organisation will be influenced by
the expectations of its stakeholders.
• The influence of some key stakeholders is represented
formally within the governance structure of an
organisation. This can be represented in terms of a
governance chain, showing the links between ultimate
beneficiaries and the managers of an organisation.

Summary (2)
• There are two generic governance structures systems:
the shareholder model and the stakeholder model
though there are variations of these internationally.
• Organisations adopt different stances on corporate
social responsibility depending on how they perceive
their role in society. Individual managers may face
ethical dilemmas relating to the purpose of their
organisation or actions it takes.
• Different stakeholders exercise different influence on
organisational purpose and strategy, dependent on the
extent of their power and interest. Managers can assess
the influence of different stakeholder groups through
stakeholder analysis.

Case - Nonmarket Environment
of Google
• EU law required data holders to store an
individual’s data only as long as necessary
• Google launched a nonmarket campaign to
influence the FCC’s design of the auction
• Google did not use material from a media
source that requested that it not do so, but in
the absence of such a request it used the
material
1-50

of Google
• Google began to supplement its News service
by inviting, individuals and organizations that
had been mentioned in an article to offer
comments attached as a link on the story
page
• The government asked for data on search
queries that it could use to develop filtering
technology to which Google refused and
found itself on the other side of the law
1-51

of Google
• Google assigned a team to develop
Google Health, which proclaimed on
a prototype Web page
• Google also announced an open
source mobile phone platform
called Android that could be used to
develop new wireless services
1-52

of Google
• Google advocated “net neutrality” and
sought laws to require ISPs to treat all
Internet traffic alike
• The company pledged to become
carbon neutral and announced a project
backed by hundreds of millions of
dollars to reduce the cost of renewable
energy by 25–50 percent
1-53

Management & Control
• The main devices or mechanisms that are believed to
ensure that managers run the firm in the interests of the
shareholders and punish badly performing managers
• The effectiveness and importance of these mechanisms
across various corporate governance systems.
– The market for corporate control and hostile takeovers,
– dividend policy,
– the board of directors,
– institutional shareholders,
– shareholder activism,
– managerial compensation,
– managerial ownership,
– monitoring by large shareholders and creditors/banks.

Learning Outcomes
By the end of this lecture, you should be able
to:
1. Assess the importance of various corporate
governance devices across the main systems of
corporate governance
2. Judge the efficiency of the various devices in
terms of preventing bad performance by the
management and/or disciplining bad managers
3. Critically evaluate the empirical research on the
importance and effectiveness of corporate
governance devices
4. Identify the gaps in the existing literature.

• Corporate governance devices or
mechanisms are arrangements that mitigate
conflicts of interests corporations may face.
• These conflicts of interests are those that
may arise between
– the providers of finance and managers,
– the shareholders and the stakeholders, and
– different types of shareholders (mainly the large
shareholder and the minority shareholders).
Introduction

• Particular corporate governance mechanisms
are more likely to prevail in one corporate
governance system than in others.
• The reason is that the prevalence of the
above conflicts of interests is also likely to
vary across systems.
• Hence, in order to study the effectiveness of
the various corporate governance devices,
one needs to adopt one of the taxonomies of
corporate governance systems.
Introduction (Continued)

• We adopt the taxonomy by Julian Franks
and Colin Mayer which distinguishes
between insider and outsider systems.
• We adopt this taxonomy for two reasons
1. It does not advocate the superiority of
one system
2. It provides a broad, yet convenient
framework to analyse the various
corporate governance devices.
Introduction (Continued)

Product Market Competition
• Competitionin product and service
markets may reduce managerial slack across all
corporate governance systems.
• For example, a French manufacturer of
household appliances operates in the same
global market as manufacturers from other
countries.
• If the French manufacturer suffers from weak
corporate governance, it may ultimately be
driven out of the market.

Product Market Competition
(Continued)
• Benjamin Hermalin has developed a
theoretical model about the effects of
competition on managerial (agent)
performance.
• He argues that competition has four distinct
effects on managerial performance
– the income effect,
– the risk-adjustment effect,
– the change-in-information effect, and
– the effect on the value of managerial actions.

• The income consists of the following
–expected income decreases with increased
competition,
–but it also puts pressure on managers to
perform better by e.g. reducing their perks
as well as other costs.
• The risk-adjustment effect concerns the
fact that competition changes the
riskiness of the various actions
managers can take.
Product Market Competition (Continued)

• The change-in-information effect consists of the
following
– Competition makes it easier for the principal to judge
the agent’s actions as there is now a (larger) peer
group of other companies
– Competition also has an effect on managerial actions
by reducing the riskiness of both easy and hard
actions
– However, the decrease in riskiness may not
necessarily be uniform across both easy and hard
actions
– Hence, it is not clear whether managers will switch
from easy to hard actions or the converse.

