1. Session 07 © Furrer 2002-20081 Corporate Strategy Fall 2008 Session 7 - Lecture 3 Corporate Governance Dr. Olivier Furrer Office: TvA 1-1-11, Phone: 361 30 79 e-mail: o.furrer@fm.ru.nl Office Hours: only by appointment

2. Session 07 © Furrer 2002-20082 Corporate Governance Market, hierarchy, and the limits to the scope of the firm. => Transaction Costs Theory. (Williamson, 1975, 1985) Principals, agents, and the limits of the control mechanisms. => Agency Theory. (Fama and Jensen, 1983) Stakeholders, Stewards, and the limits of transaction and agency theories. (Carroll, 1979, 2003; Davis, Schoorman & Donaldson, 1997; Ghoshal, 2006)

3. Session 07 © Furrer 2002-20083 An agency relationship exists when: Shareholders (Principals) Firm Owners Agency Relationship Risk Bearing Specialist (Principal) Managers (Agents) Decision Makers which creates Managerial Decision- Making Specialist (Agent) Hire Agency Theory Source: adapted from Fama and Jensen (1983)

4. Session 07 © Furrer 2002-20084 Managers’ Self-Interest Maximizing Growth, Not Earnings Diversifying Risk Managerial Risk Aversion Managerial Self-Preservation (managerial entrenchment) Managerial Enrichment

5. Session 07 © Furrer 2002-20085 Level of Diversification Manager and Shareholder Risk and Diversification Risk Dominant Business Unrelated Businesses Related Constrained Related Linked Shareholder (Business) Risk Profile Managerial (Employment) Risk Profile S M A B

6. Session 07 © Furrer 2002-20086 The hubris (or pride) hypothesis (Roll, 1986) implies that managers seek to acquire firms for their own personal motives and that the pure economic gains to the acquiring firm are not the sole motivation or even the primary motivation in the acquisition. Roll (1986) states that if the hubris hypothesis explains takeovers, the following should occur for those takeovers motivated by hubris: –The stock price of the acquiring firm should fall after the market becomes aware of the takeover bid. This should occur because the takeover is not in the best interests of the acquiring firm’s stockholders and does not represent an efficient allocation of their wealth. –The stock price of the target should increase with the bid for control. This should occur because the acquiring firm is not only going to pay a premium but also may pay a premium for excess of the value of the target. –The combined effect of the rising value of the target and the falling value of the acquiring firm should be negative. This takes into account the costs of completing the takeover process. Hubris Hypothesis of Takeovers Roll, Richard (1986), “The Hubris Hypothesis of Corporate Takeovers,” Journal of Business, 59 (2), 197-216.

7. Session 07 © Furrer 2002-20087 Hubris Hypothesis of Takeovers Hayward, Mathew L. A. and Donald C. Hambrick (1995), “Explaining Premiums Paid for Large Acquisitions: Evidence of CEO Hubris,” Unpublished Manuscript, July HUBRIS Acquisition Premium Board Vigilance CEO Recent Performance CEO Media Praise CEO Inexperience CEO Self-Importance

8. Session 07 © Furrer 2002-20088 The winner’s curse of takeovers states that bidders who overestimate the value of a target will most likely win a contest. This is due to the fact that they will be more inclined to overpay and outbid rivals who more accurately value the target. This result is not specific to takeovers but is the natural result of any bidding contest (Baserman and Samuelson, 1983). In a study of 800 acquisition from 1974 to 1983, Varaiya (1988) showed that on average the winning bid in takeover contests significantly overstated the capital market’s estimate of any takeover gains by as much as 67%. Varaiya (1988) measured overpayment as the difference between the winning bid premium and the highest bid possible before the market responded negatively to the bid. This study provides support for the existence of the winner’s curse, which in turn, also supports the hubris hypothesis. The Winner’s Curse Hypothesis of Takeovers Varaiya, Nikhil (1988), “The Winner’s Curse Hypothesis and Corporate Takeovers,” Managerial and Decision Economics, 9, 209-219.

