Topic 7

Corporate governance

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 Learning Objectives
1 define corporate governance and explain why it is used to monitor
and control managers’ strategic decisions
2 explain why ownership has been largely separated from managerial
control in the modern corporation
3 define an agency relationship and managerial opportunism and
describe their strategic implications
4 explain how three internal governance mechanisms – ownership
concentration, the board of directors and executive compensation –
are used to monitor and control managerial decisions
5 discuss types of compensation executives receive and their effects
on strategic decisions
6 describe how the external corporate governance mechanism – the
market for corporate control – acts as a restraint on top-level
managers’ strategic decisions 2
 Learning objectives

7 discuss the use of corporate governance in international

settings, in particular in Australia, Germany and Japan
8 describe how corporate governance fosters ethical strategic
decisions and the importance of such behaviours on the part of
top-level executives.

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 Corporate governance
• Definition

• corporate governance represents the set of

mechanisms used to manage the relationship among
stakeholders that determines and control the strategic
direction and performance of organisations.
• corporate governance involves oversight in areas
where owners, managers and members of boards of
directors may have conflicts of interest
• corporate governance reflects and enforces the
company values. 4
Corporate governance mechanisms
• Internal governance mechanisms
• ownership concentration
• board of directors
• executive compensation.

• External governance mechanism

• market for corporate control.
(when to purchase a firm to improve the company strategic
competitiveness)

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 Separation of ownership and
managerial control
• Historically, firms were managed by the
founder-owners and their descendants.
• In the modern corporation:
• control of the firm shifted from owners to
professional managers
• ownership has been dispersed to among many
unorganised shareholders
• shareholders purchase shares, which entitles them
to income – residual returns – from the operations
of the firm after expenses have been paid.
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An agency relationship

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 Agency relationships

• An agency relationship exists when one or

more persons (principal or principals) hire
another person or persons (agent or agents)
as decision-making specialists to perform a
service.
• the principals delegate decision-making
responsibility to an agent
• the agency relationship is related to how the firm’s
strategies are implemented. 8
 Ownership concentration
Large block shareholders have a strong
Ownership incentive to monitor management closely:
concentration • owning at least 5% of the shares means it is
worthwhile spending time, effort and
expense on monitoring
• they may also obtain board seats which
enhance their ability to monitor effectively.
Financial institutions are legally forbidden
from directly holding board seats.

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Ownership concentration (cont.)
Institutional owners (financial institutions such as
The growing stock mutual funds and pension funds) have
influence of increasing influence.
institutional • they have the size (proxy voting power) and
owners incentive (demand for returns to funds) to
discipline ineffective top-level managers
• they can influence the firm’s choice of
strategies.

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Ownership concentration (cont.)

Shareholders can convene to discuss the

Shareholder corporation’s direction.
activism If a consensus exists, shareholders can vote as a
block to elect their candidates to the board.
Institutional activism should create a premium on
companies with good corporate governance.
Managerial share ownership may align their
interests with shareholders, but it also increases
managers’ power.

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 Board of directors
Ownership Board of directors:
concentration • a group of elected individuals whose primary
responsibility is to act in the owners’ interests
by formally monitoring and controlling the
Board of
corporation’s top-level executives.
directors (a)
The board has the power to:
• direct the affairs of the organisation
• punish and reward managers
• protect the rights and interests of shareholders.

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Board of directors (cont.)
Composition of boards:
Ownership
• insiders: the firm’s CEO and other top-level
concentration managers
• related outsiders: individuals not involved
Board of with the firm’s day-to-day operations, but who
directors (b) have a relationship with the firm
• outsiders: individuals who are independent of
the firm’s day-to-day operations and other
relationships.

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Board
Ownership
of directors (cont.)
Methods of enhancing the effectiveness of boards
concentration
and directors:
• more diversity in the backgrounds of board
Enhancing the members
effectiveness of • stronger internal management and accounting
the board of control systems
directors • more formal processes to evaluate the board’s
performance
• more collaborative working and open debate
• appointing a reasonable number of outsiders
• ensuring directors have an ownership stake
through share holdings.
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 Executive compensation
Forms of compensation:
Ownership • salary, bonuses, and performance-based long-
concentration term incentive compensation such as share
options.
Factors complicating executive compensation:
Board of directors • strategic decisions by top-level managers are
complex, non-routine and affect the firm over an
extended period.
Other variables affect the firm’s performance
Executive
over time, such as unpredictable economic, social or
compensation (a) legal changes.

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Market for corporate control
Individuals and firms buy or take over
Market for undervalued corporations.
corporate control • ineffective managers are usually replaced in
such takeovers.
The threat of takeover may lead the firm to operate
more efficiently.
Changes in regulations have made hostile
takeovers difficult.

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External governance mechanism
Managerial defense tactics increase the costs of
Managerial mounting a takeover. These tactics may involve:
defense tactics • asset restructuring through divestments
• changes in the financial structure of the firm,
such as repurchasing shares
• mobilising shareholders to not approve
takeover.
Market for corporate control lacks the precision
possible with internal governance mechanisms.

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Governance mechanisms and ethical
behaviour
• A firm’s strategic competitiveness is enhanced
when its governance mechanisms take into
account the interests of all stakeholders.
• Capital market stakeholders
• shareholders in this group are viewed as the most
important
• the focus of governance mechanisms is to control
managerial decisions to assure shareholder interests
• interests of shareholders are served by the board of
directors. 18
Governance mechanisms and ethical
behaviour (cont.)
• Product market stakeholders
• customers, suppliers and host communities may
withdraw their support of the firm if their needs are
not met, at least minimally.
• Organisational stakeholders
• managers and non-managerial employees
similarly may withdraw support, reduce their work
effort or even quit.
• Effective governance produces ethical
behaviour in the formulation and
implementation of strategies. 19
THE END

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