• Increased competition also changes the relative
value of managerial actions
– By reducing the price cap, competition reduces the
agent’s expected income and hence his incentives to
work hard
– However, it also increases the value attached to cost
saving actions by the agent, making the latter work
harder.
• A priori, all of the above four effects have
ambiguous signs.
• Hermalin shows that under certain conditions the
positive income effect will dominate and
competition will increase managerial
performance.

• However, generally it is still not clear whether
increased competition increases or decreases
managerial performance.
• While empirical evidence on the effect of
competition is still sparse, the studies that exist
suggest that
– competition forces managers to work harder,
and
– it may even be a substitutefor good corporate
governance.

Incentivising and Disciplining
Managers in the Insider and Outsider
Systems
• The main mechanisms that are thought to
keep managers in check in the outsider system
are
– the market for corporate control,
– dividend policy,
– the board of directors,
– institutional shareholders,
– shareholder activism,
– managerial remuneration, and
– managerial ownership.

Incentivising and Disciplining
Managers in the Insider and Outsider
Systems (Continued)
• In the insider system, they are
– monitoring by large shareholders, and
– monitoring by banks and other large creditors.

The Market for Corporate Control
• The disciplinary role of the market
for takeovers was first proposed by
Henry Manne.
• Badly performing firms see their
share price drop.
• They then become easy targets for
hostile raiders intend on changing
the management, thereby creating
firm value.
• However, the empirical evidence
does not support Manne’s
argument.

The Market for Corporate Control
(Continued)
• A US study by William Schwert
and a UK study by Julian Franks
and Colin Mayer investigate the
pre-acquisition performance of
targets of hostile takeovers and
targets of friendly takeovers.
• Hostility is defined as the target
management’s attitude toward
the proposed takeover bid.
• Neither the US nor the UK study
finds any difference in the pre-
acquisition performance of both
types of targets.

• However, the mere threat of
a hostile takeover may be
enough to ensure that
managers do not shirk.
• Still, hostile takeovers are an
extreme and expensive
mechanism to correct
managerial failure.
• They also tend to be very
rare outside the UK
and the USA.
The Market for Corporate Control (Continued)

Dividends and Dividend Policy
• Frank Easterbrook and Michael Rozeff were
the first to formalise the corporate
governance role of dividends.
• In Rozeff’s model, dividends reduce agency
costs by reducing the free cash flow.
• However, they also increase transaction costs
as higher dividends increase the need for
costly external financing.
• Hence, there is an optimal dividend payout
which minimises the sum of both costs.

Dividends and Dividend Policy
(Continued)
• Easterbrook also argues that by committing to
high dividends the free cash flow is kept to a
minimum and wastage by the managers is
reduced.
• In addition, the firm has to raise regularly
outside finance.
• Each time it does so it subjects itself to the
scrutiny of outsiders.
• If the managers have been performing badly,
then outside finance is unlikely to be made
available.

• For dividends to be able to fulfil their
disciplinary role, they need to be sticky.
• Managers will need to carry on paying
dividends even if profits are down
temporarily.
• The role of dividends is likely to be more
important in the outsider system given the
lack of shareholder monitoring.
Dividends and Dividend Policy (Continued)

• Marc Goergen, Luc Renneboog and Luis Correia
da Silva study the flexibility of German dividends
compared to UK and US dividends.
• They find that, when profits are down
temporarily, German firms are much more
willing to cut or omit their dividends than UK
and US firms.
• German firms controlled by banks are even
more willing to cut or omit their dividends.
• They conclude that large shareholder
monitoring acts as a substitute for
dividends.
Dividends and Dividend Policy (Continued)

Boards of Directors
• UK and US firms as well as firms from most
other countries have a single-tier board where
both executive and non-executive directors sit.
• A few countries, such as Germany and China,
have two separate boards, the so called two-tier
board.
• The two-tier board consists of
– the supervisory board where the non-executives (as
well as maybe employee representatives) sit, and
– the management board where the executives sit.

Boards of Directors (Continued)
• There is an ongoing debate about whether a
single- or two-tier board is better.
• Some argue that having two boards ensures
the independence of the non-executives
from the executives.
• Others argue that having two boards
prevents the non-executives from being
effective monitors due to a lack of
information.