9. Session 07 © Furrer 2002-20089 Contextual Factors that Exacerbate Agency Problems Antitrust Enforcement Life Cycle and Free Cash Flow Market Pressure (Quarterly Earnings) Executive Compensation Disengaged Shareholders

10. Session 07 © Furrer 2002-200810 Governance Mechanisms Ownership Concentration Boards of Directors Executive Compensation Market for Corporate Control Multidivisional Organizational Structure

11. Session 07 © Furrer 2002-200811 Ownership Concentration monitor management closely time, effort and expense to monitor closely - Large block shareholders have a strong incentive to - Their large stakes make it worth their while to spend - They may also obtain Board seats which enhances their ability to monitor effectively (although financial institutions are legally forbidden from directly holding board seats) Governance Mechanisms

12. Session 07 © Furrer 2002-200812 Boards of Directors - Review and ratify important decisions - Set compensation of CEO and decide when to replace the CEO - Lack contact with day to day operations - Insiders - Related Outsiders - Outsiders Governance Mechanisms

13. Session 07 © Furrer 2002-200813 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 Governance Mechanisms

14. Session 07 © Furrer 2002-200814 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 Executive Compensation In addition, stock ownership (long-term incentive compensation) makes managers more susceptible to market changes which are partially beyond their control Incentive systems do not guarantee that managers make the “right” decisions, but they do increase the likelihood that managers will do the things for which they are rewarded Governance Mechanisms

15. Session 07 © Furrer 2002-200815 Designed to control managerial opportunism - Corporate office and Board monitor managers’ strategic decisions - Increased managerial interest in wealth maximization Multidivisional Organizational Structure Governance Mechanisms M-form structure does not necessarily limit corporate- level managers’ self-serving actions - May lead to greater rather than less diversification Broadly diversified product lines makes it difficult for top-level managers to evaluate the strategic decisions of divisional managers

16. Session 07 © Furrer 2002-200816 Market for Corporate Control Operates when firms face the risk of takeover when they are operated inefficiently The market for corporate control acts as an important source of discipline over managerial incompetence and waste Changes in regulations have made hostile takeovers difficult Many firms began to operate more efficiently as a result of the “threat” of takeover, even though the actual incidence of hostile takeovers was relatively small The 1980s saw active market for corporate control, largely as a result of available pools of capital (junk bonds) Governance Mechanisms

17. Session 07 © Furrer 2002-200817 Legislation Beginning in late 2001, several large American companies (Enron, Worldcom, etc.) experienced spectacular bankruptcies because of fraud on the part of their executives and less than optimal corporate governance practices on the part of their boards. Sarbannes-Oxley Act - CEOs and CFOs of the largest corporations should personally sign off financial statements, certifying they are true and accurate (Penalty: up to 20-year prison sentence) - A new definition of “independent director,” also changed the rules as to how to audit firms. Governance Mechanisms

18. Session 07 © Furrer 2002-200818 Shareholders Service Organizations and Corporate Governance Rating Firms Companies such as GovernanceMetrics, Moody’s, and Standard & Poor’s offer rating of corporate governance systems. Alternative theories - Stewardship Theory (Davis, Schoorman & Donaldson, 1997) - Stakeholder Theory (Freeman, 1984) - Corporate Social Responsibility (Carroll, 1979, 2003) Global Convergence in Corporate Governance Governance Mechanisms

19. Session 07 © Furrer 2002-200819 Stewardship Theory Reference: Davis, Schoorman & Donaldson, 1997

20. Session 07 © Furrer 2002-200820 Stewardship Theory Reference: Davis, Schoorman & Donaldson, 1997

21. Session 07 © Furrer 2002-200821 Stakeholder Theory Firm Local community organization Owners Consumer advocates Customer Media Competitors Governments Suppliers Environmentalists SIG Employees Reference: Freeman, 1984

22. Session 07 © Furrer 2002-200822 Carroll’s Corporate Social and Economic Responsibilities Adapted from Carroll, 1979, 2003 Economic Legal Ethical Philanthropic « Be profitable » Required « Obey the law » Required « Be ethical » Expected « Be a good corporate citizen » Desired Economic Social Responsibilities