Google Earth was blocked by the government of Bahrain because it allowed people to see the private homes and royal palaces of the ruling Khalifa family.
American Airlines filed a lawsuit against Google for selling search terms like “American Airlines” to other firms for advertising. In 2006 Google was successfully sued in France by Louis Vuitton and agreed to remove all ads for a Louis Vuitton search.
Google pledged to contribute 1 percent of its assets, 1 percent of its profits, and employee time to philanthropy.
Mba1034 cg law ethics week 5 stakeholders & bod 2013
ASPECTS OF CONTROL :STAKEHOLDERSANDCORPORATE GOVERNANCEStephen Ong, BSc(Hons) Econs(LSE), MBA International Business(Bradford)Visiting Fellow, Birmingham City UniversityVisiting Professor, Shenzhen UniversityMBA1034 GOVERNANCE, LAW & ETHICS
• Discussion: CorporateGovernance & Culture1• Stakeholders and the role ofBoards of Directors2• Case Discussion: Google• Video : Google andChina3Today’s Overview
1. Open Discussion• Mayer, Colin (2002) “Corporate Cultures andGovernance: Ownership, Control andGovernance of European and USCorporations”, TRANSATLANTICPERSPECTIVES ON US-EU ECONOMICRELATIONS:CONVERGENCE, COOPERATIONAND CONFLICT ,Conference paper, JFK Schoolof Government, Harvard University, April 11-12
Learning outcomes• Consider appropriate ways to express the strategic purpose ofan organisation in terms of statements of purpose, values,vision, mission or objectives.• Identify the components of the governance chain of anorganisation.• Understand differences in governance structures and theadvantages and disadvantages of these.• Identify differences in the corporate responsibility stances takenby organisations and how ethical issues relate to strategicpurpose.• Undertake stakeholder analysis as a means of identifying theinfluence of different stakeholder groups in terms of theirpower and interest.
Influences on strategic purposeFigure 4.1 Influences on strategic purpose
Who are the stakeholders?Stakeholders are those individuals or groups whodepend on an organisation to fulfil their owngoals and on whom, in turn, the organisationdepends.
Mission statements• A mission statement aims to provide employeesand stakeholders with clarity about the overridingpurpose of the organisation• A mission statement should answer thequestions:‘What business are we in?’‘How do we make a difference?’‘Why do we do this?’
Vision statements• A vision statement is concerned with thedesired future state of the organisation; anaspiration that will enthuse, gain commitmentand stretch performance.• A vision statement should answer the question: ‘What do we want to achieve?’
Statement of corporate values• A statement of corporate values shouldcommunicate the underlying and enduring core‘principles’ that guide an organisation’s strategyand define the way that the organisation shouldoperate.• Such core values should remain intact whatever thecircumstances and constraints faced by theorganisation.
Objectives• Objectives are statements of specific outcomesthat are to be achieved.• Objectives are frequently expressed in:financial terms (e.g. desired profit levels)market terms (e.g. desired market share)and increasinglysocial terms (e.g. corporate social responsibilitytargets)
Issues in setting objectives• Do objectives need to be specific and quantifiedtargets?• The need to identify core objectives that are crucialfor survival.• The need for a hierarchy of objectives that cascadedown the organisation and define specificobjectives at each level.
Corporate governanceCorporate governance is concerned with thestructures and systems of control by whichmanagers are held accountable to those whohave a legitimate stake in an organisation.
The growing importance ofgovernance• The separation of ownership and managementcontrol – defining different roles in governance.• Corporate failures and scandals (e.g. Enron) –focussing attention on governance issues.• Increased accountability to wider stakeholderinterests and the need for corporate socialresponsibility (e.g. green issues).
The governance chainFigure 4.2 The chain of corporate governance: typical reporting structuresSource: Adapted from David Pitt-Watson, Hermes Fund Management
The principal-agent model• Governance can be seen in terms of theprincipal agent model• Principals pay agents to act on theirbehalf (e.g. beneficiaries/trustees payinvestment managers to managefunds, Boards of Directors pay executivesto run a company).• Agents may act in their own self interest.
Issues in governance (1)• The key challenge is to align the interestsof agents with those of the principals.• Misalignment of incentives and control –e.g. beneficiaries may require long termgrowth but executives may be seekingshort term profit.• Responsibility to whom – shouldexecutives pursue solely shareholder aimsor serve a wider constituency ofstakeholders?
Issues in governance (2)• Who are the shareholders – should boards respondto the demands of institutional investmentmanagers or the needs of the ultimatebeneficiaries?• The role of institutional investors – should theyactively intervene in strategy?• Establishing the specific role of the board – inparticular the role of non-executive directors.• Scrutiny and control – statutory requirements andvoluntary codes to regulate boards.
Different governance systemsTable 4.1 Benefits and disadvantages of governance systems
The role of boards• Operate ‘independently’ of themanagement – the role of non-executivesis crucial.• Be competent to scrutinise the activities ofmanagers.• Have time to do their job properly.• Behave appropriately given expectationsfor trust, role fluidity, collectiveresponsibility, and performance.
