Chapter 13

Corporate Governance in the Twenty-First Century

OBJECTIVES

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Explain what is meant by corporate governance Describe how corporate governance relates to competitive advantage and understand its basic principles and practices Identify the roles of owners and different types of ownership profiles in corporate governance Describe how boards of directors are structured and the roles they play in corporate governance Explain and design executive incentives as a corporate governance device Describe how the market for corporate control is related to corporate governance Compare and contrast corporate governance practices around the world
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SUNBEAM
Al Dunlap¶s mgmt. philosophy 1. Shareholders are most important corporate constituents 2. Most corporations have bloated bureaucracies 3. Drastic layoffs are usually needed to save failing companies 4. Layoffs should be quick, one-time events 5. CEOs should be rewarded like stars when they perform well and fired when they do not 6. Board members should have significant personal investments in the company Results

Early success

‡ Costs slashed ‡ Stock doubled in first month ‡ Market cap rises from $1.1
billion to $5 billion

‡ With R&D budgets cut, new
product development hampered Signs ‡ Growth fails to meet targets of problems ‡ Company accused of ³channel stuffing´

Failure

‡ Board fines Dunlap ‡ He looses his stock options ‡ Sunbeam stock is delisted

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CORPORATE GOVERNANCE
In a broader perspective, governance determines how all stakeholders influence the corporation:

Share holders

Corporate governance The system by which organizations, particularly business corporations, are directed and controlled by their owners

Board

Management

Corporation

Employees

Society

Environment

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CORPORATE GOVERNANCE IMPACTS PERFORMANCE

The Italian stock exchange started a new exchange called STAR for small and midsized companies that followed strict governance prescriptions

Companies of the STAR exchange consistently out perform their counterparts on the regular exchange (e.g., during 2004 STAR firms achieved returns 24.5% greater than their counter parts)

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EARLY WARNING SIGNS OF PROBLEMS WITH KRISPY KREME

Source: M. Maremont and R. Brooks, ³Fresh Woes Batter Krispy Kreme; Doughnut Firm to Restate Results, Delay SEC Filing; Shares Take a 15% Tumble,´ Wall Street Journal (Eastern edition), January 5,2005.p.A3

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AGENTS AND PRINCIPALS

‡ When interests are virtually
Principals Shareholders of a firm Agents Act on behalf of principals in managing the firm identical, the agency problem is small: executives do what is in principals¶ best interests

‡ However interests often do
not overlap. Then agents may act to detriment of principals and visa-versa (e.g., executives raise salaries and reduce returns)

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EXAMPLES OF CODES OF GOVERNANCE
What is the recommendation on director independence? As many as possible Can the same executive be both CEO & chairperson? Split recommended Is disclosure required if the company does not comply with the recommendations? No

Country Brazil CVM Code (2002) Russia CG Code (2002) Singapore CG Committee (2001) United Kingdom Cadbury Code1 United States Conference Board and CalPers (2003)2

Is auditor rotation required? Not addressed

At least one-quarter

Split required by law

Not addressed

No

At least one-third

Split recommended

Not addressed

Yes

Majority

Split recommended

Periodic rotation of lead auditor Recommended3

Yes

Substantial majority

Separation is one of three acceptable alternatives

No

1. In 2003, a Combined Code made further additions to the code, but these basic principles remain 2. Just one of several codes in existence in the United States 3. The Sarbanes-Oxley Act requires that the lead audit partner be rotated every 5 years; changing audit firm after 10 years of continual relationship or if former audit partner is employed by the company

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SOME NEW COMPLIANCE RULES FROM SARBANES-OXLEY

‡ Auditors must list the non-audit services they are unable to perform
during an audit

‡ A one-year waiting period for audit-firm employees who leave an
accounting firm to become an executive for a former client

‡ Transactions and relationships that are off the balance sheet but that may
affect financial status must now be disclosed

‡ Personal loans from a corporation to its executives are now largely
prohibited

‡ Research analysts for securities firms must now file conflict of interest
disclosures. For instance, analysts must report whether they hold any securities in a company or have received corporate compensation

‡ Brokers and dealers must disclose if the public company is a client ‡ Altering, destroying, concealing, or falsifying records or documents with
the intent to influence a federal investigation or bankruptcy case is subject to fines and up to 20 years of imprisonment

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OWNERSHIP STRUCTURE VARIES

Source: Company annual reports

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ROLES AND ACTIONS OF BOARD OF DIRECTORS

