1. Corporate governance
Week 9

2. Outline Separation of ownership & managerial control
Ownership concentration
Boards of directors
Executive compensation
Multi-divisional structure
International corporate governance
Governance mechanisms and ethical behaviour

3. Corporate Governance
The relationship among stakeholders that is used to determine and control the strategic direction and performance of the organisation
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

4. Shareholders
The right to share in residual income means that shareholders must accept the risk that no residual profits will remain if the firm’s expenses exceed its income.
Reduce risk efficiently by holding diversified portfolios
In small firms, managers and owners are often one in the same, so there is no separation of ownership and control.
As firms grow larger, individual owners generally do not have access to sufficient capital to fund the growth of the business and seek other investors with which to share residual profits (and risk).

5. Separation of Ownership & Managerial Control
Shareholders
Purchase stock, becoming Residual Claimants
Reduce risk efficiently by holding diversified portfolios
Professional managers contract to provide decision-making
Leads to efficient specialisation of tasks, such as:
Risk bearing by shareholders
Strategy development and decision-making by managers

6. Agency Theory Hire which creates An agency relationship exists when:
Risk Bearing Specialist
(Principal)
Managerial Decision-Making Specialist
(Agent)
Shareholders
(Principals)
Firm Owners
Hire
Managers
(Agents)
Decision
Makers
which creates 17

7. Agency Theory
An agency problem occurs when 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
Example: Over-diversification that occurs because increased product diversification leads to lower employment risk for managers and greater compensation

8. Manager & Shareholder Risk & Diversification
Shareholder (Business) Risk Profile
Managerial
(Employment) Risk Profile
Risk
Dominant
Business
Related
Constrained
Related
Linked
Unrelated
Businesses
Level of Diversification 24

9. Agency Theory The Solution: Incentive-based performance contracts
Monitoring mechanisms such as the board of directors
Enforcement mechanisms such as the managerial labour market

10. Agency Theory
Principals may engage in monitoring behaviour to assess the activities and decisions of managers
However, dispersed shareholding makes it difficult and inefficient to monitor management’s behaviour
Boards of directors have a fiduciary duty to their shareholders to monitor management
However, boards of directors are often accused of being lax in performing this function

11. Agency Costs
The sum of incentive, monitoring, and enforcement costs as well as any residual losses incurred by principals because it is not possible for principals to guarantee 100% compliance through monitoring arrangements.

12. Corporate Governance Mechanisms
Prevent problems emanating from the separation of ownership and control by positively influencing managerial behaviour
Direct top level managers actions towards preferred shareholder aims is dependent on correct mechanisms

13. Governance Mechanisms
Internal
Ownership Concentration
Boards of Directors
Executive Compensation
Multidivisional Organisational Structure
External
Market for Corporate Control

14. Internal Governance Mechanisms
Ownership concentration
Relative amounts of stock owned by individual shareholders & institutional investors
Defined by the number of large block shareholders and the total % they own
Large block typically have at least 5%
Large block shareholders have a strong incentive to monitor management closely

15. Internal Governance Mechanisms
Ownership concentration
Their large stakes make it worthwhile for them to spend time, effort and expense to monitor closely
They can obtain board seats. This enhances their ability to monitor effectively (although financial institutions are legally forbidden to hold board seats directly)
Diffuse Ownership
Produces weak monitoring of managerial decisions

16. Internal Governance Mechanisms
Diffuse Ownership (cont.)
Makes it difficult for owners to coordinate their actions effectively
May result in levels of diversification that are beyond the optimum level desired by shareholders (especially when this condition is combined with weak monitoring)

17. Internal Governance Mechanisms
Board of Directors
Responsible for representing the firms owners by monitoring strategic decisions of top level managers
Consists of insiders, related outsiders and outsiders
Review and ratify important decisions
Set compensation for the CEO and decide when to replace the CEO
Usually lack contact with day-to-day operations

18. Internal Governance Mechanisms
Board of Directors
Must deal with Managerial Opportunism
Seeking of self-interest with guile where opportunism is represented by an attitude or inclination and a set of behaviors (self-interest seeking with guile).