• Is there a link between board structure and
financial performance?
• Do boards fire executives in the wake of poor
performance?
• What factors determine board changes?
• Should the roles of the chairman and the CEO
be separated?
Boards of Directors (Continued)

Is There a Link between Board
Structure and Financial Performance?
• The proportion of non-executives is normally
used as a measure of board independence.
• Boards that are dominated by non-executives
are likely to be more independent from the
management.
• However, there is little evidence in support of
a positive link between firm performance and
board independence.
• However, board composition may not be
exogenous, i.e. it may not be randomly
determined.

Is There a Link between Board Structure
and Financial Performance? (Continued)
• For example, board composition may be
determined by past performance.
• If poor performance causes an increase in the
number of non-executives, then this would
explain why no link has been found between
firm performance and board independence.
• In contrast, there is conclusive evidence that
large boards are bad for firm performance.
• There is also evidence that interlocked
directorships cause collusion.

Do Boards Fire Executive Directors in
the Wake of Poor Performance?
• There is consistent evidence of an increase in
CEO and board turnover in the wake of poor
performance.
• There is such evidence for both corporate
governance systems
– the outsider system of the UK and the USA, as well as
– the insider system of Germany and Japan.
• However, board dismissals cannot be equated
to good corporate governance.
• Managerial dismissals also only occur in cases
of extremely poor performance.

What Factors Determine Board Changes?
• Benjamin Hermalin and Michael Weisbach
find that
– inside directors are more likely to be replaced by
outside directors in poorly performing
companies;
– inside directors normally replace retiring CEOs;
– when the CEO is replaced by an outsider, some
inside directors – possibly the losers in the
contest to the succession – leave the firm; and
– firms leaving their product market replace their
inside directors with outside directors.

What Factors Determine Board
Changes? (Continued)
• Steven Kaplan and Bernadette Minton find that
banks appoint representatives to the boards of
poorly performing Japanese firms that are part
of keiretsus.

Should the Roles of the Chairman
and CEO Be Separated?
• There has been an ongoing debate as to
whether the roles of the chairman and the CEO
should be separated or whether duality is
preferable.
• Proponents of duality base themselves on the
following three arguments
1. Duality ensures that there is strong leadership
2. Splitting the two roles may create tensions
between the CEO and chairman
3. Having a separate CEO and chairman makes it
difficult to designate a single spokesperson for
the company.

Should the Roles of the Chairman
and CEO Be Separated? (Continued)
• Those opposed to duality argue that
1. Combining the two roles reduces board
independence and increase CEO entrenchment
2. It combines the role of monitoring the
executives and leading the executives in a single
person.
• In the USA, minds are still split as to whether
duality is good or bad.
• The empirical evidence on US firms is also as
yet inconclusive.

• In contrast, in the UK successive codes of best
practice in corporate governance have
recommended the separation of the two
roles.
• In contrast to US evidence which is
inconclusive, evidence from UK firms seems to
suggest that duality has no effect on
performance.
Should the Roles of the Chairman and
CEO Be Separated? (Continued)

Institutional Investors
• Institutional investors are the most
important types of shareholders in
the UK and the USA as well as a few
other countries (e.g. the
Netherlands).
• However, the jury is still out as to
whether institutional investors
monitor the management of their
investee firms.

• Some studies find positive effects of
institutional investors
– They have a positive effect on firm value
– They increase the performance sensitivity of
managerial pay
– They reduce the levels of managerial pay.
Institutional Investors (Continued)

• Other studies find negative effects of
institutional investors
– They reduce firm value
– They have short-term horizons
– They increase the likelihood and severity of
financial misreporting.

• In the UK, successive codes of best practice in
corporate governance have urged institutional
investors to become more active.
• The 2001 Myners Report states that
– institutional investors “remain unnecessarily
reluctant to take an activist stance in relation to
corporate underperformance, even where this
would be in their clients’ financial interests”.
• A number of UK studies suggest that
institutional investors are mostly passive and
prefer exit over voice.

• Jana Fidrmuc, Marc Goergen and Luc
Renneboog study the price reaction to
insider trades in UK firms
• They expect that monitoring reduces
the information conveyed by insider
trades.
• They find that the price reaction
– is highest for firms dominated by
institutional investors, and
– lowest for firms dominated by families
and other firms.
• They interpret this as evidence that
institutional investors are passive.

• However, evidence from case study
research by Marco Becht and others
suggests that institutional investors
act behind the scenes.
• Still, from an agency perspective it is
not clear why institutional investors
should be the panacea to all
corporate governance issues.

