CORPORATE GOVERNANCE

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CORPORATE GOVERNANCE

CORPORATE GOVERNANCE

Corporate Governance is a relationship among stakeholders that is used to determine and control the strategic direction & performance of organizations. Concerned with identifying ways to ensure that strategic decisions are made effectively. Used in corporations to establish order between the firms owners and its top-level managers.

AN OECD DEFINITION

Corporate governance involves a set of

relationships between a companys management, its board, its shareholders and other stakeholders ..also the structure through which objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined.

Preamble to the OECD Principles of Corporate Governance, 2004

WHY CORPORATE GOVERNANCE?

Better access to external finance Lower costs of capital interest rates on loans Improved company performance sustainability Higher firm valuation and share performance Reduced risk of corporate crisis and scandals

INTERNAL GOVERNANCE MECHANISMS CORPORATE GOVERNANCE MECHANISM

FOUR PILLARS - CORPORATE GOVERNANCE

Accountability Fairness

Transparency
Independence

BOARD OF DIRECTORS

Key Terms
Board

of Directors group of shareholder-elected individuals whose primary responsibility is to act in the owners interests by formally monitoring and controlling the corporations top-level executives

Governance Mechanisms
BOARDS OF DIRECTORS - Formally monitor & control the firms toplevel executives. - Set compensation of CEO & decide when to replace the CEO. - May lack contact with day to day operations.
Insiders Related Outsiders
Outsiders
A firms CEO & other top-level managers Individuals not involved with a firms day-today operations, but who have a relationship with the company

Individuals independent of a firms day-today operations and other relationships

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BOARD OF DIRECTORS TYPES

BOARD OF DIRECTORS

Direct the affairs of the organization Punish and reward managers

Protect shareholders rights and interests Protect owners from managerial opportunism

OUTSIDER DIRECTORS

They improve upon the weak managerial monitoring and control that corresponds to inside directors Without access to daily operations and a high level of information about managers and strategy, they tend to emphasize financial controls, to the detriment of risk-related decisions by managers

AGENCY COSTS & GOVERNANCE MECHANISMS

Managerial interests may prevail when governance mechanisms are weak.

If the board of directors control managerial autonomy, the firms strategies should better reflect the interests of the shareholders.

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ACCOUNTABILITY OF BOARD MEMBERS

Increased diversity amongst board members. The strengthening of internal management & accounting control systems. The establishment & consistent use of formal processes to evaluate boards performance. Directors are being required to own significant equity stakes as a prerequisite to holding a board seat.

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EXECUTIVE COMPENSATION
Executive compensation: A governance
mechanism aligning the interests of managers & owners through salaries, bonuses and long

term incentives such as stock options.

Stock options: A mechanism which links the

executives performance to the performance of the company.
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MARKET FOR CORPORATE CONTROL

An external governance mechanism that becomes active when a firms internal controls fail which is triggered by a firms poor performance, relative to industry competition.

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AGENCY THEORY
An agency relationship exists when: Shareholders (Principals)
Firm Owners Agency Relationship

Hire
Managers (Agents)

Risk Bearing Specialist (Principal) Managerial DecisionMaking Specialist (Agent)

Decision Makers

which creates

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AN AGENCY RELATIONSHIP

AGENCY THEORY
The Agency problem occurs when:
The desires or goals of the principal & agent conflict and it is difficult or expensive for the principal to verify that the agent has behaved appropriately. Example: Over - diversification: Greater product diversification leads to lower management employment risk & greater compensation. Solution: Principals engage in incentive-based performance contracts, monitoring mechanisms like the board of directors & enforcement mechanisms like managerial labour market to mitigate agency problems.
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PRODUCT DIVERSIFICATION AS AN EXAMPLE OF AN AGENCY PROBLEM

Diversification usually increases the size of the firm therefore complexity and an opportunity for top executives to increase their compensation.

Diversification usually reduces top executives employment risk.

Top executives have control over free cash flow and may invest in in products not associated with the firms current lines of business.
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A BASIC LIST OF MANAGEMENT DEFENCE TACTICS

Increase the costs of mounting a takeover and can entrench current management.

Golden Parachute
Raises the cost of making changes at a take-over target due to the need to pay fired executives large severance packages.

Greenmail
Where company money is used to repurchase stock from a corporate raider to avoid takeover.

Poison Pill
When the takeover target does something to make itself unpalatable to the suitor (e.g. assume a large amount of debt and then issue dividends with the money).
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Reference

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