19. Internal Governance Mechanisms
Executive Compensation
Salary, bonuses, long-term incentive compensation
To align interests of managers with those of shareholders
Executive decisions are complex and non-routine
It is difficult to establish how managerial decisions are directly responsible for outcomes

20. Internal Governance Mechanisms
Executive compensation
Incentive systems do not guarantee that managers make the ‘right’ decisions, but do increase the likelihood that managers will perform the activities and achieve the results for which they are rewarded
Stock ownership (long-term incentive compensation) makes managers more susceptible to market changes that are partially beyond their control

21. Internal Governance Mechanisms
Multi-divisional structure
Designed to control managerial opportunism
Corporate office and board monitor business-unit managers’ strategic decisions
Increased managerial interest in maximising wealth
Broadly diversified product lines make it difficult for top-level managers to evaluate the strategic decisions of divisional managers

22. Internal Governance Mechanisms
Multi-divisional structure (cont.)
It may not effectively govern actions taken by the corporate office.
Firms using the M-form structure are more likely to continue diversification.
The M-form facilitates further diversification.
Continued diversification may create conditions requiring division mangers to emphasize short-term results.

23. External Governance Mechanism
Market for corporate control
The market for corporate control acts as an important source of discipline over managerial incompetence and waste
Operates when firms face the risk of takeover where they are operated inefficiently
Changes in regulations have made hostile takeovers difficult

24. Board of Directors Powers Directing the affairs of the organisation
Punishing (disciplining) and rewarding (compensating) managers
Protecting the rights and interests of shareholders (owners)
As a result, if the board of directors is appropriately structured and operates in an effective manner, it can protect owners from managerial opportunism.

25. Board of Directors Problems
Insiders continue to dominate boards (by controlling the flow of information to outside directors)
Outside directors are nominated for board membership by insiders (primarily by the CEO) and thus are indebted to insiders

26. Board of Directors Boards working collaboratively with management
Make higher quality strategic decisions
Make decisions faster
Become more involved in decisions regarding succession (rather than blindly supporting the incumbent’s choice)

27. Board of Directors Recommendations for More Effective Board
Governance:
Increase diversity of board members’ backgrounds (Australian boards obviously lack diversity)
Strengthen internal management and accounting control systems
Establish formal processes for evaluation of the board’s performance

28. Corporate Governance in Australia
Importance of institutional shareholders
A small market for corporate control compared to the USA
Boards are relatively small: 6-12 people, very few females, many multiple board memberships, 75% non-executive directors
Australian landscape features an active financial press, an active shareholders’ association and an increasingly important role for government in corporate governance

29. Corporate Governance in Australia
Major banks dominate large companies
The top three shareholders of Amcor, BHP and Brambles are the same:
Westpac
Chase Manhattan (a US bank)
National Nominees (NAB)

30. Corporate Governance in Australia
There must be protection for all shareholders (including those with a minority holding)
Management must be held accountable to shareholders regularly
There must be transparency and full disclosure by each Australian Stock Exchange-listed company
There must be an active, and independent, board that oversees a corporation’s management.

31. Laws and Institutions in Australia
Legislation:
Corporations Law
Trade Practices Act 1974
Prices Surveillance Act 1983
The Australian Competition and Consumer Commission (ACCC);
Australian Securities and Investments Commission (ASIC);
Australian Stock Exchange (ASX)
Shareholder activists
Financial media

32. Corporate Governance in Germany
Public firms often have a dominant shareholder frequently a bank
Medium-to-large firms have a two-tiered board:
Vorstand monitors and controls managerial decisions
Aufsichtsrat selects the Vorstand
Employees, union members and shareholders appoint members to the Aufsichtsrat
There is usually less emphasis on shareholder value than for Australian. firms, although this may be changing

33. Corporate Governance in Japan
Obligation, ‘family’ and consensus are important factors
Banks (especially ‘main bank’) are highly influential with firm’s managers
Keiretsus are strongly interrelated groups of firms tied together by cross-shareholdings
Powerful government intervention
Close relationships between firms and government sectors
Passive and stable shareholders who exert little control
Virtual absence of external market for corporate control

34. Ethical Corporate Behaviour
It is important to serve the interests of multiple stakeholder groups
Important stakeholder groups
Shareholders are served by the board of directors
Product market stakeholders (customers, suppliers and host communities) and
organisational stakeholders (managerial and non-managerial employees)
There is a controversial belief that ethically responsible firms should introduce governance mechanisms that serve all stakeholders’ interests

35. Australian Shareholders Association
An active lobby group against corporate governance misbehaviour
Has policies about:
Executive performance
Conflict of interest
Disclosure
Poor firm performance