Shareholder Activism
• Shareholders may prefer to act behind the
scenes to address poor managerial
performance in their investee firms.
• However, they may use so called proxy
contests as a means of last resort if
management remains unresponsive.
• Proxy contests consist of soliciting the
support of other shareholders, via their
votes, to bring about change.

Shareholder Activism (Continued)
• While shareholder-initiated proxy voting is
frequent in the USA and on the increase in
the UK, it is relatively rare in Continental
Europe.
• Whereas proxy contests are relatively
successful in the USA, they are less
successful in the UK and Continental Europe.
• Nevertheless, managers of US firms are not
legally bound to implement shareholder
proposals whereas they have to in the UK
and most of Continental Europe.

• The stock market reaction to proxy contests is
also different between the USA and the UK-
Continental Europe
– In the USA, the stock price reaction is normally
positive
– In the UK and Continental Europe, it is negative
suggesting that the market interprets proxy
contests as a signal of shareholder discontent
rather than positive change.
Shareholder Activism (Continued)

Managerial Compensation
• One possible way of aligning the interests of
the managers with those of the shareholders
is managerial compensation.
• By making managerial compensation
sensitive to firm performance, managers
should have the right incentives
to maximise shareholder
value.

Managerial Compensation (Continued)
• Managerial compensation may consist of
various components including
– the base (or cash) compensation,
– long-term incentive plans (LTIPs) such as stock
options and restricted stock grants,
– benefits, and
– perquisites.

Figure 1 – Level and composition of CEO pay for 2005
$ 0
$ 200
$ 400
$ 600
$ 800
$ 1,000
$ 1,200
$ 1,400
$ 1,600
$ 1,800
$ 2,000
$ 2,200
CEOPay(US$000s)
Argentina
Australia
Belgium
Brazil
Canada
China(HongKong)
China(Shanghai)
France
Germany
India
Italy
Japan
Malaysia
Mexico
Netherlands
Poland
Singapore
SouthAfrica
SouthKorea
Spain
Sweden
Switzerland
Taiwan
UnitedKingdom
UnitedStates
Venezuela
2005 CEO Pay Mix: International Comparison
Salary Bonus Option/LTIPs Other
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012

Is Managerial Compensation
Sensitive to Firm Performance
• Pay sensitivity to performance has been
documented for a range of countries, including
the USA, the UK and Germany.
• However, other factors have also been shown
to have an effect
– firm size, and
– ownership and control.

Is Managerial Compensation Sensitive
to Firm Performance (Continued)
• An important factor influencing managerial pay
is firm size.
• This suggests that executive directors benefit
from empire building via increased salaries.
• The empirical evidence suggests that this is a
concern
– Firms where managerial compensation is sensitive to
firm size are more likely to conduct acquisitions
– Managers experience a net increase in their
compensation despite the drop in post-acquisition
stock performance and sales

– Managerial compensation increases in
line with good post-acquisition
performance, but is insensitive to
bad performance
– In contrast, changes in compensation
after large capital expenditures are
much smaller and also more sensitive to
poor performance
– Managers seem to use the higher
information asymmetry surrounding
acquisitions to boost their
compensation.
Is Managerial Compensation Sensitive to
Firm Performance (Continued)

• Another factor influencing managerial
pay is ownership and control
–Widely held firms have been reported to
have higher managerial compensation
than firms with large shareholders
–This suggests that large shareholder
monitoring is a substitute for managerial
incentivising via compensation packages.

• Some argue that
– managerial compensation is unlikely to address
corporate governance issues, and
– it is a corporate governance issue in itself as
directors of firms with poor governance are able to
set their own, excessive pay.
• Managerial pay has also been shown to be
asymmetric as
– it increases with good luck,
– but not with bad luck.

Lucian Bebchuk and Jesse Fried go one step
further.
• They argue that managers are entirely self-
serving and they maximise their pay
subject to a public outrage constraint.

How Should One Design Managerial
Compensation Contracts?
• There is an extensive theoretical and empirical
literature on the design of managerial
compensation.
• Both stock ownership and stock options have
their advantages and drawbacks.
• Stock ownership seems to make managers even
more risk averse given its downside.
• Stock options address this issue as they have a
limited downside.
• However, they also seem to exacerbate conflicts
of interests between managers and
shareholders.

Managerial Ownership
• The principal–agent problem stems from
the separation of ownership and control.
• One way of mitigating this problem is to
give managers shares in their firm.
• However, managerial ownership may also
entrench managers.
• Hence, there may be two sides to
managerial ownership.

Managerial Ownership
(Continued)
• Two types of studies analyse the link
between performance and managerial
ownership
– Those that assume ownership to
be exogenous, i.e. determined
outside the system
– Those that assume ownership to
be endogenous, i.e. ownership
may depend on firm
characteristics such as past
performance.

