Corporate Governance Systems in the United States Limited liability public corporation Diffuse ownership of voting equity shares Large number of individual share owners Internal Control Mechanisms Role of the Board of Directors Ownership Concentration Executive Compensation Alternative Governance Systems

1. Corporate Governance and
Performance

2. Corporate Governance
Systems in the United States
• Diffuse stock ownership
– Limited liability public corporation
– Diffuse ownership of voting equity shares
– Large number of individual share owners

3. • Requires little direct monitoring of
individual firms by investors
– Limited liability of investors
– Diversification allows investors to ignore
idiosyncratic risks of individual companies
– Equity ownership shares actively traded
• Commercial banks and insurance
companies limited in their ability to hold
large equity positions in individual
companies

4. • Contractual theory of the firm
– Firm as network of actual and implicit
contracts
• Contracts specify roles of stakeholders and
define their rights, obligations, and payoffs
• Potential conflicts
– Contracts unable to envisage many changes in
conditions that develop
– Participants may have personal goals
– Separation of ownership and control
• Operations of firm are conducted and controlled
by managers without major stock ownerships
• Conflicts of interest arise between owners and
managers

5. • Agency problem — divergence of interests
between owners (the principal) and
management (their agent)
• Fractional firm ownership by managers can
lead managers to work less and to consume
excessive perquisites
• Additional monitoring expenditures (agency
costs) are required
– Auditing systems
– Bonding assurances
– Organization systems

6. • Divergent interests of stakeholders
– Business firms must recognize wide range
of expectations of diverse stakeholders
– Business firms must recognize external
influences — job safety, product safety,
environmental impacts
– Business firms must recognize wide range
of stakeholders and external influences to
achieve long-run value maximization

7. Internal Control Mechanisms
• Shareholders elect board of directors to
represent their interests
• Problems of how all stakeholders can
obtain representation of their views and
interests have not been resolved
• Public expectations look to board of
directors to balance interests of all
stakeholders

8. Role of the Board of Directors
• Views of role of monitoring board
– In theory, monitoring by board of directors
can deal with problems of corporate
governance
– Boards have been ineffective
• Board fails to recognize problems of firm
• Board does not stand up to top officers
• External control devices such as hostile
takeovers have multiplied because of failure of
boards

9. • Composition of the board
– Role of outside directors
• One view: Outside directors — directors who
neither work for the corporation nor have
extensive dealings with company
• Another view: Outside directors play larger role in
monitoring management than inside directors
• Outside directors enhance viability of board in
achieving low-cost internal transfers of control
• Lower probability of collusion with top management

10. • It is proved that inside and outside directors
behave differently in monitoring top
management
• Outsider-dominated boards more likely to
remove CEO
• Replacement of CEO
– Statistically significant inverse relation between firm's
market-adjusted share performance in a year and
likelihood of subsequent change in CEO
– For outsider-dominated boards, responsiveness of
removal decision to stock market performance is
three times larger than for other board types
– Replacement decision takes place relatively quickly

11. • Compensation of board members
– Well-structured compensation systems may
motivate directors
• Director stock ownership better aligns director
interests with stockholders
– Stock ownership requirements for directors and/or
payment of part or all of directors' annual retainer in
stock and stock options
– Finance directors' retirements with stock
• Studies find directors of top-performing
companies hold greater number of shares than
do counterparts at poor-performing firms
– Critics argue that compensation should not
be motivating factor

12. • Evaluating a board of directors
– Evaluate CEO performance annually
– Link CEO pay to clear performance criteria
– Review and evaluate strategic and operating plans
– Require significant stock ownership and
compensate directors in stock
– No more than three insiders
– Require election each year and mandatory
retirement at 70

13. – Key committees should be composed of outside
directors
– Limits on number of boards and ban on interlocking
directorships
– Disqualify (from board) anyone receiving fees from
company
• Some pension funds and mutual funds judge
boards by stock market performance of their
companies — a "blinkered view"

14. Ownership Concentration
• Equity ownership by managers must
balance
– Convergence or alignment of interests
– Entrenchment considerations —
managerial ownership and control of voting
rights may allow pursuit of self-interest

15. • Performance related to management or insider
ownership percentages
– Ownership concentration increased from 0 to 5%
• Performance improved
• Alignment-of-interest effect
• Direction of causality may be reversed — high
performance firms more likely to give managers
stock bonuses
• High performance firms may have substantial
intangible assets that require greater ownership
concentrations to induce proper use of these
assets

16. – Ownership concentration in range 5% to 25%
• Performance deteriorated
• Management entrenchment dampens
performance
– Ownership concentration above 25%
• Performance improved but slowly
• Incremental entrenchment effects attenuated

17. • Economic variables influence ownership-
performance relationship
– Relative growth rates of industries
– Differences in demand-supply relationships among
industries
– Relative value change patterns among industries and
firms within them
– Stock price movements

