1. Who Controls Our Business?
Chapter 10
Corporate Governance
Who Controls Our Business?

2. 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

3. Corporate Governance and Ethical Behavior
The Firm
It is important to serve the interests of the firm’s multiple stakeholder groups!
Although 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 Andersen
Capital Market
Stakeholders
Product Market
Stakeholders
Organizational
Stakeholders

4. Corporate Governance and Ethical Behavior
The Firm
It is important to serve the interests of the firm’s multiple stakeholder groups!
Capital Market
Stakeholders
In 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 directors
Hence, the focus of governance mechanisms is on the control of managerial decisions to ensure that shareholders’ interests will be served

5. Separation of Ownership and Managerial Control
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
risk bearing by shareholders
strategy development and decision-making by managers

6. Agency Relationship: Owners and Managers
Shareholders
(Principals)
Firm owners
Managers
(Agents)
Decision makers
Risk bearing specialist (principal) pays compensation to
A managerial decision-making specialist (agent)
An Agency
Relationships

7. Agency Theory Problem The agency problem occurs when: Solution:
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:
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

8. Agency Theory Conflicts
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, however, Boards of Directors are often accused of being lax in performing this function

9. Corporate Governance Mechanisms
The Firm
Corporate Governance Mechanisms
Internal 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
Executive Compensation
use of salary, bonuses, and long-term incentives to align managers’ interests with shareholders’ interests

10. Corporate Governance Mechanisms
The Firm
The Firm
External 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

11. Governance Mechanisms
Ownership
Concentration
Large 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 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)

12. Governance Mechanisms
Ownership
Concentration
Insiders
The 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 company
Outsiders
Individuals who are independent of the firm’s day-to-day operations and other relationships
Boards of
Directors

13. Governance Mechanisms
Ownership
Concentration
Recommendations for more effective Board Governance:
Increase diversity of board members’ backgrounds
Strengthen internal management and accounting control systems
Establish formal processes for evaluation of the board’s performance
Boards of
Directors

14. Governance Mechanisms
Ownership
Concentration
Salary, bonuses, long term incentive compensation
Executive decisions are complex and non-routine. Many factors intervene making it difficult to establish how managerial decisions are directly responsible for outcomes
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 rewarded
Boards of
Directors
Executive
Compensation

15. Governance Mechanisms
Ownership
Concentration
Firms 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 small
Changes in regulations have made hostile takeovers more difficult
Acts as an important source of discipline over managerial incompetence and waste
Boards of
Directors
Executive
Compensation
Market for
Corporate Control