Corporate governance Week 9

Outline Separation of ownership & managerial control Ownership concentration Boards of directors Executive compensation Multi-divisional structure International corporate governance Governance mechanisms and ethical behaviour

Corporate Governance The relationship among stakeholders that is used to determine and control the strategic direction and performance of the organisation 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

Shareholders The right to share in residual income means that shareholders must accept the risk that no residual profits will remain if the firm’s expenses exceed its income. Reduce risk efficiently by holding diversified portfolios In small firms, managers and owners are often one in the same, so there is no separation of ownership and control. As firms grow larger, individual owners generally do not have access to sufficient capital to fund the growth of the business and seek other investors with which to share residual profits (and risk).

Separation of Ownership & Managerial Control Shareholders Purchase stock, becoming Residual Claimants Reduce risk efficiently by holding diversified portfolios Professional managers contract to provide decision-making Leads to efficient specialisation of tasks, such as: Risk bearing by shareholders Strategy development and decision-making by managers

Agency Theory Hire which creates An agency relationship exists when: Risk Bearing Specialist (Principal) Managerial Decision-Making Specialist (Agent) Shareholders (Principals) Firm Owners Hire Managers (Agents) Decision Makers which creates 17

Agency Theory An 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 appropriately Example: Over-diversification that occurs because increased product diversification leads to lower employment risk for managers and greater compensation

Manager & Shareholder Risk & Diversification Shareholder (Business) Risk Profile Managerial (Employment) Risk Profile Risk Dominant Business Related Constrained Related Linked Unrelated Businesses Level of Diversification 24

Agency Theory The Solution: Incentive-based performance contracts Monitoring mechanisms such as the board of directors Enforcement mechanisms such as the managerial labour market

Agency Theory Principals may engage in monitoring behaviour to assess the activities and decisions of managers However, dispersed shareholding makes it difficult and inefficient to monitor management’s behaviour Boards of directors have a fiduciary duty to their shareholders to monitor management However, boards of directors are often accused of being lax in performing this function

Agency Costs The sum of incentive, monitoring, and enforcement costs as well as any residual losses incurred by principals because it is not possible for principals to guarantee 100% compliance through monitoring arrangements.

Corporate Governance Mechanisms Prevent problems emanating from the separation of ownership and control by positively influencing managerial behaviour Direct top level managers actions towards preferred shareholder aims is dependent on correct mechanisms

Governance Mechanisms Internal Ownership Concentration Boards of Directors Executive Compensation Multidivisional Organisational Structure External Market for Corporate Control

Internal Governance Mechanisms Ownership concentration Relative amounts of stock owned by individual shareholders & institutional investors Defined by the number of large block shareholders and the total % they own Large block typically have at least 5% Large block shareholders have a strong incentive to monitor management closely

Internal Governance Mechanisms Ownership concentration Their large stakes make it worthwhile for them to spend time, effort and expense to monitor closely They can obtain board seats. This enhances their ability to monitor effectively (although financial institutions are legally forbidden to hold board seats directly) Diffuse Ownership Produces weak monitoring of managerial decisions

Internal Governance Mechanisms Diffuse Ownership (cont.) Makes it difficult for owners to coordinate their actions effectively May result in levels of diversification that are beyond the optimum level desired by shareholders (especially when this condition is combined with weak monitoring)

Internal Governance Mechanisms Board of Directors Responsible for representing the firms owners by monitoring strategic decisions of top level managers Consists of insiders, related outsiders and outsiders Review and ratify important decisions Set compensation for the CEO and decide when to replace the CEO Usually lack contact with day-to-day operations

Internal Governance Mechanisms Board of Directors Must deal with Managerial Opportunism Seeking of self-interest with guile where opportunism is represented by an attitude or inclination and a set of behaviors (self-interest seeking with guile).

Internal Governance Mechanisms Executive Compensation Salary, bonuses, long-term incentive compensation To align interests of managers with those of shareholders Executive decisions are complex and non-routine It is difficult to establish how managerial decisions are directly responsible for outcomes

Internal Governance Mechanisms Executive compensation Incentive systems do not guarantee that managers make the ‘right’ decisions, but do increase the likelihood that managers will perform the activities and achieve the results for which they are rewarded Stock ownership (long-term incentive compensation) makes managers more susceptible to market changes that are partially beyond their control

Internal Governance Mechanisms Multi-divisional structure Designed to control managerial opportunism Corporate office and board monitor business-unit managers’ strategic decisions Increased managerial interest in maximising wealth Broadly diversified product lines make it difficult for top-level managers to evaluate the strategic decisions of divisional managers

Internal Governance Mechanisms Multi-divisional structure (cont.) It may not effectively govern actions taken by the corporate office. Firms using the M-form structure are more likely to continue diversification. The M-form facilitates further diversification. Continued diversification may create conditions requiring division mangers to emphasize short-term results.

External Governance Mechanism Market for corporate control The market for corporate control acts as an important source of discipline over managerial incompetence and waste Operates when firms face the risk of takeover where they are operated inefficiently Changes in regulations have made hostile takeovers difficult

Board of Directors Powers Directing the affairs of the organisation Punishing (disciplining) and rewarding (compensating) managers Protecting the rights and interests of shareholders (owners) As a result, if the board of directors is appropriately structured and operates in an effective manner, it can protect owners from managerial opportunism.

Board of Directors Problems Insiders continue to dominate boards (by controlling the flow of information to outside directors) Outside directors are nominated for board membership by insiders (primarily by the CEO) and thus are indebted to insiders

Board of Directors Boards working collaboratively with management Make higher quality strategic decisions Make decisions faster Become more involved in decisions regarding succession (rather than blindly supporting the incumbent’s choice)

Board of Directors Recommendations for More Effective Board Governance: Increase diversity of board members’ backgrounds (Australian boards obviously lack diversity) Strengthen internal management and accounting control systems Establish formal processes for evaluation of the board’s performance

Corporate Governance in Australia Importance of institutional shareholders A small market for corporate control compared to the USA Boards are relatively small: 6-12 people, very few females, many multiple board memberships, 75% non-executive directors Australian landscape features an active financial press, an active shareholders’ association and an increasingly important role for government in corporate governance

Corporate Governance in Australia Major banks dominate large companies The top three shareholders of Amcor, BHP and Brambles are the same: Westpac Chase Manhattan (a US bank) National Nominees (NAB)

Corporate Governance in Australia There must be protection for all shareholders (including those with a minority holding) Management must be held accountable to shareholders regularly There must be transparency and full disclosure by each Australian Stock Exchange-listed company There must be an active, and independent, board that oversees a corporation’s management.

Laws and Institutions in Australia Legislation: Corporations Law Trade Practices Act 1974 Prices Surveillance Act 1983 The Australian Competition and Consumer Commission (ACCC); Australian Securities and Investments Commission (ASIC); Australian Stock Exchange (ASX) Shareholder activists Financial media

Corporate Governance in Germany Public firms often have a dominant shareholder frequently a bank 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 There is usually less emphasis on shareholder value than for Australian. firms, although this may be changing

Corporate Governance in 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 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

Ethical Corporate Behaviour It is important to serve the interests of multiple stakeholder groups Important stakeholder groups Shareholders are served by the board of directors Product market stakeholders (customers, suppliers and host communities) and organisational stakeholders (managerial and non-managerial employees) There is a controversial belief that ethically responsible firms should introduce governance mechanisms that serve all stakeholders’ interests

Australian Shareholders Association An active lobby group against corporate governance misbehaviour Has policies about: Executive performance Conflict of interest Disclosure Poor firm performance