Corporate Governance

 Corporate governance is  a relationship among stakeholders that is used to determine and control the strategic direction and performance of organizations   concerned with identifying ways to ensure that strategic decisions are made effectively used in corporations to establish order between the firm’s owners and its top-level managers 1

Corporate Governance Mechanisms

Internal Governance Mechanisms

Board of Directors Managerial Incentive Compensation Ownership Concentration

External Governance Mechanisms

Market for Corporate Control 2

 

Separation of Ownership and Managerial Control

Basis of the modern corporation  shareholders purchase stock, becoming residual claimants  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 3

Agency Relationship:

Owners and Managers Shareholders (Principals) • Firm owners 4

Agency Relationship:

Owners and Managers Shareholders (Principals) • Firm owners • Decision makers Managers (Agents) 5

Agency Relationship:

Owners and Managers Shareholders (Principals) • Firm owners • Decision makers Managers (Agents) • Risk bearing specialist (principal) pays compensation to a managerial decision-making specialist (agent) An Agency Relationship 6

Agency Theory Problem

  The agency problem occurs when:  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 inappropriately Solution:  principals engage in incentive-based performance contracts   monitoring mechanisms such as the board of directors enforcement mechanisms such as the managerial labor market to mitigate the agency problem 7

Manager and Shareholder Risk and Diversification

S

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

M

Dominant Business

A

Related Related Constrained Linked

Diversification B

Unrelated Businesses 8

Governance Mechanisms

Board of Directors Insiders • The firm’s CEO and other top-level managers Affiliated Outsiders • Individuals not involved with day-to day operations, but who have a relationship with the company Independent Outsiders • Individuals who are independent of the firm’s day-to-day operations and other relationships 9

Governance Mechanisms

Board of Directors Role of the Board of Directors • Monitor – Are managers acting in shareholders best interests • Evaluate & Influence – examine proposals, decisions actions, provide feedback and offer direction • Initiate & Determine – delineate corporate mission, specify strategic options, make decisions 10

Governance Mechanisms

Board of Directors 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 11

Governance Mechanisms

Board of Directors Executive Compensation • Stock ownership (long-term incentive compensation) makes 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 12

CEO Pay

CEO Pay and Performance

 Classic pay for performance relationship  Unfortunately, this relationship is weak Firm Performance  The stronger relationship is with firm size 13

CEO Pay CEO Pay and Firm Size  Relationship between pay and firm size is curvilinear.

 CEO pay increases at a decreasing rate Firm Size 14

Relationship Between Firm performance and Firm Size

 Relationship between firm performance and firm size is curvilinear .  Beyond some point, as size increases, firm performance declines  BUT…  From the graph of CEO pay vs. firm size, pay doesn’t decline Firm Size 15

Relationship Between Firm performance and Equity Ownership

 Relationship between firm performance (Tobin’s Q) and managerial ownership is curvilinear .  Beyond some point, as ownership increases, firm value declines Managerial Ownership in % 16

Governance Mechanisms

Board of Directors Executive Compensation Ownership Concentration • Large block shareholders (often institutional owners) have a strong incentive to monitor management closely • Exit vs. Voice – Cannot costlessly exit due to equity stake (transaction costs) so they press for change (exercise voice) • They may also obtain Board seats which enhances their ability to monitor effectively (although financial institutions are legally forbidden from directly holding board seats) 17

Governance Mechanisms

Board of Directors Executive Compensation Ownership Concentration • Types of institutional investors - Mutual funds, pension funds, foundations, churches, universities, insurance companies • Pressure-resistant versus pressure sensitive - Mutual and pension funds are pressure resistant • Are Institutional investors the same?

Short vs. long term • Components of voice: - Pension fund hit lists - Shareholder liability suits - Investor alliances - Proxy contests 18

Governance Mechanisms

Board of Directors Executive Compensation Ownership Concentration 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 19

Managerial Defense Tactics

     Designed to fend off the takeover attempt Increase the costs of making the acquisitions Causes incumbent management to become entrenched while reducing the chances of introducing a new management team May require asset restructuring Institutional investors oppose the use of defense tactics 20

Financial Mechanisms

Takeover Defenses:

    Poison pills Leveraged recapitalizations Greenmail Litigation 21

Financial Mechanisms Asset-Based Mechanisms

Takeover Defenses:

    Poison pills Leveraged recapitalizations Greenmail Litigation    Scorched earth defense Crown jewel sales Pac-man defense 22

Financial Mechanisms Asset-Based Mechanisms Third Party Mechanisms

Takeover Defenses:

    Poison pills Leveraged recapitalizations Greenmail Litigation    Scorched earth defense Crown jewel sales Pac-man defense   White knight defense Other bidder (competitive bid situation) 23