Modern Competitive Strategy 3 rd Edition Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

Chapter 12 Corporate Governance 12-2

What Is Corporate Governance? The institutions that design and monitor the rules used to make decisions in a firm, especially those involving compliance 12-3

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 through Incentives Monitoring 12-4

Berle and Means (1932) 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 (i.e., pay themselves more) 12-5

Berle and Means (cont’d) But: Widespread ownership also meant that owners could reduce their risk by investing in more companies Owners could also sell their shares in poorly performing firms without the problems caused by poor liquidity Managers might know more than owners about decisions that were best for the firm So: Giving managers greater discretion might actually improve a firm’s performance 12-6

Figure 12.1 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 The Separation of Ownership and Control 12-7

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 Project details received by the board depend on the firm’s size, complexity, and the scale of the project Legal responsibilities of the board include duty of care, duty of loyalty, and the business judgment rule 12-8

The Board of Directors (cont’d) Board composition Inside directors: upper management, family members Outside (independent) directors: persons not employed by the firm or related to the firm by blood or commercial transactions Committees (composed of independent directors) Audit, compensation, and nominating Other committees that deal with various governance issues Finance, Executive, Risk, Strategy, Technology, others Lead director The chief independent director Chairs executive sessions of independent directors at board meetings 12-9

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” Carries with it a requirement to develop knowledge related to the firm’s business May require the support of in-house and external experts and consultants Implies the duty to inquire into and remain informed about the firm’s ongoing activities Reduces the potential for management misbehavior 12-10

Duty of Loyalty Defined as a “duty in good faith to act in the best interests of the corporation” The firm’s interests must dominate conflicts between the interests of a director and the firm The firm’s interest is congruent with but not identical with shareholders Other constituencies – called stakeholders, e.g., local communities, labor, and suppliers - may be considered 12-11

Business Judgment Rule Underlies the “duty of care” obligation 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 Preserves directors’ willingness to take risks in investments in new products or markets 12-12

What Happened at Enron? Overly aggressive growth goals: The firm diversified into risky ventures with low earnings growth Profits in many cases depended on uncertain volumes realized far into the future Questionable use of standard accounting practices: Removal of high risk projects from the balance sheet using special purpose entities (SPEs) Booking future revenues as current using mark-to-market accounting 12-13

What Happened at Enron? (cont’d) 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 Valuation of many SPEs was in part dependent on Enron’s stock price Mark-to-market accounting created confusion about the relationship between profits and cash flow 12-14

Figure 12.2 Percentage of Change in the Enron Share Price Compared to the NASDAQ and Dow Jones Indices from 1990 until the Enron Bankruptcy in late

What Happened at Enron? (cont’d) 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 Unexpected business failures Management incompetence, especially regarding cost control Enron’s share price fell sharply starting in September, 2000 and the firm went bankrupt in June,

The Response to the Enron Fiasco (and problems in other firms) Public outcry Sarbanes-Oxley Act in January, 2002 Established the Public Company Accounting Oversight Board Required the CEO and CFO to attest to the effectiveness of the firm’s financial controls Made CEOs and CFOs accountable for financial reports by requiring that they sign off on them Required the firm’s auditors to attest to the firm’s internal audit Imposed strict rules for a firm’s audit committee (e.g., all independent directors, the presence of a financial expert) 12-17

The Response to the Enron Fiasco (cont’d) Redesign of rules by the major stock exchanges of U.S. for corporate governance of listed companies Notable among these were the new prescriptions of the New York Stock Exchange (NYSE) and NASDAQ 12-18

Did Sarbanes-Oxley make a difference? Rule 404 Requires a stringent and costly internal audit of the firm’s processes Problems in processes that had a material effect on the firm’s financial data had to be reported Most problems (in 2005) were in tax accounting, documentation, and personnel expertise Smaller firms were hurt more by this rule given the high fixed costs of adhering to it But in general, research has shown that after SOX: shareholders receive better information about firms listing shares on U.S. exchanges sends a stronger signal of financial strength 12-19

Are Better Governed Firms Higher Performers? Gompers, Ishii and Metrick (2003) showed that Investing in better governed firms and selling worse governed firms short resulted in an 8% return Better governed firms had fewer policies that impeded a takeover Worse governed firms had more of these policies 12-20

Anti-takeover Defenses Tactics for delaying hostile bidders Blank check Staggered board Special meeting Written consent Board and management protection Compensation plan Golden parachutes Liability and indemnification 12-21

Anti-takeover Defense (cont’d) Voting rules Supermajority voting Other Fair price Poison pill 12-22

Board of Directors Effectiveness 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 12-23

Table 12.1a Effects of Board Independence and Size on Firm Independence 12-24

Table 12.1b Effects of Board Independence and Size on Firm Independence (cont’d) 12-25

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: Firm size is primary Controlling for size, compensation is weakly related to shareholder returns Controlling for size and performance, ingratiation behavior affects compensation 12-26

Table 12.2 Trends in Executive Compensation (Health Insurance Industry) 12-27

Table 12.3 What Predicts CEO Compensation in the Health Insurance Industry? 12-28

Table 12.4 How Many Health Insurance Firms Were Consistently Above or Below the Norm? 12-29

Governance in Different Countries Governance rules, practices and legal aspects vary across countries Countries differ in the strength of: Boards Owners Networks of directors, owners and sources of capital Government intervention The key is the combined effects of these institutional components on management behavior 12-30

Table 12.5 Institutional Environments of Large Firms By Country 12-31