Governance and Risk Management

1. Governance and Risk Management Chapter 17

2. Basics of Corporate Governance • Corporations: group of consensual, contractual relations among several constituencies • Corporate charter (or Articles of incorporation): agreement between corporation and state in which it is incorporated as to how the corporation will be run; includes: • Authorized shares of corporation • Corporation’s name • Corporation’s purpose

3. Basics of Corporate Governance • Corporate charter (continued) • In return, corporation pays franchise tax to state based on authorized capital of company • May be amended after they are originally filed by incorporators by majority or super-majority vote of shareholders • For public companies, vote requires: • Proxy filing with Securities and Exchange Commission (SEC) • Hiring of proxy solicitor to encourage shareholders to vote their shares

4. Basics of Corporate Governance • By-laws • “Fill the gaps” left by charter • Address board elections and composition, appointment of officers, timing and conduct of corporate annual meetings, etc. • Amended by board if permitted by state of incorporation and charter; otherwise, amendable by shareholders

5. Basics of Corporate Governance • Board of directors • Elected by shareholders at annual stockholders’ meeting • Each share is generally entitled to one vote per director unless there is cumulative voting or multiple classes of stock • Directors who receive most votes win • Directors are expected to maximize value per share

6. Directors’ Fiduciary Duties • Directors’ two duties to shareholders under Delaware law: • Duty of care • Director must act in good faith and strive to exercise ordinary prudential care in making business decisions through processes • “Business judgment rule”: presumption in favor of director’s decision-making even if expected results of decision are not realized • “Total fairness standard”: if director has a conflict of interest, he/she must prove that his/her decision was fair to all parties

7. Directors’ Fiduciary Duties • Delaware law (continued) • Duty of loyalty • Director must act in best interests of corporation and not do things that harm corporation • Director cannot compete directly with corporation unless other directors have expressly permitted competing enterprise • Failure to adhere to these two duties may lead to personal liability by director

8. Daily Governance of the Corporation • Chief executive officer (CEO) • Board recruits and hires CEO to run day-to-day operations • CEO serves as management’s representative to board and is frequently same person as chair of board • CEO hires management team (chief financial officer, chief marketing officer, and other “C-level” executives) • Board holds CEO accountable for corporation’s operating performance and stock price performance

9. Daily Governance of the Corporation • Managers have fiduciary duties of care and loyalty that prohibit them from: • Competing with their employer • Usurping business opportunities • Misappropriating corporate trade secrets and confidential information • Consequences for breaching duties to corporation: • Managers may be sued personally. • Manager’s employment may be terminated.

10. Daily Governance of Corporation • Sarbanes-Oxley Act: Management of public companies is responsible for structuring corporation with adequate “internal controls” so that company has integrity in its financial reporting and other processes • Corporation must report any deficiencies in and status of its internal controls in its public filings with SEC. • This process provides current/prospective shareholders with a view on the riskiness of corporation’s internal management systems.

11. Risk Management • The board of directors and management must appropriately select and manage the risks that a corporation takes as it seeks to increase the per share value of its stock. • Three key risks: • Counterparty risk • Interest rate risk • Liquidity risk

12. Risk Management • Counterparty risk: risk that an organization/person with which a corporation has a business relationship, fails to perform its obligations • Borrowers default on their loan agreements with banks. • Prospective buyers “fail to close” on purchase contract with home sellers. • Domino-like effect (must consider counterparties’ counterparty risk) • To mitigate this risk, avoid concentration of lenders, vendors, customers, etc. (i.e. diversify) • Easier for large company to do than for small, entrepreneurial firm

13. Risk Management • Interest rate risk: risk that a shift in interest rates will adversely affect either company’s assets or liabilities • If a corporation has $100 million of floating rate debt outstanding, a rise in interest rates will increase company’s interest expense burden. • If interest rate increases, value of investor’s fixed rate bonds will be reduced (since bond prices rise when interest rates fall and vice versa). • The lower the coupon payment and the longer the bond has until maturity, the greater the interest rate risk. • To mitigate this risk, balance duration (weighted average cash flows) and mix of fixed/floating interest rate instruments between assets and liabilities • Easier for large financial firms to do than for smaller and non-financial firms

14. Risk Management • Liquidity risk: possibility that firm will not have sufficient cash on hand or immediately available credit to pay its bills as they come due • Some possible causes: • Accounts receivable go bad (due to counterparty risk) • Lenders get nervous and call loan before due date • Unexpected order which necessitates emergency purchase of inventory • To mitigate this risk, keep higher cash balances • Cash is expensive • Without sufficient profitability, raising equity to provide that cash is also expensive • Keeping cash rather than re-investing can be costly • Nevertheless, a failure to have sufficient cash can cause financial distress or bankruptcy

15. Risk Management • Other types of risk: • Product obsolescence risk • Exchange rate risk (for companies doing business internationally) • Succession risk: risk that company cannot adequately replace its current CEO • Corporate boards and audit committees must identify particular risks and ways to mitigate/eliminate those risks!