1 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

2 Corporate Governance Mechanisms Ownership concentration –relative amounts of stock owned by individual shareholders and institutional investors Board of Directors –individuals responsible for representing the firm’s owners by monitoring top-level managers’ strategic decisions Internal Governance Mechanisms

3 Corporate Governance Mechanisms Executive Compensation –use of salary, bonuses, and long- term incentives to align managers’ interests with shareholders’ interests Monitoring by top-level managers Monitoring by top-level managers –they may obtain Board seats (not in financial institutions) –they may elect Board representatives Internal Governance Mechanisms

4 Corporate 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 External Governance Mechanisms

5 Separation of Ownership and Managerial Control Basis of the modern corporation 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 Modern public corporation form leads to efficient specialization of tasks –risk bearing by shareholders –strategy development and decision-making by managers

6 Agency Theory Problem The agency problem occurs when: 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 appropriately Solution: 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 Risk Diversification DominantBusinessUnrelatedBusinessesRelatedConstrainedRelatedLinked Managerial (employment) risk profile B Shareholder (business) risk profile S A M

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

9 Governance Mechanisms OwnershipConcentration Large block shareholders have a strong incentive to monitor management closelyLarge 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 closelyTheir 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)They may also obtain Board seats which enhances their ability to monitor effectively (although financial institutions are legally forbidden from directly holding board seats)

10 Governance Mechanisms OwnershipConcentration Boards of Directors Insiders The firm’s CEO and other top-level managersThe 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 companyIndividuals not involved with day- to-day operations, but who have a relationship with the companyOutsiders Individuals who are independent of the firm’s day-to-day operations and other relationshipsIndividuals who are independent of the firm’s day-to-day operations and other relationships

11 Governance Mechanisms OwnershipConcentration Boards of Directors Recommendations for more effective Board Governance: Increase diversity of board members’ backgroundsIncrease diversity of board members’ backgrounds Strengthen internal management and accounting control systemsStrengthen internal management and accounting control systems Establish formal processes for evaluation of the board’s performanceEstablish formal processes for evaluation of the board’s performance

12 Governance Mechanisms OwnershipConcentration Boards of Directors ExecutiveCompensation Salary, bonuses, long term incentive compensationSalary, bonuses, long term incentive compensation Executive decisions are complex and non-routineExecutive decisions are complex and non-routine Many factors intervene making it difficult to establish how managerial decisions are directly responsible for outcomesMany factors intervene making it difficult to establish how managerial decisions are directly responsible for outcomes

13 Governance Mechanisms OwnershipConcentration Boards of Directors ExecutiveCompensation Stock ownership (long-term incentive compensation) makes managers more susceptible to market changes which are partially beyond their controlStock 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 rewardedIncentive 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

14 Governance Mechanisms OwnershipConcentration Boards of Directors ExecutiveCompensation Market for Corporate Control Firms face the risk of takeover when they are operated inefficientlyFirms 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 smallMany 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 difficultChanges in regulations have made hostile takeovers difficult Acts as an important source of discipline over managerial incompetence and wasteActs as an important source of discipline over managerial incompetence and waste

15 International Corporate Governance: Owner and manager are often the same in private firms Owner and manager are often the same in private firms Public firms often have a dominant shareholder, frequently a bank 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 Frequently there is less emphasis on shareholder value than in U.S. firms, although this may be changing Germany

16 International Corporate Governance: Medium to large firms have a two-tiered board 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 Germany

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

18 International Corporate Governance: Other characteristics: 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 Japan

19 Corporate Governance and Ethical Behavior In the U.S., shareholders (in the capital market stakeholder group) are viewed as the most important stakeholder groupIn the U.S., shareholders (in the capital market stakeholder group) are viewed as the most important stakeholder group which are served by the board of directorswhich are served by the board of directors Hence, the focus of governance mechanisms is on the control of managerial decisions to ensure that shareholders’ interests will be servedHence, the focus of governance mechanisms is on the control of managerial decisions to ensure that shareholders’ interests will be served It is important to serve the interests of the firm’s multiple stakeholder groups! Capital Market Stakeholders

20 It is important to serve the interests of the firm’s multiple stakeholder groups! Corporate Governance and Ethical Behavior Product market stakeholders (customers, suppliers and host communities) and organizational stakeholders (managerial and non-managerial employees) are also important stakeholder groupsProduct market stakeholders (customers, suppliers and host communities) and organizational stakeholders (managerial and non-managerial employees) are also important stakeholder groups Product Market Stakeholders Capital Market Stakeholders

21 It is important to serve the interests of the firm’s multiple stakeholder groups! Corporate Governance and Ethical Behavior Although the idea is subject to debate, some believe that ethically responsible companies design and use governance mechanisms that serve all stakeholders’ interestsAlthough the idea is subject to debate, some believe that ethically responsible companies design and use governance mechanisms that serve all stakeholders’ interests Importance of maintaining ethical behavior through governance mechanisms is seen in the example of Enron and Arthur AndersenImportance of maintaining ethical behavior through governance mechanisms is seen in the example of Enron and Arthur Andersen Product Market Stakeholders OrganizationalStakeholders Capital Market Stakeholders