Corporate social responsibilityCorporate social responsibility (CSR) is thecommitment by organisations to ‘behaveethically and contribute to economicdevelopment while improving the qualityof life of the workforce and their familiesas well as the local community and societyat large’.11 World Business Council for Sustainable Development.
Corporate social responsibility stancesTable 4.2 Corporate social responsibility stances
Questions of corporate socialresponsibility – internal aspects (1)Table 4.3 Some questions of corporate social responsibility
Questions of corporate socialresponsibility – external aspects (2)Table 4.3 Some questions of corporate social responsibility (Continued)
The ethics of individuals andmanagersEthical issues have to be faced at the individuallevel :• The responsibility of an individual who believesthat the strategy of the organisation isunethical – resign, ignore it or take action.• ‘Whistle-blowing’ - divulging information tothe authorities or media about an organisation ifwrong doing is suspected.
26External Influences are importantPrivate sector“Many of the failures in the last 18 months can be traced back topoor strategies & business models, which investors hadapproved or not challenged”Hector Sants ,CEO, FSA, Feb09Public Sector“One of the worst NHS hospital care scandals – in which up to 1,200patients died – could happen again, campaigners warned yesterday.As a full public inquiry opened into the appalling standards of careat the Mid-Staffordshire NHS Foundation Trust”, Julie Bailey said“little had changed at the hospital and complaints were still beingroutinely 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)OrganizationSuppliers CustomersPublic AuthoritiesStaff DirectorsStakeholders are – groups of people who are affected by what the companydoes, therefore they should be able to influence what the company does.Investors
Stakeholders of a large organisationFigure 4.3 Stakeholders of a large organisationSource: Adapted from R.E. Freeman, Strategic Management: A Stakeholder Approach, Pitman, 1984. Copyright 1984 by R. Edward Freeman.
StakeholdersTypical 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 matterstherefore reflect• CG guidance shows that decisions should also includethe interests of these groups? - King III especially• Companies Act 2006 (Business Review), OECD CGguide (2004) take into account these issues• Most companies place profit above stakeholder needs(Mallin: p56)– foreign investment ,– international outsourcing• Stakeholder mapping – balance of interest versuspower?• Stakeholder satisfaction
Companies Act 2006Effective from Oct 1 2007Aligns 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 endfinancial position• Includes environmental, employment, social & community issues• Includes discussion of methods & measure of financial & non-financialperformance• A fair projection of the business’s prospects , including an analysis of keyevents (risks) that are likely to affect the company.• Not a prescriptive checklist – just broad guidelines forcontent/process which can be modified to suit company• But, the EAs should check to see if the review accords withevidence 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 andcomplexity of the business.In the case of a quoted company the business review must, to the extent necessary for anunderstanding of the development, performance or position of the company’sbusiness, include—(a) the main trends and factors likely to affect the future development, performance and positionof the company’s business; and(b) information about— (i) environmental matters (including the impact of the company’s businesson the environment), (ii) the company’s employees, and (iii) social and communityissues, including information about any policies of the company in relation to those mattersand the effectiveness of those policies; and(c) subject to subsection (11), information about persons with whom the company has contractualor 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, performanceor position of the company’s business, include—(a) analysis using financial key performance indicators, and (b) where appropriate, analysis usingother key performance indicators, including information relating to environmental matters and employeematters
Stakeholder conflicts of expectationsTable 4.4 Some common conflicts of expectations
Stakeholder mappingStakeholder mapping identifies stakeholderexpectations and power and helps inunderstanding political priorities.
Stakeholder mapping: thepower/interest matrixFigure 4.4 Stakeholder mapping: the power/interest matrixSource: Adapted from A. Mendelow, Proceedings of the Second International Conference on Information Systems, Cambridge, MA, 1986
Stakeholder mapping issues• Determining purpose and strategy – whoseexpectations need to be prioritised?• Do the actual levels of interest and powerreflect the corporate governance framework?• Who are the key blockers and facilitators ofstrategy?• Is it desirable to try to reposition certainstakeholders?• Can the level of interest or power of keystakeholders be maintained?• Will stakeholder positions shift according to theissue/strategy being considered.
PowerPower is the ability of individuals or groups topersuade, induce or coerce others into followingcertain courses of action.
Sources of powerTable 4.5 Sources and indicators of power
Indicators of powerTable 4.5 Sources and indicators of power (Continued)
Summary (1)• An important managerial task is to decide how theorganisation should express its strategic purposethrough statements of mission, vision, values orobjectives.• The purpose of an organisation will be influenced bythe expectations of its stakeholders.• The influence of some key stakeholders is representedformally within the governance structure of anorganisation. This can be represented in terms of agovernance chain, showing the links between ultimatebeneficiaries and the managers of an organisation.
Summary (2)• There are two generic governance structures systems:the shareholder model and the stakeholder modelthough there are variations of these internationally.• Organisations adopt different stances on corporatesocial responsibility depending on how they perceivetheir role in society. Individual managers may faceethical dilemmas relating to the purpose of theirorganisation or actions it takes.• Different stakeholders exercise different influence onorganisational purpose and strategy, dependent on theextent of their power and interest. Managers can assessthe influence of different stakeholder groups throughstakeholder analysis.
