1. PowerPoint Presentation by Charlie Cook Gordon Walker McGraw-Hill/Irwin Copyright © 2004 McGraw Hill Companies, Inc. All rights reserved. Chapter 11 Corporate Governance

2. 11–2 What Is Corporate Governance? Corporate governance comprises the institutions and mechanisms that design and monitor the rules used to make decisions in a firm, especially those involving compliance. Corporate governance comprises the institutions and mechanisms that design and monitor the rules used to make decisions in a firm, especially those involving compliance.

3. 11–3 Agency Theory Agency theory focuses on the relationship between the principal and the agent. Agency theory focuses on the relationship between the principal and the agent. –In the case of corporate governance: »The principal is the shareholder. »The agent is the firm’s management. The principal tries to ensure that the agent acts in the principal’s interest. The principal tries to ensure that the agent acts in the principal’s interest. –Incentives –Monitoring

4. 11–4 Berle and Means Argued that control of the modern corporation passed from owners to managers because owners had become too dispersed for effective control. Argued that control of the modern corporation passed from owners to managers because owners had become too dispersed for effective control. Managers were positioned to take more for themselves than they were due (e.g., paying themselves more). Managers were positioned to take more for themselves than they were due (e.g., paying themselves more).

5. 11–5 Berle and Means (cont’d) Widespread ownership also meant that owners could reduce their risk by investing in more companies. Widespread ownership also meant that owners could reduce their risk by investing in more companies. –Owners could sell their shares in poorly performing firms. Managers might know more than owners about which decisions were best for the firm—giving managers greater discretion might actually improve a firm’s performance. Managers might know more than owners about which decisions were best for the firm—giving managers greater discretion might actually improve a firm’s performance.

6. 11–6 The Board of Directors Shareholders exercise influence over managerial decision-making primarily through their election of the board of directors. Shareholders exercise influence over managerial decision-making primarily through their election of the board of directors. The board has primary responsibility for corporate governance. The board has primary responsibility for corporate governance. Project detail received by the board depends on the firm’s size and complexity. Project detail received by the board depends on the firm’s size and complexity. Legal responsibilities of the board include duty of care, duty of loyalty, and the business judgment rule. Legal responsibilities of the board include duty of care, duty of loyalty, and the business judgment rule.

7. 11–7 The Board of Directors Board membership composition Board membership composition –Inside directors: members of upper management –Outside directors: persons not employed directly by the firm Committees (composed of outside directors) Committees (composed of outside directors) –Audit, compensation, and nominating Other committees that deal with various governance issues Other committees that deal with various governance issues –Finance and executive committees

8. 11–8 The Decision Process under the Separation of Ownership and Control Figure 11.1 Top ManagementThe Board of Directors Project Initiation: Generates proposals for allocating resources and structuring contracts Project Ratification: Chooses among the proposals to be implemented Project Implementation: Executes the proposals chosen by the board Project Monitoring: Measures and rewards project and firm performance

9. 11–9 Duty of Care Defined as “the care that an ordinarily prudent person would reasonably be expected to exercise in a like position and under similar circumstances.” Defined as “the care that an ordinarily prudent person would reasonably be expected to exercise in a like position and under similar circumstances.” –Carries with it a requirement to develop knowledge related to the firm’s business. –Implicit is the duty to inquire into and remain informed about the firm’s ongoing activities

10. 11–10 Duty of Loyalty Defined as a “duty in good faith to act in the best interests of the corporation.” Defined as a “duty in good faith to act in the best interests of the corporation.” When there is a conflict between a director’s interests and the firm’s interests, the firm’s interests must be predominate. When there is a conflict between a director’s interests and the firm’s interests, the firm’s interests must be predominate. The firm’s interest is congruent with but not identical with shareholders. The firm’s interest is congruent with but not identical with shareholders. –Other constituencies such as local communities, labor, and suppliers may be considered.

