Corporate Governance and Organizational Architecture FMAChicago Clifford W. Smith SIMON

Organizational Architecture Allocation of decision rights within the organization Allocation of decision rights within the organization Structure of systems to evaluate performance Structure of systems to evaluate performance Methods of rewarding individuals Methods of rewarding individuals

Our analysis draws heavily on economics Differs from much of the management literature Differs from much of the management literature Finance, accounting, organizations historically were institutional/normative Finance, accounting, organizations historically were institutional/normative Five decades ago, finance began to change Five decades ago, finance began to change -Positive analysis -Empirical evidence Three decades ago, accounting followed Three decades ago, accounting followed

Corporate Governance involves The partitioning of decision rights among shareholders, board members, management and others The partitioning of decision rights among shareholders, board members, management and others Systems to monitor and evaluate their performance Systems to monitor and evaluate their performance Methods by which these groups are rewarded Methods by which these groups are rewarded

Corporate Governance is Organizational Architecture at the Top of the Firm

InternalCharter and Bylaws Board Structure Organizational Structure Accounting System Budgeting System HR System Financial Architecture Oversight Agencies Capital Markets Labor Markets Input Markets Product Markets ExternalLegal/Regulatory/Tax

Corporate Governance thus involves a broad array of facets Some (charter, bylaws, organizational structure, accounting system, budgeting system, HR system and financial architecture) are largely chosen internally Some (charter, bylaws, organizational structure, accounting system, budgeting system, HR system and financial architecture) are largely chosen internally Others (oversight agencies, input and output markets and legal/regulatory/tax) are largely external to the firm Others (oversight agencies, input and output markets and legal/regulatory/tax) are largely external to the firm These various facets are interrelated These various facets are interrelated

InternalCharter/Bylaws -Ownership Structure -Ownership Structure -Voting Rules -Voting Rules -Anti-Takeover Provisions -Anti-Takeover Provisions Board Structure Organizational Structure Accounting System Budgeting System HR System Financial Architecture Oversight Agencies Capital Markets Labor Markets Input Markets Product Markets ExternalLegal/Regulatory/Tax

InternalCharter/Bylaws Board Structure - Board Composition - Board Composition - Board Compensation - Board Compensation - Committee Structure - Committee Structure Organizational Structure Accounting System Budgeting System HR System Financial Architecture Oversight Agencies Capital Markets Labor Markets Input Markets Product Markets ExternalLegal/Regulatory/Tax

Decision Management vs. Decision Control Initiation Initiation Ratification Ratification Implementation Implementation Monitoring Monitoring

InternalCharter/Bylaws Board Structure Organizational Structure -Centralization vs. Decentralization -Centralization vs. Decentralization -Business Units: Function vs. Product vs. Geography -Business Units: Function vs. Product vs. Geography Accounting System Budgeting System HR System Financial Architecture Oversight Agencies Capital Markets Labor Markets Input Markets Product Markets ExternalLegal/Regulatory/Tax

InternalCharter and Bylaws Board Structure Organizational Structure Accounting System -Financial Reporting -Financial Reporting -Managerial (cost) accounting -Managerial (cost) accounting -Internal Audit -Internal Audit Budgeting System HR System Financial Architecture Oversight Agencies Capital Markets Labor Markets Input Markets Product Markets ExternalLegal/Regulatory/Tax

InternalCharter and Bylaws Board Structure Organizational Structure Accounting System Budgeting System HR System -Fixed vs. Incentive Compensation -Fixed vs. Incentive Compensation -Accounting Based vs. Stock Based Incentive Compensation -Accounting Based vs. Stock Based Incentive Compensation Financial Architecture Oversight Agencies Capital Markets Labor Markets Product Markets ExternalLegal/Regulatory/Tax

InternalCharter and Bylaws Board Structure Organizational Structure Accounting System Budgeting System HR System Financial Architecture -Leverage -Leverage -Contract Structure (Covenants…) -Contract Structure (Covenants…) -Risk Management -Risk Management -Leasing -Leasing Oversight Agencies Capital Markets Labor Markets Input Markets Product Markets ExternalLegal/Regulatory/Tax