Case - Nonmarket Environmentof Google• EU law required data holders to store anindividual’s data only as long as necessary• Google launched a nonmarket campaign toinfluence the FCC’s design of the auction• Google did not use material from a mediasource that requested that it not do so, but inthe absence of such a request it used thematerial1-44
Case - Nonmarket Environmentof Google• Google began to supplement its News serviceby inviting, individuals and organizations thathad been mentioned in an article to offercomments attached as a link on the storypage• The government asked for data on searchqueries that it could use to develop filteringtechnology to which Google refused andfound itself on the other side of the law1-45
Case - Nonmarket Environmentof Google• Google assigned a team to developGoogle Health, which proclaimed ona prototype Web page• Google also announced an opensource mobile phone platformcalled Android that could be used todevelop new wireless services1-46
Case - Nonmarket Environmentof Google• Google advocated “net neutrality” andsought laws to require ISPs to treat allInternet traffic alike• The company pledged to becomecarbon neutral and announced a projectbacked by hundreds of millions ofdollars to reduce the cost of renewableenergy by 25–50 percent1-47
Management & Control• The main devices or mechanisms that are believed toensure that managers run the firm in the interests of theshareholders and punish badly performing managers• The effectiveness and importance of these mechanismsacross 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 OutcomesBy the end of this lecture, you should be ableto:1. Assess the importance of various corporategovernance devices across the main systems ofcorporate governance2. Judge the efficiency of the various devices interms of preventing bad performance by themanagement and/or disciplining bad managers3. Critically evaluate the empirical research on theimportance and effectiveness of corporategovernance devices4. Identify the gaps in the existing literature.
• Corporate governance devices ormechanisms are arrangements that mitigateconflicts of interests corporations may face.• These conflicts of interests are those thatmay arise between– the providers of finance and managers,– the shareholders and the stakeholders, and– different types of shareholders (mainly the largeshareholder and the minority shareholders).Introduction
• Particular corporate governance mechanismsare more likely to prevail in one corporategovernance system than in others.• The reason is that the prevalence of theabove conflicts of interests is also likely tovary across systems.• Hence, in order to study the effectiveness ofthe various corporate governancedevices, one needs to adopt one of thetaxonomies of corporate governancesystems.Introduction (Continued)
• We adopt the taxonomy by Julian Franksand Colin Mayer which distinguishesbetween insider and outsider systems.• We adopt this taxonomy for two reasons1. It does not advocate the superiority ofone system2. It provides a broad, yet convenientframework to analyse the variouscorporate governance devices.Introduction (Continued)
Product Market Competition• Competitionin product and servicemarkets may reduce managerial slack across allcorporate governance systems.• For example, a French manufacturer ofhousehold appliances operates in the sameglobal market as manufacturers from othercountries.• If the French manufacturer suffers from weakcorporate governance, it may ultimately bedriven out of the market.
Product Market Competition(Continued)• Benjamin Hermalin has developed atheoretical model about the effects ofcompetition on managerial (agent)performance.• He argues that competition has four distincteffects 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 increasedcompetition,–but it also puts pressure on managers toperform better by e.g. reducing their perksas well as other costs.• The risk-adjustment effect concerns thefact that competition changes theriskiness of the various actionsmanagers can take.Product Market Competition (Continued)
• The change-in-information effect consists of thefollowing– Competition makes it easier for the principal to judgethe agent’s actions as there is now a (larger) peergroup of other companies– Competition also has an effect on managerial actionsby reducing the riskiness of both easy and hardactions– However, the decrease in riskiness may notnecessarily be uniform across both easy and hardactions– Hence, it is not clear whether managers will switchfrom easy to hard actions or the converse.Product Market Competition (Continued)
• Increased competition also changes the relativevalue of managerial actions– By reducing the price cap, competition reduces theagent’s expected income and hence his incentives towork hard– However, it also increases the value attached to costsaving actions by the agent, making the latter workharder.• A priori, all of the above four effects haveambiguous signs.• Hermalin shows that under certain conditions thepositive income effect will dominate andcompetition will increase managerialperformance.Product Market Competition (Continued)
• However, generally it is still not clear whetherincreased competition increases or decreasesmanagerial performance.• While empirical evidence on the effect ofcompetition is still sparse, the studies that existsuggest that– competition forces managers to workharder, and– it may even be a substitutefor good corporategovernance.Product Market Competition (Continued)
Incentivising and DiscipliningManagers in the Insider and OutsiderSystems• The main mechanisms that are thought tokeep managers in check in the outsider systemare– the market for corporate control,– dividend policy,– the board of directors,– institutional shareholders,– shareholder activism,– managerial remuneration, and– managerial ownership.
Incentivising and DiscipliningManagers in the Insider and OutsiderSystems (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 marketfor takeovers was first proposed byHenry Manne.• Badly performing firms see theirshare price drop.• They then become easy targets forhostile raiders intend on changingthe management, thereby creatingfirm value.• However, the empirical evidencedoes not support Manne’sargument.
The Market for Corporate Control(Continued)• A US study by William Schwertand a UK study by Julian Franksand Colin Mayer investigate thepre-acquisition performance oftargets of hostile takeovers andtargets of friendly takeovers.• Hostility is defined as the targetmanagement’s attitude towardthe proposed takeover bid.• Neither the US nor the UK studyfinds any difference in the pre-acquisition performance of bothtypes of targets.
