Governance

1. 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

2. The Firm 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 firm’s owners by monitoring top-level managers’ strategic decisions

3. 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

4. Agency Theory Basic Terms • Organizations: series of contractual relationships between agents and principals • Principals: owners (shareholders) of a firm • Agents:people hired by the owners to run the firm (managers and workers) • Agency Costs: costs associated with monitoring agent behavior and enforcing contracts • Goal: efficient arrangement (lowest agency costs) of agent-principal relationships.

5. Agency Relationship Managers (Agents) Shareholders (Principals) Agency Relationship: Owners and Managers • Firm owners • Decision makers • A specialist in risk-bearing (the principal) pays compensation to • A specialist in managerial decision-making specialist (the agent)

6. 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)

7. 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 are invested.

8. 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 management’s 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

9. 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

10. The Firm 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

11. Executive Compensation Governance Mechanisms • 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

12. S M A B Manager and Shareholder Risk and Diversification Shareholder (business) risk profile Managerial (employment) risk profile Risk Dominant Business Related Constrained Related Linked Unrelated Businesses Diversification

13. 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 performance-based incentives when results are good, and peer-based incentives when results are bad (Murphy, 1999) • Stealth” compensation ...

14. 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.

15. The Firm The Firm 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

16. 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.

17. Ownership Concentration Governance Mechanisms • Large block shareholders have a 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)

18. Boards of Directors Governance Mechanisms • Insiders • The firm’s CEO and other top-level 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 firm’s day-to-day operations and other relationships

19. Boards of Directors Governance Mechanisms • 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 board’s performance

20. Executive Compensation Governance Mechanisms • 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

21. Market for Corporate Control Governance Mechanisms • 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

22. 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

23. 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

24. International Corporate Governance: Japan • Obligation, “family” and consensus are important factors • Banks (especially “main bank”) are highly influential with firm’s managers • Keiretsus are strongly interrelated groups of firms tied together by cross-shareholdings

25. 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