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Lecture 10 Corporate Governance

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1 Lecture 10 Corporate Governance

2 Objectives Introduce corporate governance (separation of ownership, managerial opportunism). Explain three internal governance mechanisms (ownership concentration, the board of directors and executive compensation). Describe external corporate governance mechanism - the market for corporate control. Discuss corporate governance in international settings. Ethical issues.

3 Trends in recent corporate governance.
In 1990s, CEOs worth more than their weight in gold: Michael Eisner, CEO of Disney ($631 million), Stephen Case, CEO of America Online ($220 million), Jack Welch, CEO of GE ($164 million), Carly Fiorina, CEO of HP ($80-90 million). In a record number of CEOs left their jobs through dismissal, retirement or recruitment to another firm. All of this scrutiny may have a price: Average tenure months. “At the current rate, almost 50 percent of the largest U.S. firms will have a new CEO in next four years” Harvard Business Review.

4 Define corporate governance.
What is Corporate Governance The way in which organisations are directed and controlled. (Cadbury 1992) Banks Mutual funds Insurance companies Pension funds – largest pool of money in the world Hedge funds Shareholders Main company Board (e.g. chairman’s, audit, remuneration, nomination) Managers Stakeholders (e.g. suppliers, consumers, local communities) Employees The Primary objective: ensure that the interests of top-level managers are aligned with the interests of the shareholders

5 Separation of ownership and managerial control
Small firms- simplest, an owner-manager Large firms are usually more complicated Shareholders (principles) Firm owners Hire Managers (Agents) Decision makers and create An agency relationship Risk-bearing specialists (principle) Paying compensation to A managerial decision–making specialist (agent)

6 Managerial opportunism: the seeking of self-interest with guile.
An agency relationship and managerial opportunism Managerial opportunism: the seeking of self-interest with guile. Product diversification The size of the firm. The portfolio of the businesses. The firm’s free cash flows.

7 Manager and Shareholder Risk and Diversification
Shareholder (Business) Risk Profile Managerial (Employment) Risk Profile S Risk M A Dominant Business Related Constrained Related Linked B Unrelated Businesses Level of Diversification 24

8 Enron: The seventh largest company in USA. The collapse of Enron wiped out shareholders investment (£60bn) and employee’s retirement saving, and led to 21,000 people losing their jobs. Filed bankruptcy in December 2001 with debts of £18bn. In September 2006, Andrew Fastow, the former CFO was jailed for six years.

9 WorldCom: America's second-biggest long-distance phone company and the largest mover of internet traffic. WorldCom reported more than $107bn (£67.9bn) in assets and debts of $32bn. Bernie Ebbers, the chief executive officer engaged an $11 billion accounting fraud received a 25 years prison

10 Corporate governance Mechanism
Internal Governance mechanisms Ownership concentration Board of directors Executive compensation External governance mechanism Market for corporate control Agency costs: the sum of incentive costs, monitoring costs, enforcement costs, and individual financial loses incurred by principles because governance mechanisms can not guarantee total compliance by the agent.

11 Ownership concentration: relative amounts of stock owned by individual shareholders and institutional investors Ownership concentration in firms and with levels of product diversification. Concentration with firm value The growing influence of institutional owners Institutional owners: financial institutions such as stock mutual funds and pension funds.

12 Board of directors: a group of elected individuals whose primary responsibility is to act in the owners’ best interests by formally monitoring and controlling the corporation’s top-level executives. Classifications of board of director members Insiders The firm’s CEO and other top-level managers Related outsiders Individuals not involved with the firm’s day-to-day operations, but who have a relationship with the company Outsiders Individuals who are independent of the firm in terms of day-to-day operations and other relationships

13 Today’ typical board Size Insider/outsider mix
Meeting frequency/committees

14 Enhancing the effectiveness of the Board of Directors
Increases in the diversity of the background of board members. The strengthening of internal management and accounting control systems. The establishment and consistent use of formal processes to evaluate the board’s performance. Additional changes The creation of a ‘lead director’ Modification of the compensation of directors

15 Executive compensation
Short term incentive: Salary – Cash The guaranteed bonuses Deliberate obfuscation Loans Golden hello (W.James, a pay package of $52 million, including $25.3 million of restricted shares and $22 million from Boeing to replace his 3M pension)

16 Executive compensation
Long term Executive compensation: Stock options: the right to purchase a block of the company’s stock at some specified point in the future at a ‘strike price’ set at the time of award, often the current trading price. ‘The company’s stock option programme is designed to focus attention on stock values, and to develop company ownership, promote employee loyalty, reward long-term business success and develop a parallel interest between key employees and shareholders’ A typical description of a stock option plan Re-pricing Backdating (picked the date in the past with the lowest stock price, making he grants automatically ‘in the money’); spring loading options (setting an option grant date just before an announcement of good news), and bullet-dodging (setting an option grant date just after an announcement of bad news)

17 Executive compensation
Restricted stock: awarded stock with limits on its transferability for a set time, normally 2-3 years. Very popular in a down market. Phony cuts (Steve Jobs returned to Apple in 1997, who took $1 a year in compensation. In Jan.2000, Apple’ board gave Jobs an option grant covering 20 million shares ($43.59 a share; $471 million); But the stock fell, and so the board give Jobs another option grant in 2001 – 7.5 million shares ($18.30). The stock fell to £14.91, the board gave him 5 million free shares. And the original option grants had all been backdated.)