• However, the mere threat ofa hostile takeover may beenough to ensure thatmanagers do not shirk.• Still, hostile takeovers are anextreme and expensivemechanism to correctmanagerial failure.• They also tend to be veryrare outside the UKand the USA.The Market for Corporate Control (Continued)
Dividends and Dividend Policy• Frank Easterbrook and Michael Rozeff werethe first to formalise the corporategovernance role of dividends.• In Rozeff’s model, dividends reduce agencycosts by reducing the free cash flow.• However, they also increase transaction costsas higher dividends increase the need forcostly external financing.• Hence, there is an optimal dividend payoutwhich minimises the sum of both costs.
Dividends and Dividend Policy(Continued)• Easterbrook also argues that by committing tohigh dividends the free cash flow is kept to aminimum and wastage by the managers isreduced.• In addition, the firm has to raise regularlyoutside finance.• Each time it does so it subjects itself to thescrutiny of outsiders.• If the managers have been performingbadly, then outside finance is unlikely to bemade available.
• For dividends to be able to fulfil theirdisciplinary role, they need to be sticky.• Managers will need to carry on payingdividends even if profits are downtemporarily.• The role of dividends is likely to be moreimportant in the outsider system given thelack of shareholder monitoring.Dividends and Dividend Policy (Continued)
• Marc Goergen, Luc Renneboog and Luis Correiada Silva study the flexibility of German dividendscompared to UK and US dividends.• They find that, when profits are downtemporarily, German firms are much morewilling to cut or omit their dividends than UKand US firms.• German firms controlled by banks are evenmore willing to cut or omit their dividends.• They conclude that large shareholdermonitoring acts as a substitute fordividends.Dividends and Dividend Policy (Continued)
Boards of Directors• UK and US firms as well as firms from mostother countries have a single-tier board whereboth executive and non-executive directors sit.• A few countries, such as Germany andChina, have two separate boards, the so calledtwo-tier board.• The two-tier board consists of– the supervisory board where the non-executives (aswell as maybe employee representatives) sit, and– the management board where the executives sit.
Boards of Directors (Continued)• There is an ongoing debate about whether asingle- or two-tier board is better.• Some argue that having two boards ensuresthe independence of the non-executivesfrom the executives.• Others argue that having two boardsprevents the non-executives from beingeffective monitors due to a lack ofinformation.
• Is there a link between board structure andfinancial performance?• Do boards fire executives in the wake of poorperformance?• What factors determine board changes?• Should the roles of the chairman and the CEObe separated?Boards of Directors (Continued)
Is There a Link between BoardStructure and Financial Performance?• The proportion of non-executives is normallyused as a measure of board independence.• Boards that are dominated by non-executivesare likely to be more independent from themanagement.• However, there is little evidence in support ofa positive link between firm performance andboard independence.• However, board composition may not beexogenous, i.e. it may not be randomlydetermined.
Is There a Link between Board Structureand Financial Performance? (Continued)• For example, board composition may bedetermined by past performance.• If poor performance causes an increase in thenumber of non-executives, then this wouldexplain why no link has been found betweenfirm performance and board independence.• In contrast, there is conclusive evidence thatlarge boards are bad for firm performance.• There is also evidence that interlockeddirectorships cause collusion.
Do Boards Fire Executive Directors inthe Wake of Poor Performance?• There is consistent evidence of an increase inCEO and board turnover in the wake of poorperformance.• There is such evidence for both corporategovernance 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 equatedto good corporate governance.• Managerial dismissals also only occur in casesof extremely poor performance.
What Factors Determine Board Changes?• Benjamin Hermalin and Michael Weisbachfind that– inside directors are more likely to be replaced byoutside directors in poorly performingcompanies;– inside directors normally replace retiring CEOs;– when the CEO is replaced by an outsider, someinside directors – possibly the losers in thecontest to the succession – leave the firm; and– firms leaving their product market replace theirinside directors with outside directors.
What Factors Determine BoardChanges? (Continued)• Steven Kaplan and Bernadette Minton find thatbanks appoint representatives to the boards ofpoorly performing Japanese firms that are partof keiretsus.
Should the Roles of the Chairmanand CEO Be Separated?• There has been an ongoing debate as towhether the roles of the chairman and the CEOshould be separated or whether duality ispreferable.• Proponents of duality base themselves on thefollowing three arguments1. Duality ensures that there is strong leadership2. Splitting the two roles may create tensionsbetween the CEO and chairman3. Having a separate CEO and chairman makes itdifficult to designate a single spokesperson forthe company.
Should the Roles of the Chairmanand CEO Be Separated? (Continued)• Those opposed to duality argue that1. Combining the two roles reduces boardindependence and increase CEO entrenchment2. It combines the role of monitoring theexecutives and leading the executives in a singleperson.• In the USA, minds are still split as to whetherduality is good or bad.• The empirical evidence on US firms is also asyet inconclusive.