Studies Assuming Managerial
Ownership to be Exogenous
• Morck, Shleifer and Vishny allow for a non-linear
relationship between managerial ownership and
firm value for the USA.
• They find evidence of such a non-linear
relationship
– Firm value rises with ownership in the 0–5% region
– It then decreases in the 5–25% region to reach its
minimum value
– It then increases again above 25% ownership, but at
a decreasing rate.

Ownership to be Exogenous (Continued)
• There are three criticisms of this
study
–It has low explanatory power
–Being a US study, there is low cross-
sectional variation of ownership
–The study ignores non-managerial
ownership.

Ownership to be Exogenous (Continued)
• Karen Wruck looks at 128 US firms with large
changes of ownership.
• She includes non-managerial ownership.
• She replicates the Morck et al. model
– She finds the same effects for the 0–5% and 5–
25% ranges
– However, she only finds a positive effect in
the 25–100% range when she considers total
ownership.

Studies Assuming Managerial Ownership
to be Exogenous (Continued)
• John McConnell and Henri Servaes clearly
distinguish between managerial and non-
managerial ownership.
• They find a curvilinear link between firm value
and managerial ownership.
• Firm value reaches its maximum in the
40–50% ownership range.
• They also find a positive linear link between
firm value and institutional ownership.

to be Exogenous (Continued)
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8
MSV
McC&S
Wruck
Managerial ownership
Firm value

to be Endogenous (Continued)
• These studies allow for
current managerial
ownership to depend on past
firm characteristics, including
firm performance.
• These studies do not tend to
find a link between
managerial ownership and
firm value.

• Stacey Kole argues that if ownership
influences firm value, there should be
corrective transfers.
• She uses the same sample as Morck et al.
• She finds the same effects for the 0–5% and
5–25% ranges, but no effect above 25%.
• She then regresses performance for each of
the years 1977–85 on 1980 ownership.
• She finds a link for the years 1977–80, but no
link for the years 1981–85.

• She concludes that there should be a reversal
of causality as past performance seems to
have an effect on current managerial
ownership.

• In addition to managerial ownership, Anup
Agrawal and Charles Knoeber look at the
following six governance mechanisms
– institutional ownership,
– large shareholder monitoring,
–non-executives directors,
– the managerial labour market,
– the market for corporate control, and
– monitoring by debtholders.
• They employ a whole battery of econometric
techniques.

• The only persistent effect they find is a negative
effect of non-executives on firm value.
• They explain this negative effect by the fact that
non-executives frequently represent interest
groups other than the shareholders with
objectives other than shareholder value
maximisation.
• Charles Himmelberg, Glenn Hubbard and Darius
Palia allow for both ownership and firm
performance to be endogenous.
• They do not find that current performance
depends on past ownership either.

Large Shareholder Monitoring
• Do large shareholders enhance firm value?
• Some theoretical research suggests that large
shareholders create value via their monitoring
which overcomes the free-rider problem.
• Generally, there is little empirical evidence that
large shareholders create value.
• Nevertheless, there is some evidence from the
USA and Germany that family control
creates value.
• However, this only seems to be the case when
the founder is the CEO or chairman.

Large Shareholder Monitoring
(Continued)
• In contrast, when one of the founder’s
descendents acts as the CEO there is
normally value destruction.
• Finally, evidence on East Asian countries
by Faccio et al. suggests that families
expropriate the minority
shareholders by paying out
dividends that are too low.
• Other theoretical papers argue that
large shareholders may overmonitor the
management.

Bank and Creditor Monitoring
• Debt on its own may be a powerful
disciplinary mechanism.
• As debt commits part of the firm’s cash
flows to its servicing, it reduces managerial
discretion and wastage.
• Firms with a large creditor may also benefit
from the monitoring by the latter.

Bank and Creditor Monitoring
(Continued)
• As the German system has been
traditionally qualified as being bank
based, there is a body studying the
effects of German banks on firm
performance.
• However, the evidence is as yet
inconclusive as to the effect of bank
ownership and board representation
on firm performance.

Conclusions
• The relative importance of
corporate governance mechanisms
varies across the insider and
outsider system.
• The effectiveness of the various
corporate governance
mechanisms.
• The likely endogeneity of corporate
governance mechanisms.
• The interdependence of corporate
governance mechanisms.

The Role of Boards in
Corporate Governance
• What is the role of Boards of directors in
corporate governance, mainly from a UK
perspective, with reference to the academic
literature.