18. • Managerial ownership and bond returns
- No relation between bond returns and
managerial ownership below 5%
– Positive relation for managerial ownership
between 5% and 25%
• Increased incentives for managers to act in
shareholders' interest, taking risks that are
potentially harmful to bondholders
• Rational bondholders required higher returns

19. – Weak negative relation for ownership
above 25%
• Managers become more risk averse
• Managers have high stake in firm — greater
incentives to protect their private benefits and
objectives
• Managers' interest more aligned with
bondholders — lower bond premia

20. Executive Compensation
• Conflict of interest between owners and
managers reduced if executive
compensation plans more tightly related
pay to performance

21. • Executive compensation and firm's
corporate governance —
Sample of 495 observations for 205 publicly traded
U.S. firms
– Board of director characteristics and ownership
structure significantly related to CEO
compensation
• CEO compensation higher
– CEO was also board chair
– Board was larger
– Greater percentage of outside directors appointed by CEO
– More outside directors considered 'gray'
– Outside directors older and served on more than three other
boards

22. • CEO compensation lower
– Greater percentage of inside directors in board
– Lower CEO's ownership stake
– Existence of non-CEO internal board members or external
blockholders who owned at least 5% of equity
– Significant negative relationship between
compensation predicted by board and ownership
variables and subsequent firm operating and
market performance
• Board and ownership variables are proxies for
effectiveness of firm's governance structure
• CEOs of firms with greater agency problems were
able to obtain higher compensation
• Firms with greater agency problems perform worse

23. • Other proposals for improved pay-
performance policies
– Limit base salaries of top executives
– Bonus and stock option plans based on
stock appreciation
– Stock appreciation benchmarks should
consider
• Close competitors
• Wider peer group
• Broader stock market indexes

24. – Stock options based on premium of 10-20%
over current market and should not be
repriced
– Company loan programs should enable top
executives to buy substantial amounts of
firm's stock
– Directors should be paid mainly in stock
with minimum specified holding periods

25. Alternative Governance
Systems
• Summary of U.S. governance system
– Managerial stock ownership has increased
over time
– Large and small shareholders protected by
well-developed systems of laws, court
decisions, and financial market that facilitate
• Efficient transaction of securities
• Protect minority rights
• Enable shareholders to sue directors for violations
of fiduciary duty

26. – Changes in stock market prices quickly
penalize companies for poor performance
and reward them for excellence
– Vigilant stock market may cause managers
to emphasize short-term results
– Bankruptcy laws are highly protective of
managers; after entering into bankruptcy
• Management remains in possession of company
• Provision is made for automatic stay
• Interest continues to accrue only on fully secured
debt
• New financing is facilitated since it has priority
status

27. – German governance system
• Creditors have stronger rights than in U.S.
• Shareholder rights are weaker than in U.S.
• Large shareholders, often major banks and
financial groups, exercise control over large
firms as permanent investors and lenders
• Small investors have virtually no participation in
stock market

28. – Japanese governance system
• Degree of protection to shareholder and
creditor rights fall between U.S. and Germany
• Powerful banks and long-term shareholders in
Japan not as powerful as in Germany;
anecdotal evidence questions this conclusion
– Japanese companies have financed in U.S. during
earlier periods of time when Japan supposedly had
lower financing costs than rest of world
– Japanese firms sought to avoid strong controls that
came with financing from Japanese banks

29. • Industrial firms own shares in one another and
groups of firms become tied together by cross-
shareholdings (Kaplan, 1994)
• Governance system has facilitated participation
by small investors in stock market

30. – U.S., Germany, and Japan have in
common well-articulated set of rules that
provide effective legal protection for at
"least some type of investors" and are
enforced by courts and regulatory agencies

31. – Governance systems in other countries
• Italy
– Predominantly family controlled
– Difficulty raising outside funds
– Investment mainly financed internally
– Bank financing mainly by state banks for state firms
• Rest of world
– Similar to Italy
– Absence of system of laws, regulations, and courts
to protect minority investors and creditors
– Rules of game are deficient
– Large firms, mostly family controlled, rely on internal
financing, or obtain help from government controlled
banks

32. – German and Japanese corporate
governance differ from U.S.
• Stronger role of banks and financial groups
• In theory, large ownership position of owners-
lenders lead to effective monitoring
– Critique of German and Japanese corporate
governance model
• Banks have not monitored closely firms to which
they provide both equity and debt capital; banks
become active only when client firms experience
difficulties

33. • German and Japanese models appear good
only because of earlier favorable economic
environment — all parties have same long-term
interests and goals
• As economic growth slows, conflicts of interest
among different stakeholders arise
• Supervisory boards (in Germany particularly) did
not seem to meet often enough and acted slowly
– Incompetent managers permitted to complete
standard 5-year contract
– Chairman of board often leader of executive board
– Supervisory boards not adequately informed
• Large banking corporations have their own
governance problems