InternalCharter and Bylaws Board Structure Organizational Structure Accounting System Budgeting System HR System Financial Architecture Oversight Agencies -Public Accounting Firms -Public Accounting Firms -D & O Insurance -D & O Insurance Capital Markets Labor Markets Input Markets Product Markets ExternalLegal/Regulatory/Tax

InternalCharter and Bylaws Board Structure Organizational Structure Accounting System Budgeting System HR System Financial Architecture Oversight Agencies Capital Markets -Exchange Listing -Exchange Listing -Investment Banks -Investment Banks -Institutional Investors, Blockholders, Analysts -Institutional Investors, Blockholders, Analysts -Bond Rating Agencies -Bond Rating Agencies -Mergers/Tender Offers -Mergers/Tender Offers Labor Markets Input Markets Product Markets ExternalLegal/Regulatory/Tax

InternalCharter and Bylaws Board Structure Organizational Structure Accounting System Budgeting System HR System Financial Architecture Oversight Agencies Capital Markets Labor Markets -Managerial -Managerial -Board -Board Input Markets Product Markets ExternalLegal/Regulatory/Tax

InternalCharter and Bylaws Board Structure Organizational Structure Accounting System Budgeting System HR System Financial Architecture Oversight Agencies Capital Markets Labor Markets Input Markets Product Markets Legal/Regulatory/Tax Legal/Regulatory/Tax -State Incorporation -State Incorporation -Federal/State Securities -Federal/State Securities -Sarbanes-Oxley -Sarbanes-Oxley External -Williams Act

InternalCharter and Bylaws -Antitakeover provisions Board Structure Organizational Structure Accounting System Budgeting System HR System -Golden parachutes Financial Architecture -Antitakeover debt covenants -Antitakeover debt covenants Oversight Agencies Capital Markets -Tender Offers -Investment Banks -Bond Rating Agencies Labor Markets Input Markets Product Markets Legal/Regulatory/Tax External-Williams Act Corporate Governance is an integrated system—For example, if a hostile takeover is contemplated:

Conclusions Despite widely reported governance failures (Enron, Tyco, WorldCom, Adelphia) thousands of firms uniformly have avoided such problems Despite widely reported governance failures (Enron, Tyco, WorldCom, Adelphia) thousands of firms uniformly have avoided such problems -This extensive press coverage reflects the rarity of the events -This extensive press coverage reflects the rarity of the events -Governance failures are like commercial airplane crashes -Governance failures are like commercial airplane crashes

Conclusions Private incentives exist within the contracting process to resolve these problems in the least costly manner Private incentives exist within the contracting process to resolve these problems in the least costly manner

Conclusions The most rapid, effective, and flexible response to a corporate control failure is within the internal systems of the organization The most rapid, effective, and flexible response to a corporate control failure is within the internal systems of the organization -Is this problem occurring in my firm? -Is this problem occurring in my firm? -Can we do anything to reduce the likelihood of a similar failure? -Can we do anything to reduce the likelihood of a similar failure? -Can we credibly convince external parties that such a failure is unlikely? -Can we credibly convince external parties that such a failure is unlikely?

Conclusions Regulation imposes costs Regulation imposes costs -Direct compliance costs have been discussed more extensively but I believe represent the smaller component -Direct compliance costs have been discussed more extensively but I believe represent the smaller component -Opportunity costs are large and will grow -Opportunity costs are large and will grow -Some regulation (Williams Act, antitakeover statutes) reduce the effectiveness of the corporate control process -Some regulation (Williams Act, antitakeover statutes) reduce the effectiveness of the corporate control process -Regulation limits firm’s abilities to craft customized policies reflecting their specific circumstances -Regulation limits firm’s abilities to craft customized policies reflecting their specific circumstances -Regulation limits experimentation -Regulation limits experimentation

Corporate Governance and Organizational Architecture FMAChicago Clifford W. Smith SIMON