11. 11–11 Business Judgment Rule Underlies the “duty of care” obligation. Underlies the “duty of care” obligation. Acts as a “safe harbor” or protection when the duty of care is being questioned. Acts as a “safe harbor” or protection when the duty of care is being questioned. Shields directors from liability for taking reasonable actions on behalf of the firm that subsequently turn out badly. Shields directors from liability for taking reasonable actions on behalf of the firm that subsequently turn out badly. Preserves directors’ willingness to take risks in investments in new products or markets. Preserves directors’ willingness to take risks in investments in new products or markets.

12. 11–12 What Happened at Enron? Overly aggressive growth goals Overly aggressive growth goals –Product and geographical diversification into risky ventures with low earnings growth. –Trading profits in many cases depended on uncertain volumes delivered far into the future. Speculative solutions: Speculative solutions: –Removal of high risk projects from the balance sheet using special purpose entities (SPEs) –The booking of future revenues as current revenues using mark-to-market accounting.

13. 11–13 What Happened at Enron?… The designs and effects of the SPEs were highly questionable. The designs and effects of the SPEs were highly questionable. Mark-to-market accounting created confusion about the relationship between profits and cash flow. Mark-to-market accounting created confusion about the relationship between profits and cash flow. As Enron’s share price began to track the NASDAQ rather than the NYSE in the late 1990’s (due the startup of Enron online), red flags appeared. As Enron’s share price began to track the NASDAQ rather than the NYSE in the late 1990’s (due the startup of Enron online), red flags appeared.

14. 11–14 Percentage Change in the Enron Share Price Compared to the NASDAQ and Dow Jones Indices from 1990 until Enron Bankruptcy in late 2001 Figure 11.2

15. 11–15 What Happened at Enron?… Cascading problems Cascading problems –Managerial conflict of interest in the SPEs –High risk taking in the new ventures –Outsized transactions or financial results due to accounting sleight-of-hand –Management incompetence leading to out of control costs Enron’s share price fell sharply starting in September, 2000 and the firm went bankrupt in June, 2001. Enron’s share price fell sharply starting in September, 2000 and the firm went bankrupt in June, 2001.

16. 11–16 The Response to the Enron Fiasco Public outcry Public outcry Sarbanes-Oxley Act in January, 2002 Sarbanes-Oxley Act in January, 2002 –Established the Public Company Accounting Oversight Board. –Made CEOs and CFOs accountable for financial reports by requiring that they sign off on them. –Required management to attest to the effectiveness of the firm’s financial controls. –Required the firm’s auditors to sign on to their assessment. –Imposed strict rules for a firm’s audit committee.

17. 11–17 Board of Directors Effectiveness Empirical studies show that: Empirical studies show that: –More independent directors do not necessarily lead to higher firm performance. –Shareholders benefit when independent directors have power (e.g., on the finance committee). –A board with more outsiders is more likely to avoid policies that are not in the shareholders’ interests. –Independent directors act as conduits of innovation to the firm.

18. 11–18 Effects of Board Independence and Size on Firm Independence Table 11.1a

19. 11–19 Effects of Board Independence and Size on Firm Independence (cont’d) Table 11.1b

20. 11–20 CEO Compensation Possible determinants of CEO compensation: Possible determinants of CEO compensation: –Firm size (revenues) –Higher returns to shareholders –CEO influence on the board Research indicates that each is valid to some degree: Research indicates that each is valid to some degree: –Firm size is primary. –Controlling for size, compensation is weakly related to shareholder returns. –Controlling for size and performance, ingratiation behavior affects compensation.

21. 11–21 Trends in Executive Compensation– All Firms, 1999 to 2001 Table 11.2

22. 11–22 What Predicts CEO Compensation? Table 11.3

23. 11–23 How Many Firms Were Consistently Above or Below the Norm? Table 11.4

24. 11–24 Governance in Different Countries Governance rules and practices vary across countries. Governance rules and practices vary across countries. –Countries differ in the strength of: »Boards »Owners »Networks of directors, owners and sources of capital »Government intervention The key is combined effects of these institutional components on management behavior. The key is combined effects of these institutional components on management behavior.

25. 11–25 Institutional Environments of Large Firms By Country Table 11.5