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 firms owners and its top-level managers

Corporate Governance Mechanisms

Internal Governance Mechanisms
Board of Directors Managerial Incentive Compensation Ownership Concentration

External Governance Mechanisms

Market for Corporate Control

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

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Agency Relationship: Owners and Managers

Shareholders (Principals) Firm owners

Agency Relationship: Owners and Managers

Shareholders (Principals) Firm owners Decision makers Managers (Agents)

Agency Relationship: Owners and Managers

Shareholders (Principals) Firm owners Decision makers Managers (Agents)

Risk bearing specialist (principal) pays compensation to a managerial decision-making specialist (agent)

An Agency Relationship
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Agency Theory Problem

The 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 inappropriately 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
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Solution:

Manager and Shareholder Risk and Diversification

Shareholder (business) risk profile S Managerial (employment) risk profile M

Risk

A Dominant Related Business Constrained

Diversification

Related Linked

Unrelated Businesses
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Governance Mechanisms
Board of Directors

Insiders

The firms CEO and other top-level managers

Affiliated Outsiders

Individuals not involved with day-today operations, but who have a relationship with the company

Independent Outsiders

Individuals who are independent of the firms day-to-day operations and other relationships

Governance Mechanisms
Board of Directors

Role of the Board of Directors

Monitor Are managers acting in shareholders best interests Evaluate & Influence examine proposals, decisions actions, provide feedback and offer direction Initiate & Determine delineate corporate mission, specify strategic options, make decisions

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Governance Mechanisms
Board of Directors Executive Compensation 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

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Governance Mechanisms
Board of Directors Executive Compensation 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 do increase the likelihood that managers will do the things for which they are rewarded

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CEO Pay and Performance

Classic pay for performance relationship CEO Pay Unfortunately, this relationship is weak

Firm Performance

The stronger relationship is with firm size

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CEO Pay and Firm Size

Relationship between pay and firm size is curvilinear. CEO pay increases at a decreasing rate

CEO Pay

Firm Size
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Relationship Between Firm performance and Firm Size

Relationship between firm performance and firm size is curvilinear.

Firm Performance

Beyond some point, as size increases, firm performance declines BUT From the graph of CEO pay vs. firm size, pay doesnt decline

Firm Size
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Relationship Between Firm performance and Equity Ownership

Relationship between firm performance (Tobins Q) and managerial ownership is curvilinear. Beyond some point, as ownership increases, firm value declines

Firm Value

Managerial Ownership in %
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Governance Mechanisms
Board of Directors Executive Compensation Ownership Concentration
Large block shareholders (often institutional owners) have a strong incentive to monitor management closely Exit vs. Voice Cannot costlessly exit due to equity stake (transaction costs) so they press for change (exercise voice) They may also obtain Board seats which enhances their ability to monitor effectively (although financial institutions are legally forbidden from directly holding board seats)
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Governance Mechanisms
Board of Directors Executive Compensation Ownership Concentration
Types of institutional investors - Mutual funds, pension funds, foundations, churches, universities, insurance companies Pressure-resistant versus pressuresensitive - Mutual and pension funds are pressure resistant Are Institutional investors the same? - Short vs. long term Components of voice:
Pension fund hit lists Shareholder liability suits Investor alliances Proxy contests

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Governance Mechanisms
Board of Directors Executive Compensation Ownership Concentration Market for Corporate Control 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 difficult Acts as an important source of discipline over managerial incompetence and waste

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Managerial Defense Tactics

Designed to fend off the takeover attempt Increase the costs of making the acquisitions Causes incumbent management to become entrenched while reducing the chances of introducing a new management team May require asset restructuring Institutional investors oppose the use of defense tactics

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Takeover Defenses:
Financial Mechanisms Poison pills Leveraged recapitalizations Greenmail Litigation

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Takeover Defenses:
Financial Mechanisms Asset-Based Mechanisms Poison pills Leveraged recapitalizations Greenmail Litigation Scorched earth defense Crown jewel sales Pac-man defense

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Takeover Defenses:
Financial Mechanisms Asset-Based Mechanisms Poison pills Leveraged recapitalizations Greenmail Litigation Scorched earth defense Crown jewel sales Pac-man defense White knight defense Other bidder (competitive bid situation)

Third Party Mechanisms

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