1 On the Efficiency of Internal and External Corporate Control Mechanisms Walsh, James P. and Seward, James K. (1990), Academy of Management Review, 15 (3): On the Efficiency of Internal and External Corporate Control Mechanisms Walsh, James P. and Seward, James K. (1990), Academy of Management Review, 15 (3): Prepared by: Enrique, Lihong, John, Jongkuk

2 Introduction In modern firms, owners usually diversify their holdings: Owners usually do not monitor managers themselves Boards of Directors are hired to monitor the managers for the owners As the amount of influence of individual shareholders decrease, the influence of top management increases

3 Owner’s Interests To earn the maximum economic profit with a compatible degree of risk To distribute the profits generously and equitably among the owners To maintain market conditions favorable to the owner (Berle & Means, 1932)

4 Manager’s Interests Unfortunately the management may be motivated by: Prestige Power Gratification of professional zeal This is the “agency problem”

5 Internal Control Options These are measures designed to bring the economic interests of managers and shareholders into alignment Managerial vs. Environmental Assessments must be made: Bad decisions Unfavorable business environment

6 Assessment How does the board assess the situation? From inside directors By comparing with other similar firms Managers can become the scapegoats for poor performance

7 MisplacedMisguided IncompetentShirking High Low High Effort Ability Figure 1: Inferences about top Management Performance

8 Internal Control Options Alter the incentives of top management Are the incentives structured correctly? Increasing the magnitude of compensation Tying compensation to firm results Accounting rates of return Use market measures like stock price Dismiss top management

9 Internal Entrenchment Practices Alter personal assessments of the board Withholding information Using outside consulting reports Set norms where they cannot be questioned Alter Situation Assessments Pointing out the environmental difficulties

10 Internal Entrenchment Practices Alter Performance Assessments Set low expectations Redefine performance metrics Avoid Internal Control Mechanisms Avoid pay-for-performance plans Aim for high management salaries Use accounting measures for bonuses Become non-substitutable (Lee Iacocca)

11 Addressing Internal Control Inefficiencies Include outside directors on the board Increase the ownership of managers May increase manager entrenchment May also align managers and owners

12 External Control Options The Market for Corporate Control Assumptions: Underperformance will be represented in company stock Other management teams will compete for the company’s resources The firm will be acquired

13 Reasons to Acquire a Firm Reasons to Acquire Synergies Tax Savings Wealth transfers Hubris Elimination of inefficient management Target firms usually increase in value

14 Dual Class Re-capitalization Acquisitions and divestitures Greenmail Poison Pills New Securities Spin offs, Sell offs etc. Supermajority amendments Fair Price amendments State of incorporation Voting Rights amendments Litigation by target Standstill Agreements Anti-takeover amendments Golden Parachutes Shareholder Approval Required No Shareholder Approval Required OperatingNon-Operating

15 Effective Governance Internal: Incentives are designed appropriately and management responds appropriately External: None needed Board Obstruction Internal: Incentives are designed inappropriately and management is scapegoated External: Going private Managerial Deadwood Internal: Incentives are designed appropriately and management responds inappropriately External: Tender Offers Governance Failure Internal: Incentives are designed inappropriately and management exhibits low ability and effort External: hostile takeovers Good Bad Board of Directors GoodBad Management

16 International Perspectives Different countries use different mechanisms I.E., Japan generally does not use turnover as a control mechanism Monitoring often comes from banks and capital sources

17 Conclusions Both internal and external controls are used by firms to control managers Management can use various methods to entrench themselves against these controls Work by financial economists and organizational theorists can be synthesized