• In contrast, in the UK successive codes of bestpractice in corporate governance haverecommended the separation of the tworoles.• In contrast to US evidence which isinconclusive, evidence from UK firms seems tosuggest that duality has no effect onperformance.Should the Roles of the Chairman andCEO Be Separated? (Continued)
Institutional Investors• Institutional investors are the mostimportant types of shareholders inthe UK and the USA as well as a fewother countries (e.g. theNetherlands).• However, the jury is still out as towhether institutional investorsmonitor the management of theirinvestee firms.
• Some studies find positive effects ofinstitutional investors– They have a positive effect on firm value– They increase the performance sensitivity ofmanagerial pay– They reduce the levels of managerial pay.Institutional Investors (Continued)
• Other studies find negative effects ofinstitutional investors– They reduce firm value– They have short-term horizons– They increase the likelihood and severity offinancial misreporting.Institutional Investors (Continued)
• In the UK, successive codes of best practice incorporate governance have urged institutionalinvestors to become more active.• The 2001 Myners Report states that– institutional investors “remain unnecessarilyreluctant to take an activist stance in relation tocorporate underperformance, even where thiswould be in their clients’ financial interests”.• A number of UK studies suggest thatinstitutional investors are mostly passive andprefer exit over voice.Institutional Investors (Continued)
• Jana Fidrmuc, Marc Goergen and LucRenneboog study the price reaction toinsider trades in UK firms• They expect that monitoring reducesthe information conveyed by insidertrades.• They find that the price reaction– is highest for firms dominated byinstitutional investors, and– lowest for firms dominated by familiesand other firms.• They interpret this as evidence thatinstitutional investors are passive.Institutional Investors (Continued)
• However, evidence from case studyresearch by Marco Becht and otherssuggests that institutional investorsact behind the scenes.• Still, from an agency perspective it isnot clear why institutional investorsshould be the panacea to allcorporate governance issues.Institutional Investors (Continued)
Shareholder Activism• Shareholders may prefer to act behind thescenes to address poor managerialperformance in their investee firms.• However, they may use so called proxycontests as a means of last resort ifmanagement remains unresponsive.• Proxy contests consist of soliciting thesupport of other shareholders, via theirvotes, to bring about change.
Shareholder Activism (Continued)• While shareholder-initiated proxy voting isfrequent in the USA and on the increase inthe UK, it is relatively rare in ContinentalEurope.• Whereas proxy contests are relativelysuccessful in the USA, they are lesssuccessful in the UK and Continental Europe.• Nevertheless, managers of US firms are notlegally bound to implement shareholderproposals whereas they have to in the UKand most of Continental Europe.
• The stock market reaction to proxy contests isalso different between the USA and the UK-Continental Europe– In the USA, the stock price reaction is normallypositive– In the UK and Continental Europe, it is negativesuggesting that the market interprets proxycontests as a signal of shareholder discontentrather than positive change.Shareholder Activism (Continued)
Managerial Compensation• One possible way of aligning the interests ofthe managers with those of the shareholdersis managerial compensation.• By making managerial compensationsensitive to firm performance, managersshould have the right incentivesto maximise shareholdervalue.
Managerial Compensation (Continued)• Managerial compensation may consist ofvarious components including– the base (or cash) compensation,– long-term incentive plans (LTIPs) such as stockoptions and restricted stock grants,– benefits, and– perquisites.
Is Managerial CompensationSensitive to Firm Performance• Pay sensitivity to performance has beendocumented for a range of countries, includingthe USA, the UK and Germany.• However, other factors have also been shownto have an effect– firm size, and– ownership and control.
Is Managerial Compensation Sensitiveto Firm Performance (Continued)• An important factor influencing managerial payis firm size.• This suggests that executive directors benefitfrom empire building via increased salaries.• The empirical evidence suggests that this is aconcern– Firms where managerial compensation is sensitive tofirm size are more likely to conduct acquisitions– Managers experience a net increase in theircompensation despite the drop in post-acquisitionstock performance and sales
– Managerial compensation increases inline with good post-acquisitionperformance, but is insensitive tobad performance– In contrast, changes in compensationafter large capital expenditures aremuch smaller and also more sensitive topoor performance– Managers seem to use the higherinformation asymmetry surroundingacquisitions to boost theircompensation.Is Managerial Compensation Sensitive toFirm Performance (Continued)
• Another factor influencing managerialpay is ownership and control–Widely held firms have been reported tohave higher managerial compensationthan firms with large shareholders–This suggests that large shareholdermonitoring is a substitute for managerialincentivising via compensation packages.Is Managerial Compensation Sensitive toFirm Performance (Continued)
• Some argue that– managerial compensation is unlikely to addresscorporate governance issues, and– it is a corporate governance issue in itself asdirectors of firms with poor governance are able toset their own, excessive pay.• Managerial pay has also been shown to beasymmetric as– it increases with good luck,– but not with bad luck.Is Managerial Compensation Sensitive toFirm Performance (Continued)
Lucian Bebchuk and Jesse Fried go one stepfurther.• They argue that managers are entirely self-serving and they maximise their paysubject to a public outrage constraint.Is Managerial Compensation Sensitive toFirm Performance (Continued)
How Should One Design ManagerialCompensation Contracts?• There is an extensive theoretical and empiricalliterature on the design of managerialcompensation.• Both stock ownership and stock options havetheir advantages and drawbacks.• Stock ownership seems to make managers evenmore risk averse given its downside.• Stock options address this issue as they have alimited downside.• However, they also seem to exacerbate conflictsof interests between managers andshareholders.
