Governance

Knowledge objective
Understand corporate governance ...
as a system of ownership and stakeholder interests as an agency problem in terms of TMT incentives in relation to value creation in terms of markets for corporate control in relation to international

Corporate Governance Mechanisms

Internal Governance Mechanisms
Ownership concentration relative amounts of stock owned by individual and institutional investors Board of Directors individuals responsible for representing the firms owners by monitoring top-level managers strategic decisions

Separation of Ownership and Control

Basis of the modern corporation
shareholders purchase stock, becoming residual claimants who bear residual risk shareholders reduce risk by holding diversified portfolios professional managers are contracted to provide decision-making

Modern public corporation form leads to efficient specialization of tasks

risk bearing by shareholders strategy development and decision-making by managers
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Agency Theory
Basic Terms
Organizations:

series of contractual relationships between agents and principals

Principals:
Agents:

owners (shareholders) of a firm

people hired by the owners to run the firm (managers and workers)
Agency
Goal:

Costs: costs associated with monitoring agent behavior and enforcing contracts
efficient arrangement (lowest agency costs) of agent-principal relationships.
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Agency Relationship:
Owners and Managers
Shareholders (Principals)
Firm owners

Decision makers

Managers (Agents)

A specialist in risk-bearing (the principal) pays compensation to A specialist in managerial decisionmaking specialist (the agent)

Agency Relationship
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Principal-Agent Theory
The heart of principal-agent theory is the trade-off between (a) the cost of measuring behavior and (b) the cost of measuring outcomes and transferring risk to the agent. Information is asymmetrically distributed between principals and agents
(Eisenhardt, 1989)
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Examples Problem of Product Diversification Increased size, and the relationship of size to managerial compensation Reduction of managerial employment risk Use of Free Cash Flows Managers prefer to invest these funds in additional product diversification (see above). Shareholders prefer the funds as dividends so they control how the funds 7 are invested.

Agency Theory: Conflicts

Principals engage in monitoring behavior to assess the activities and decisions of managers But dispersed shareholding makes it difficult and inefficient to monitor managements behavior Boards of Directors have a fiduciary duty to shareholders to monitor top management However, Boards of Directors are often accused of being lax in performing this function

Agency Theory Problem

Problem: cost of measuring behavior the desires or goals of the principal and agent conflict and it is difficult or expensive for the principal to verify that the agent has behaved appropriately Solution: Measure outcomes, transfer risk to the agent principals create incentive-based performance contracts principals monitor contract performance (e.g., BOD) Markey supply of managerial know-how (CEOs) mitigate the agency problem
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Corporate Governance Mechanisms

Internal Governance Mechanisms
Executive Compensation use of salary, bonuses, and long-term incentives to align managers interests with shareholders interests Monitoring by top-level managers they may obtain Board seats (not in financial institutions) they may elect Board representatives

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Governance Mechanisms
Executive Compensation

Stock ownership (long-term incentive compensation) managers more susceptible to market changes which are partially beyond their control Incentive systems do not guarantee that managers make the right decisions, but do increase the likelihood that managers will do the things for which they are rewarded
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Manager and Shareholder Risk and Diversification

Shareholder (business) S risk profile Managerial (employment) risk profile M

Risk

A Dominant Related Business Constrained

Diversification

Related Linked

Unrelated Businesses
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Some research findings

Management controlled firms maximize CEO pay, s.t. legitimacy, externally controlled firms minimize CEO pay, s.t.CEO labor market (Hambrick & Finkelstein, 1995) Antitakeover defenses increase the premium for a hostile takeover by ~40% Directors usually have only a nominal equity interest in the firm, but may receive substantial reputational or monetary benefits from CEO nominations Compensation consultants - accent performancebased incentives when results are good, and peerbased incentives when results are bad (Murphy, 1999) 13 Stealth compensation ...

Agency Theory Conflicts

Agency Problem exists elsewhere among stakeholders, e.g., between shareholders and debtholders

Debtholders often limit dividend payments (covenants) Why? If the firm pays all excess cash to shareholders, there may not be enough left for debtholders. Dividends are a means that shareholders can use to expropriate wealth from debtholders.
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Corporate Governance Mechanisms

External Governance Mechanisms Market for Corporate Control the purchase of a firm that is underperforming relative to industry rivals in order to improve its strategic competitiveness

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External Control
External control mechanisms: SEC, External auditors; Bondholders and lenders (banks); Financial analysts and credit rating agencies; Mergers and acquisitions; Institutional investors- pension funds, mutual funds; Stock prices; Labor markets.
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Governance Mechanisms
Ownership Large block shareholders have a Concentration strong incentive to monitor

management closely Their large stakes make it worth their while to spend time, effort and expense to monitor closely They may also obtain Board seats which enhances their ability to monitor effectively (although financial institutions are legally forbidden from directly holding board seats)
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Governance Mechanisms
Boards of Directors

Insiders

The firms CEO and other toplevel managers

Related Outsiders

Individuals not involved with day-to-day operations, but who have a relationship with the company

Outsiders

Individuals who are independent of the firms day-to-day operations and other relationships 18

Governance Mechanisms
Boards of Directors Recommendations for more effective Board Governance: Increase diversity of board members backgrounds Strengthen internal management and accounting control systems Establish formal processes for evaluation of the boards performance

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Governance Mechanisms
Executive Compensation Salary, bonuses, long term incentive compensation Executive decisions are complex and non-routine Many factors intervene making it difficult to establish how managerial decisions are directly responsible for outcomes

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Governance Mechanisms
Market for Corporate Control Firms face the risk of takeover when they are operated inefficiently Many firms begin to operate more efficiently as a result of the threat of takeover, even though the actual incidence of hostile takeovers is relatively small Changes in regulations have made hostile takeovers difficult Acts as an important source of discipline over managerial incompetence and waste
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International Corporate Governance:

Owner and manager are often the same in private firms Public firms often have a dominant shareholder, frequently a bank Frequently there is less emphasis on shareholder value than in U.S. firms, although this may be changing

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International Corporate Governance:

Germany
Medium to large firms have a two-tiered board
vorstand monitors and controls managerial decisions aufsichtsrat selects the Vorstand employees, union members and shareholders appoint members to the Aufsichtsrat

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International Corporate Governance:

Japan
Obligation, family and consensus are important factors Banks (especially main bank) are highly influential with firms managers Keiretsus are strongly interrelated groups of firms tied together by cross-shareholdings

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International Corporate Governance:

Japan
Other characteristics:
powerful government intervention close relationships between firms and government sectors passive and stable shareholders who exert little control virtual absence of external market for corporate control

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