Learning Outcomes
By the end of this lecture, you should be able to:
• explain the main initiatives introduced in the UK to
improve the effectiveness of boards of directors;
• evaluate the impact of these initiatives on board
function;
• discuss the findings of academic research relating to
the effectiveness of boards as a corporate
governance mechanism.

Corporate Governance: A Practical Guide
An 'effective board' should have:
• clear strategy aligned to capabilities
• vigorous implementation of strategy
• key performance drivers monitored
• effective risk management
• sharp focus on views of City and other key
stakeholders
• regular evaluation of board performance.

The Fish Rots from the Head
(Garratt, 1996)
• Said boards spent too much
time ‘managing’
• Not enough time ‘directing’
• Should be 'learning boards'

Unitary and Two-tier Board
Structures
Unitary boards (UK, US)
• executive and non-executive directors
• make decisions as a unified group
Two-tier boards (Germany, Taiwan)
• 2 separate boards
• management board
• supervisory board

Two-Tier Board
Management board
• only executives
• focuses on operational issues
• headed by chief executive
Supervisory board
• only non-executive directors
• deals with other strategic decisions
• oversees the management board
• chairman sits as a non-executive
• often a vehicle for stakeholder inclusion

One-Tier model
UK & USA
• We examine 3 mechanisms for improving
corporate governance in boards
• Splitting chairman/chief executive position
• Improve effectiveness of NEDs
• Curb excessive executive remuneration

Splitting the Role of Chairman and
Chief Executive: one-tier boards
Chairman
• pivotal role in helping the board to achieve
its potential
• responsible for leading the board
• responsible for setting the board agenda
• responsible for ensuring board effectiveness
• 'conductor of an orchestra'

Chief Executive
• determines
corporate
strategy
• manages day
to day running
of business

Cadbury Report emphasised:
• No individual could gain ‘unfettered’ control
of the decision-making process
• Should be a clear division of responsibility at
the top of the company, ensuring balance of
power
• 90% UK listed companies split roles after
Cadbury

Higgs Report (2003)
re-emphasized split roles:
• "The roles of chairman and chief executive
should not be exercised by the same
individual"
• The essence of these recommendations,
among others made by Higgs, was
incorporated in the Combined Code in July
2003.

Research into Split Roles
• Donaldson and Davies (1994)
• Splitting roles can reduce agency problems
and result in improved corporate
performance because of more independent
decision making
• Peel and O'Donnell (1995)
• Found that splitting roles led to significantly
higher financial performance

Split Roles in the US
• US has been slower to take up split roles
• But things are changing
• CEO wields excessive power
• US boards are excessively large
• "American companies should adopt the common
European practice of separating the jobs of
chairman and chief executive, entrenching a check
at the heart of their corporate governance systems.
" (The Economist, 28 November 2002)

The Role of Non-executive Directors
(NEDs)
• Collapse of Enron focused attention on NEDs
• Tyson Report specified NED role:
• provide advice and direction to company management
in developing and evaluating strategy
• Monitor company management in strategy
implementation and performance
• monitor company's legal and ethical performance
• Monitor veracity and adequacy of financial/ other
company information provided to investors and other
stakeholders
• assume responsibility for appointing, evaluating and,
where necessary, removing senior management
• planning succession for top management positions.

Byrd and Hickman (1992, p.196)
• "The inside directors provide valuable
information about the firm’s activities, while
outside directors may contribute both
expertise and objectivity in evaluating the
managers’ decisions. The corporate board,
with its mix of expertise, independence, and
legal power, is a potentially powerful
governance mechanism“

Higgs Report emphasized NEDs
must have:
• integrity
• high ethical standards
• sound judgement
• ability and willingness to
challenge issues
• strong interpersonal skills
• "no crooks, no cronies,
no cowards"!

Non Executive Directors
Spira and Bender (2004)
• discussed tension between the strategic and
monitoring roles of NEDs
Cadbury Report recommended:
• minimum of 3 NEDs
• majority NEDs should be independent

Higgs Report 20 January 2003 based
on 3 pieces of research:
• data on the size, composition and
membership of boards and committees in the
2,200 UK listed companies, as well as the age
and gender of their directors
• survey of 605 executive directors, non-
executive directors and chairmen of UK listed
companies conducted by MORI
• interviews of 40 directors in top UK listed
companies carried out by academics in the
field

Recommendations: NED
• NEDs should comprise at least half board
• One NED should take direct responsibility for
shareholder concerns (SID)
• Strong reaction from business community:
• "This could lead to multiple splits in the board
which every man and wife could come along and
exploit. And that would be a madhouse"

The Tyson Report: Widening the
'Gene Pool'
• NEDs criticized as "Pale, stale and male"
• Higgs also suggested NEDs should come from more
diverse backgrounds
Tyson Report explored greater diversity:
• background
• skills
• experience of members
• race
• gender
• nationality
• age

Milliken and Martins (1996)
• Emphasized the importance of board diversity
to effectiveness and financial performance
• Widening boardroom diversity also helps
companies engender trust among their
stakeholders

Some organisations providing
broader source of NEDs
• Association of Executive Search Consultants
• Charity and Fundraising Appointments
• High Tech Women
• City Women's Network.