Managerial Ownership• The principal–agent problem stems fromthe separation of ownership and control.• One way of mitigating this problem is togive managers shares in their firm.• However, managerial ownership may alsoentrench managers.• Hence, there may be two sides tomanagerial ownership.
Managerial Ownership(Continued)• Two types of studies analyse the linkbetween performance and managerialownership– Those that assume ownership tobe exogenous, i.e. determinedoutside the system– Those that assume ownership tobe endogenous, i.e. ownershipmay depend on firmcharacteristics such as pastperformance.
Studies Assuming ManagerialOwnership to be Exogenous• Morck, Shleifer and Vishny allow for a non-linearrelationship between managerial ownership andfirm value for the USA.• They find evidence of such a non-linearrelationship– Firm value rises with ownership in the 0–5% region– It then decreases in the 5–25% region to reach itsminimum value– It then increases again above 25% ownership, but ata decreasing rate.
Studies Assuming ManagerialOwnership to be Exogenous (Continued)• There are three criticisms of thisstudy–It has low explanatory power–Being a US study, there is low cross-sectional variation of ownership–The study ignores non-managerialownership.
Studies Assuming ManagerialOwnership to be Exogenous (Continued)• Karen Wruck looks at 128 US firms with largechanges 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 inthe 25–100% range when she considers totalownership.
Studies Assuming Managerial Ownershipto be Exogenous (Continued)• John McConnell and Henri Servaes clearlydistinguish between managerial and non-managerial ownership.• They find a curvilinear link between firm valueand managerial ownership.• Firm value reaches its maximum in the40–50% ownership range.• They also find a positive linear link betweenfirm value and institutional ownership.
Studies Assuming Managerial Ownershipto be Exogenous (Continued)0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8MSVMcC&SWruckManagerial ownershipFirm value
Studies Assuming Managerial Ownershipto be Endogenous (Continued)• These studies allow forcurrent managerialownership to depend on pastfirm characteristics, includingfirm performance.• These studies do not tend tofind a link betweenmanagerial ownership andfirm value.
Studies Assuming Managerial Ownershipto be Endogenous (Continued)• Stacey Kole argues that if ownershipinfluences firm value, there should becorrective transfers.• She uses the same sample as Morck et al.• She finds the same effects for the 0–5% and5–25% ranges, but no effect above 25%.• She then regresses performance for each ofthe years 1977–85 on 1980 ownership.• She finds a link for the years 1977–80, but nolink for the years 1981–85.
Studies Assuming Managerial Ownershipto be Endogenous (Continued)• She concludes that there should be a reversalof causality as past performance seems tohave an effect on current managerialownership.
Studies Assuming Managerial Ownershipto be Endogenous (Continued)• In addition to managerial ownership, AnupAgrawal and Charles Knoeber look at thefollowing 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 econometrictechniques.
Studies Assuming Managerial Ownershipto be Endogenous (Continued)• The only persistent effect they find is a negativeeffect of non-executives on firm value.• They explain this negative effect by the fact thatnon-executives frequently represent interestgroups other than the shareholders withobjectives other than shareholder valuemaximisation.• Charles Himmelberg, Glenn Hubbard and DariusPalia allow for both ownership and firmperformance to be endogenous.• They do not find that current performancedepends on past ownership either.
Large Shareholder Monitoring• Do large shareholders enhance firm value?• Some theoretical research suggests that largeshareholders create value via their monitoringwhich overcomes the free-rider problem.• Generally, there is little empirical evidence thatlarge shareholders create value.• Nevertheless, there is some evidence from theUSA and Germany that family controlcreates value.• However, this only seems to be the case whenthe founder is the CEO or chairman.
Large Shareholder Monitoring(Continued)• In contrast, when one of the founder’sdescendents acts as the CEO there isnormally value destruction.• Finally, evidence on East Asian countriesby Faccio et al. suggests that familiesexpropriate the minorityshareholders by paying outdividends that are too low.• Other theoretical papers argue thatlarge shareholders may overmonitor themanagement.
Bank and Creditor Monitoring• Debt on its own may be a powerfuldisciplinary mechanism.• As debt commits part of the firm’s cashflows to its servicing, it reduces managerialdiscretion and wastage.• Firms with a large creditor may also benefitfrom the monitoring by the latter.
Bank and Creditor Monitoring(Continued)• As the German system has beentraditionally qualified as being bankbased, there is a body studying theeffects of German banks on firmperformance.• However, the evidence is as yetinconclusive as to the effect of bankownership and board representationon firm performance.
Conclusions• The relative importance ofcorporate governance mechanismsvaries across the insider andoutsider system.• The effectiveness of the variouscorporate governancemechanisms.• The likely endogeneity of corporategovernance mechanisms.• The interdependence of corporategovernance mechanisms.
The Role of Boards inCorporate Governance• What is the role of Boards of directors incorporate governance, mainly from a UKperspective, with reference to the academicliterature.