18 Executive compensation
But long term incentive compensation is complicated for: Executive decisions are complex and non-routine. Many factors intervene making it difficult to establish how managerial decisions are directly responsible for outcomes. In addition, 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 they do increase the likelihood that managers will do the things for which they are rewarded.

19 Market for corporate control: an external governance mechanism that becomes active when a firm’s internal controls fail. “court of last resort” . The 1980s saw active market for corporate control, largely as a result of available pools of capital (junk bonds). Many firms began to operate more efficiently as a result of the “threat” of takeover, even though the actual incidence of hostile takeovers was relatively small. Changes in regulations have made hostile takeovers difficult. Takeover attempts were focused on above-average performance firms (e.g. the hedge funds) The market for corporate control acts as an important source of discipline over managerial incompetence and waste.

20 Managerial defence tactics
Preventative tactics Poison pill: preferred stock in the merged firm offered to shareholders at a highly attractive rate of exchange; Flip-in options Flip-over rights Corporate charter amendment: an amendment to stagger the elections of members to the board of directors of the target firm so that all are not elected during the same year, which prevents a bidder from installing a completely new board in the same year. Golden Parachutes: Lump-sum payments of cash that are distributed to a selected group of senior executives when the firm is acquired in a takeover bid;

21 Reactive tactics Greenmail: the repurchase of shares of stock that have been acquired by the aggressor at a premium in exchange for an agreement that the aggressor will no longer target the company for a target. (e.g. Bass Brothers and Texaco) Standstill agreement: contract between the parties in which the pursuer agrees not to acquire any more stock of the target firm for a specified period of time in exchange for the firm paying the pursuer a fee. (e.g. Comcast and AT&T Broadband) Capital structure change: dilution of stock - making it more costly for a bidder to acquire (may include recapitalisation e.g. issuing employee stock ownership, selling additional shares and share buybacks).

22 Hostile takeover defense tactics
Defence strategy Category Popularity among firms Effectiveness as a defense Poison pill (flip over and flip in) preventive high Corporate charter amendment medium low Golden parachutes Greenmail reactive very low Standstill agreements Capital structure changes

23 International corporate governance: Germany
Owner and manager are often the same in private firms Public firms often have a dominant shareholder too, frequently a bank Medium to large firms have a two-tiered board Vorstand (management board) monitors and controls managerial decisions Aufsichtsrat (supervisory board) selects the Vorstand Employees, union members and shareholders appoint members to the Aufsichtsrat Frequently there is less emphasis on shareholder value than in U.S. firms, although this may be changing.

24 International corporate governance: 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. Other characteristics: 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.

25 International corporate governance: China
Confucianism which has dominated Chinese social ideology for over 2000 years. Incentives within the State Structures of Control: Political status Financial rewards Informal opportunities for gain Banks and stock markets are major sources for SOEs.

26 Business ethics in corporate strategy – 1
Business ethics are the standards and conduct that an organisation sets itself in its dealings within the organisation and outside its environment. These need to be reflected in the mission statement.

27 Business ethics in corporate strategy – 2
There are four main reasons for considering the ethical conduct of organisations: To some extent, inescapable, e.g. legal limits on conduct. Some areas may be important: e.g. ‘green’ issues. Part of the professionalization of business, e.g. treatment of workers. Self-interest, e.g. bad publicity as a result of incorrect behaviour.

28 Business ethics in corporate strategy – 3
Three prime considerations in developing business ethics: extent of ethical considerations their cost and the recipient of the responsibility. Numerous differences exist between organisations over what should be covered under ethics, reflecting fundamentally different approaches to doing business.

29 Summary Corporate governance is a relationship among stakeholders that is used to determine a firm’s direction and control its performance. How firm monitor and control top-level managers’ decisions and actions affects the implementation of strategies. Effective governance that aligns managers’ decisions with shareholders’ interests can help produce a competitive advantage. Separation of ownership and control create an agency problem when an agent pursues goals that conflict with principals’ goals. Principles establish and use governance mechanisms to control this problem (internal: ownership concentration, the board of directors and executive compensation; one external: takeover)

30 Reading lists Deutsch, Y., Kei, K. & Laamanen, T. 2007, Decision making in acquisitions: the effect of outside director’s compensation on acquisation patterns, Journal of Management, 33 (1): Faleye, O. 2007, Classified boards, firm value and managerial entrenchment, Journal of Financial Economics, 83: Henry, A. (2008) Understanding Strategic Management, Oxford Press, chapter 8. Pearce, J. A. and Robinson, R.B. 2004, Hostile takeover defenses that maximize shareholder wealth, Business Horizons 47/5 September-October, Kirvogorsky, V. 2006, Ownership, board structure and performance in continental Europe, International Journal of Accounting, 41 2: Lynch R. (2008) Corporate Strategy, Prentice Hall, 5th edition, chapter 6.

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