Governance and Risk Management Chapter 17

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

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

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

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

Directors’ Fiduciary Duties Directors’ two duties to shareholders under Delaware law: 1.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

Directors’ Fiduciary Duties Delaware law (continued) 2.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

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

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.

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.

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: 1.Counterparty risk 2.Interest rate risk 3.Liquidity risk

Risk Management 1.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

Risk Management 2.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

Risk Management 3.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

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!