NEDs and the Credit Crunch
• Deficiencies in NEDs role within financial institutions
contributed to current global financial crisis
• FT article during financial crisis said companies
need to:
• improve the qualifications and on-going training for
NEDs
• pay more attention to the relevant experience and
competence when recruiting NEDs
• Increase the time commitment given by NEDs

Executive Remuneration
• ‘Fat cats’
• Higgs Report
• Company chairmen in FTSE 100 companies
were earning £426,000 per annum on
average
• This was in 2003!

ACCA, 2008, Principles 6
• "Remuneration arrangements should be
aligned with individual performance in such a
way as to promote organizational
performance. Inappropriate arrangements,
however, can promote perverse
incentives that do not properly serve the
organisation's shareholders or other principal
stakeholders"

Greenbury Report 1995
Recommended remuneration committees to:
• "determine pay packages needed to attract, retain
and motivate directors of the quality required but
should avoid paying more than is necessary for
this purpose“
Core, Holthausen and Larcker (1999)
• Found links between excessive executive
remuneration, ‘bad’ corporate governance and
poor corporate performance

Pay and Performance
Thompson (2005)
• found various initiatives
to make executive
remuneration more
transparent had not had
much impact on the
relationship between
executive pay and
performance

Voting on Directors’
Remuneration
• October 2001 the UK Government
announced proposals to produce an
annual directors’ remuneration
report that would be approved by
shareholders
• No need to legislate as investors
have acted in this area

Bonuses and the Financial Crisis
January 2009
• French President, Nicolas Sarkozy, insisted on
bonuses and dividends being reduced for
executives in French banks
• BNP Paribas, France's largest bank, chairman
and chief executive forwent their 2008
bonuses voluntarily, in response to public
dissatisfaction

UK Shareholders, Remuneration
and the Global Financial Crisis
• Grave concerns about excessive remuneration
packages
• Institutional investor representative bodies
• (ABI) (NAPF) caution companies against paying out
large bonuses to senior executives
• UK institutional shareholders voted against
remuneration policies
• Currently discussion on taxing bank directors’
bonuses when peoples’ taxes are paying off the
banks’ debts!

RECIPE FOR A GOOD BOARD
• The board should meet frequently
• The board should maintain a good balance of power
• An individual should not be allowed to dominate board
meetings and decision making
• Members of the board should be open to other members’
suggestions
• There should be a high level of trust between board
members
• Board members should be ethical and have a high level of
integrity
• There must be a high level of effective communication
between members of the board
• The board should be responsible for the financial statements
• Non-executive directors should (generally) provide an
independent viewpoint

Good Board …
• The board should be open to new ideas and strategies
• Board members should not be opposed to change
• The board must possess an in-depth understanding of the
company’s business
• The board must be dynamic in nature
• The board must understand the inherent risks of the business
• The board must be prepared to take calculated risks: no risk
no return
• The board must communicate with shareholders, be aware
of shareholder needs and translate them into management
strategy
• The board must be aware of stakeholder issues and be
prepared to engage actively with their stakeholders
• As education becomes increasingly important, board
members should not be averse to attending training courses

Ethical Health of Boards
ACCA, 2008, Principle 2
• "Boards should set the right tone and
behave accordingly, paying particular
attention to ensuring the continuing
ethical health of their organizations.
Directors should regard one of their
responsibilities as being guardians of
the corporate conscience … Boards
should ensure they have appropriate
procedures for monitoring their
organisation's 'ethical health‘”

Next Casestudy 3 : Premier Oil
1. Read and prepare the Casestudy on
Premier Oil (Monks & Minow (2011)) for
discussion next class. Identify the
corporate governance issues faced.
2. You are required to:
– Analyse the scenario’s in the
case study and plot the resulting
risk analysis on an appropriate
risk map.
– Map out the stakeholder
power/interest issues, and
propose the appropriate
corporate actions.