Learning OutcomesBy the end of this lecture, you should be able to:• explain the main initiatives introduced in the UK toimprove the effectiveness of boards of directors;• evaluate the impact of these initiatives on boardfunction;• discuss the findings of academic research relating tothe effectiveness of boards as a corporategovernance mechanism.
Corporate Governance: A Practical GuideAn 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 keystakeholders• regular evaluation of board performance.
The Fish Rots from the Head(Garratt, 1996)• Said boards spent too muchtime ‘managing’• Not enough time ‘directing’• Should be learning boards
Unitary and Two-tier BoardStructuresUnitary boards (UK, US)• executive and non-executive directors• make decisions as a unified groupTwo-tier boards (Germany, Taiwan)• 2 separate boards• management board• supervisory board
Two-Tier BoardManagement board• only executives• focuses on operational issues• headed by chief executiveSupervisory 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 modelUK & USA• We examine 3 mechanisms for improvingcorporate governance in boards• Splitting chairman/chief executive position• Improve effectiveness of NEDs• Curb excessive executive remuneration
Splitting the Role of Chairman andChief Executive: one-tier boardsChairman• pivotal role in helping the board to achieveits potential• responsible for leading the board• responsible for setting the board agenda• responsible for ensuring board effectiveness• conductor of an orchestra
Chief Executive• determinescorporatestrategy• manages dayto day runningof business
Cadbury Report emphasised:• No individual could gain ‘unfettered’ controlof the decision-making process• Should be a clear division of responsibility atthe top of the company, ensuring balance ofpower• 90% UK listed companies split roles afterCadbury
Higgs Report (2003)re-emphasized split roles:• "The roles of chairman and chief executiveshould not be exercised by the sameindividual"• The essence of theserecommendations, among others made byHiggs, was incorporated in the CombinedCode in July 2003.
Research into Split Roles• Donaldson and Davies (1994)• Splitting roles can reduce agency problemsand result in improved corporateperformance because of more independentdecision making• Peel and ODonnell (1995)• Found that splitting roles led to significantlyhigher 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 commonEuropean practice of separating the jobs ofchairman and chief executive, entrenching a checkat 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 managementin developing and evaluating strategy• Monitor company management in strategyimplementation and performance• monitor companys legal and ethical performance• Monitor veracity and adequacy of financial/ othercompany information provided to investors and otherstakeholders• assume responsibility for appointing, evaluatingand, where necessary, removing senior management• planning succession for top management positions.
Byrd and Hickman (1992, p.196)• "The inside directors provide valuableinformation about the firm’s activities, whileoutside directors may contribute bothexpertise and objectivity in evaluating themanagers’ decisions. The corporateboard, with its mix ofexpertise, independence, and legal power, isa potentially powerful governancemechanism“
Higgs Report emphasized NEDsmust have:• integrity• high ethical standards• sound judgement• ability and willingness tochallenge issues• strong interpersonal skills• "no crooks, nocronies, no cowards"!
Non Executive DirectorsSpira and Bender (2004)• discussed tension between the strategic andmonitoring roles of NEDsCadbury Report recommended:• minimum of 3 NEDs• majority NEDs should be independent
Higgs Report 20 January 2003 basedon 3 pieces of research:• data on the size, composition andmembership of boards and committees in the2,200 UK listed companies, as well as the ageand gender of their directors• survey of 605 executive directors, non-executive directors and chairmen of UK listedcompanies conducted by MORI• interviews of 40 directors in top UK listedcompanies carried out by academics in thefield
Recommendations: NED• NEDs should comprise at least half board• One NED should take direct responsibility forshareholder concerns (SID)• Strong reaction from business community:• "This could lead to multiple splits in the boardwhich every man and wife could come along andexploit. And that would be a madhouse"
The Tyson Report: Widening theGene Pool• NEDs criticized as "Pale, stale and male"• Higgs also suggested NEDs should come from morediverse backgroundsTyson Report explored greater diversity:• background• skills• experience of members• race• gender• nationality• age
Milliken and Martins (1996)• Emphasized the importance of board diversityto effectiveness and financial performance• Widening boardroom diversity also helpscompanies engender trust among theirstakeholders
Some organisations providingbroader source of NEDs• Association of Executive Search Consultants• Charity and Fundraising Appointments• High Tech Women• City Womens Network.
NEDs and the Credit Crunch• Deficiencies in NEDs role within financial institutionscontributed to current global financial crisis• FT article during financial crisis said companiesneed to:• improve the qualifications and on-going training forNEDs• pay more attention to the relevant experience andcompetence when recruiting NEDs• Increase the time commitment given by NEDs
Executive Remuneration• ‘Fat cats’• Higgs Report• Company chairmen in FTSE 100 companieswere earning £426,000 per annum onaverage• This was in 2003!
