ECON 308 Week 15 Corporate Governance Chapter 18 1

Learning Objectives Describe the nature of publicly-traded organizations Identify and assess issues related to separation of ownership and control Describe the top-level architecture of US corporations Assess the role of Sarbanes-Oxley in correcting architecture failures Appendix: Identify advantages and disadvantages of alternative organizational forms 2

Corporate structure Corporations have the legal standing of an individual Shareholders elect a board of directors with primary decision control rights Shareholder-owners have limited liability Corporations may establish governance procedures within legal boundaries 3

Corporate ownership publicly-traded versus closely-held Stock in closely-held corporations is not freely traded Stock of publicly-traded corporations may be freely bought and sold 4

Corporate governance objectives Maximizing value Protecting assets Meeting legal requirements 5

Separation of ownership and control Incentive issues –Are executive interests aligned with those of stockholders? Survival of corporations –Despite governance concerns, the corporate form seems both productive and resilient Benefit of publicly-traded corporations –Ability to raise large amounts of capital 6

Top-level architecture US corporations Decision rights divided among selected stakeholders –Shareholders –Governing board –Top management –External monitors Distinction between decision rights and decision control 7

Government impacts on decision rights State regulations affect firms incorporated within those states Federal laws and regulations further stipulate decision rights Courts have impact through interpretations of laws 8

Shareholders Ultimate owners Limited participation in management –Elect board –Board oversees management –Some ratification rights 9

Shareholder incentives Small shareholders (individuals) have incentive to free ride rather than be actively involved Institutional investors (e.g. pension funds) differ in incentives to challenge management Blockholders internalize more of the benefits of active involvement 10

Board of Directors Delegates legal authority to professional managers Primary function is top-level decision control Other responsibilities –Hire, monitor, fire CEO –Authorize strategic directions –Approve large capital outlays 11

Board composition and work Size can vary from 4 to 33+ Over half are outside directors CEO usually sits on board –Frequently chairs the board Much work done in committees –Audit –Compensation –Nominating 12

Board member incentives Some stock ownership aligns financial interests with other shareholders High-profile board members have reputational concerns Are members independent of top management? 13

Top management CEO’s decision authority flows from the board More decision rights are delegated as firm size and complexity increase Senior management retains important decision rights –Shape strategic direction –Establish overall architecture –Recruiting and retaining key personnel 14

Top management incentives Straight salary Performance-based compensation –Bonuses –Stock options –Stock ownership 15

External monitors Public accounting firms Stock market analysts Commercial banks Credit-rating agencies Regulatory authorities 16

International corporate governance Historical emphasis on broader set of stakeholders –Employees –Lenders –Affiliated companies –Broader public Gradual shift toward US architecture 17

Monitoring effect of market forces Management failure opens door to hostile takeover Management failure closes door to further professional opportunities Inefficiency places firm’s products at competitive disadvantage 18

Sarbanes-Oxley Act of 2002 Establishes Public Companies Accounting Oversight Board Prohibits certain transactions between companies and managers Holds CEOs and CFOs accountable for financial statements Establishes civil and criminal penalties for violations 19