Core Readings
• Solomon, Jill (2010) Corporate Governance and
Accountability 3rd Edition, Wiley, UK. Ch.4-5
• Goergen, Marc (2012) International Corporate
Governance, Pearson. Ch.5, 9-10
• Larker & Tayan (2011) Ch.3-5,12
• Monks & Minow (2011) Ch.2 & 3
• Johnson, Scholes & Whittington(2008) Ch.4
• CIMA - Performance Strategy: Study Text (2012) BPP
Learning Media Ltd. Part B : 5-6
• Boddy(2005) Management: An introduction, 3rd
Edition, Pearson

Additional Readings (1)
• Byrd, J. W. and Hickman, K. A. (1992) ‘Do outside directors monitor
managers?’, Journal of Financial Economics, 32, 195–221.
• Donaldson, L. and Davies, J. H. (1994) ‘Boards and company
performance—Research challenges the conventional wisdom’,
Corporate Governance: An International Review, 2(3), July, 151–160.
• Peel, M. and O’Donnell, E. (1995) ‘Board structure, corporate
performance and auditor independence’, Corporate Governance: An
International Review, 3(4), October, 207–217.
• Milliken, F. J. and L. L. Martins (1996) "Searching for Common
Threads: Understanding the Multiple Effects of Diversity in
Organisational Groups", Academy of Management Review, 21,
pp.402-433.
• Core, J. E., Holthausen, R. W. and Larcker, D. F. (1999) ‘Corporate
governance, chief executive officer compensation, and firm
performance’, Journal of Financial Economics, 51, 371–406.
• Thompson, S. (2005) "The Impact of Corporate Governance
Reforms on the Remuneration of Executives in the UK", Corporate
Governance: An International Review, Vol.13, No.1, January, pp.19-
25.

Additional Readings (2)
• Berle, A. and Means, G. (1932) The Modern Corporation and Private Property, New York.
• Monks, R. A. G. (1994) ‘Tomorrow’s corporation’, Corporate Governance: An International Review, 2(3),
July, 125–130.
• Nesbitt, S. L. (1994) ‘Long-term rewards from shareholder activism: A study of the “CalPERS effect”’,
Journal of Applied Corporate Finance, 6, 75–80.
• Stapledon, G. P. (1995) ‘Exercise of voting rights by institutional shareholders in the UK’, Corporate
Governance: An International Review, 3(3), 144–155.
• Stapledon, G. P. (1996) Institutional Shareholders and Corporate Governance, Clarendon Press, Oxford.
• Smith, M. P. (1996) ‘Shareholder activism by institutional investors: Evidence from CalPERS’, Journal of
Finance, 51(1), March, 227–252.
• Agrawal, A. and Knoeber, C. R. (1996) ‘Firm performance and mechanisms to control agency problems
between managers and shareholders’, Journal of Financial and Quantitative Analysis, 31(3), September,
377–397.
• Mallin, C. A. (1996) ‘The Voting Framework: A Comparative Study of Voting Behaviour of Institutional
Investors in the US and the UK’, Corporate Governance: An International Review, 4(2), April, 107–122.
• Solomon, A. and Solomon, J. F. (1999) ‘Empirical evidence of long-termism and shareholder activism in
UK unit trusts’, Corporate Governance: An International Review, 7(3), July, 288–300.
• Faccio, M. and Lasfer, M. A. (2000) ‘Do occupational pension funds monitor companies in which they hold
large stakes?’, Journal of Corporate Finance, 6, 71–110.
• Solomon, J. F., Solomon, A., Joseph, N. L. and Norton, S. D. (2000) ‘Institutional investors’ views on
corporate governance reform: Policy recommendations for the 21st century’, Corporate Governance: An
International Review, 8(3), July, 217–226.
• Mallin, C. A. (2001) ‘Institutional investors and voting practices: An international comparison’, Corporate
Governance: An International Review, 9(2), April, 118–126.
• Myners (2001) Institutional Investment in the United Kingdom: A Review (The Myners Report), London.
• MacKenzie, C. (2004) "Don't Stop Rattling Those Boardroom Chains: Corporate Activists Are Key to
Maintaining Shareholder Returns", Financial Times, 10th May, p.6.
• National Association of Pension Funds (NAPF) (2005) Pension Scheme Governance - Fit for the 21st
Century, NAPF Discussion Paper, July.

Next Week’s Ideas for Discussion
• Foo Nin Ho, Wang Hui-Ming Deanna and
Vitell, Scott J.(2012) A Global Analysis of
Corporate Social Performance: The Effects
of Cultural and Geographic Environments,
Journal of Business Ethics, 2012:107:
pp.423–433

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