ACCA, 2008, Principles 6• "Remuneration arrangements should bealigned with individual performance in such away as to promote organizationalperformance. Inappropriatearrangements, however, can promoteperverse incentives that do notproperly serve the organisationsshareholders or other principal stakeholders"
Greenbury Report 1995Recommended remuneration committees to:• "determine pay packages needed to attract, retainand motivate directors of the quality required butshould avoid paying more than is necessary forthis purpose“Core, Holthausen and Larcker (1999)• Found links between excessive executiveremuneration, ‘bad’ corporate governance andpoor corporate performance
Pay and PerformanceThompson (2005)• found various initiativesto make executiveremuneration moretransparent had not hadmuch impact on therelationship betweenexecutive pay andperformance
Voting on Directors’Remuneration• October 2001 the UK Governmentannounced proposals to produce anannual directors’ remunerationreport that would be approved byshareholders• No need to legislate as investorshave acted in this area
Bonuses and the Financial CrisisJanuary 2009• French President, Nicolas Sarkozy, insisted onbonuses and dividends being reduced forexecutives in French banks• BNP Paribas, Frances largest bank, chairmanand chief executive forwent their 2008bonuses voluntarily, in response to publicdissatisfaction
UK Shareholders, Remunerationand the Global Financial Crisis• Grave concerns about excessive remunerationpackages• Institutional investor representative bodies• (ABI) (NAPF) caution companies against paying outlarge bonuses to senior executives• UK institutional shareholders voted againstremuneration policies• Currently discussion on taxing bank directors’bonuses when peoples’ taxes are paying off thebanks’ 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 boardmeetings and decision making• Members of the board should be open to other members’suggestions• There should be a high level of trust between boardmembers• Board members should be ethical and have a high level ofintegrity• There must be a high level of effective communicationbetween members of the board• The board should be responsible for the financial statements• Non-executive directors should (generally) provide anindependent 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 thecompany’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 riskno return• The board must communicate with shareholders, be awareof shareholder needs and translate them into managementstrategy• The board must be aware of stakeholder issues and beprepared to engage actively with their stakeholders• As education becomes increasingly important, boardmembers should not be averse to attending training courses
Ethical Health of BoardsACCA, 2008, Principle 2• "Boards should set the right tone andbehave accordingly, paying particularattention to ensuring the continuingethical health of their organizations.Directors should regard one of theirresponsibilities as being guardians ofthe corporate conscience … Boardsshould ensure they have appropriateprocedures for monitoring theirorganisations ethical health‘”
Core Readings• Solomon, Jill (2010) Corporate Governance andAccountability 3rd Edition, Wiley, UK. Ch.4-5• Goergen, Marc (2012) International CorporateGovernance, 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 (2011) BPPLearning Media Ltd. Part B : 5-6• Baron, David P.(2013) Business and itsenvironment, 7th Edition, Pearson
Additional Readings (1)• Byrd, J. W. and Hickman, K. A. (1992) ‘Do outside directors monitormanagers?’, Journal of Financial Economics, 32, 195–221.• Donaldson, L. and Davies, J. H. (1994) ‘Boards and companyperformance—Research challenges the conventionalwisdom’, Corporate Governance: An InternationalReview, 2(3), July, 151–160.• Peel, M. and O’Donnell, E. (1995) ‘Board structure, corporateperformance and auditor independence’, Corporate Governance: AnInternational Review, 3(4), October, 207–217.• Milliken, F. J. and L. L. Martins (1996) "Searching for CommonThreads: Understanding the Multiple Effects of Diversity inOrganisational Groups", Academy of ManagementReview, 21, pp.402-433.• Core, J. E., Holthausen, R. W. and Larcker, D. F. (1999) ‘Corporategovernance, chief executive officer compensation, and firmperformance’, Journal of Financial Economics, 51, 371–406.• Thompson, S. (2005) "The Impact of Corporate GovernanceReforms on the Remuneration of Executives in the UK", CorporateGovernance: 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 InternationalReview, 2(3), July, 125–130.• Nesbitt, S. L. (1994) ‘Long-term rewards from shareholder activism: A study of the “CalPERSeffect”’, Journal of Applied Corporate Finance, 6, 75–80.• Stapledon, G. P. (1995) ‘Exercise of voting rights by institutional shareholders in the UK’, CorporateGovernance: 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 ofFinance, 51(1), March, 227–252.• Agrawal, A. and Knoeber, C. R. (1996) ‘Firm performance and mechanisms to control agency problemsbetween managers and shareholders’, Journal of Financial and QuantitativeAnalysis, 31(3), September, 377–397.• Mallin, C. A. (1996) ‘The Voting Framework: A Comparative Study of Voting Behaviour of InstitutionalInvestors 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 inUK 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 holdlarge stakes?’, Journal of Corporate Finance, 6, 71–110.• Solomon, J. F., Solomon, A., Joseph, N. L. and Norton, S. D. (2000) ‘Institutional investors’ views oncorporate governance reform: Policy recommendations for the 21st century’, Corporate Governance: AnInternational Review, 8(3), July, 217–226.• Mallin, C. A. (2001) ‘Institutional investors and voting practices: An international comparison’, CorporateGovernance: 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) "Dont Stop Rattling Those Boardroom Chains: Corporate Activists Are Key toMaintaining Shareholder Returns", Financial Times, 10th May, p.6.• National Association of Pension Funds (NAPF) (2005) Pension Scheme Governance - Fit for the 21stCentury, NAPF Discussion Paper, July.
Next Week’s Ideas for Discussion• Morck, Randall and Yeung, Bernard (2003)Agency problems in large Family BusinessGroups, Entrepreneurship: Theory andPractice, Summer 2003. Vol. 27, No. 4: pp.367 – 382