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EFFECTS OF CEO FIRINGS

Source: M.wiersema, ³Holes at the Top: Why CEO Firings Backfire,´ Harvard Business Review 80;12 (2002), 70-77

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INCENTIVE ALIGNMENT
Conflicts of interest can arise Principals Agents Incentive alignment can solve such problems

Example:

‡ A company receives a buy-out
offer

‡ Shareholders (principals) would
benefit because price assures a good return on investment

‡ Management (agents) resists
because they may lose their jobs

Boards can include ³golden parachute´ provisions in manager¶s compensation packages

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HOW WOULD YOU DO THAT? ± DENDRITE INTERNATIONAL

Dendrite¶s challenge: How can Dendrite better align management incentives with shareholders?

Dendrite¶s solution: 20 senior-most executives must own 15,000 to 100,000 shares of stock Must be common shares not options Must be achieved within 5 years Executives may elect to receive incentive compensation in stock instead of cash

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EXECUTIVE STOCK OWNERSHIP IN 2004

Largest 250 companies with stock ownership guidelines Number of companies Executives Directors 142 123 Percent of companies 57 49 Percent increase from 2001 to 2004 58 127

Source: Adapted from Fredrick W. Cook & Co., Inc., ³Stock Ownership Policies: Prevalence and design of Executive and Director Ownership Policies Among the Top 250 Companies,´ www.fecook.com/surveys.html (accessed Nov 29, 2005), Sep 2004

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INCENTIVE COMPENSATION

Annual bonus plans

Oldest form of incentive pay. Board can evaluate executives¶ performance along multiple dimensions and allocate a yearend cash award

Stock options

An employee receives the right to buy a set number of shares of company stock at a later date for a predetermined price

Other longterm incentives

More recent forms of incentive compensation. Long-term bonuses linked to performance over several years. May help executives avoid short-term myopia and focus on long-term

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CEO PAY COMPARISON

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HIGHEST PAID CEOs

Source: Company annual reports and ExecComp Service of Thomson Financial

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EXECUTIVE PAY TRENDS

Source: U.S. Bureau of Labor Statistics

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THE MARKET FOR CORPORATE CONTROL

Share holders Elect Corporate control: The right to choose the members of the board of directors of a company and to control all major decisions made by a company Board Hires/fires Top management Directs Corporation Example:

‡ Corporate raiders such
as T. Boone Pickens, CarI Icahn, Ted Turner and Michael Milken

‡ Oracle engaged in 18month battle to gain control of PeopleSoft

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POOR CORPORATE GOVERNANCE, A WORLD-WIDE PROBLEM
Recent examples of scandal-ridden non-U.S. multinationals

‡ Netherlands Ahold Group (grocery stores)

‡ Italy¶s Parmalat (dairy and food products)

‡ France¶s Vivendi (entertainment)

‡ French-Belgian Firm ELF (petroleum)

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CORPORATE GOVERNANCE: U.S VS. JAPAN

U.S

Japan

Owner-manager relationship

Adversarial

Co-operative

Manager and shareholder relationship

Through one company

Through a Keiretsu (group of interlocking companies)

Ownership concentration

Control function

Monitoring function

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CORPORATE GOVERNANCE IN GERMANY AND CHINA

Germany ‡ Two-tier board system ‡ Management board manages the enterprise ‡ Supervisory board appoints, supervises, and advises members of the management board

China ‡ Only recently started a securities market ‡ Majority of listed companies started off as state-owned enterprises ‡ State ownership remains high across all industries

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HOW WOULD YOU DO THAT? ± CHIQUITA
How should Chiquita compensate its new CEO? Chiquita The Chiquita board set objectives as: 1. Delivery of quality products to consumers 2. Quality returns to shareholders 3. Transform Chiquita into a global player Sales 2004 ($ millions) Net income ($ millions) CEO salary ($ thousands) CEO bonus ($ thousands) CEO total Compensation ($ thousands) What is appropriate? 2,613 96 Dole 4,773 84 950 1,368 4,387 Del Monte 2,171 134 810 870 7,394

Source: Company annual reports

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SUMMARY

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Explain what is meant by corporate governance Describe how corporate governance relates to competitive advantage and understand its basic principles and practices Identify the roles of owners and different types of ownership profiles in corporate governance Describe how boards of directors are structured and the roles they play in corporate governance Explain and design executive incentives as a corporate governance device Describe how the market for corporate control is related to corporate governance Compare and contrast corporate governance practices around the world
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