Transparency 10-1 Used in corporations to establish order between the firm’s owners and its top-level managers 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 Corporate Governance

Transparency 10-2 Basis of the modern corporation Professional managers contract to provide decision- making - Risk bearing by shareholders - Strategy development and decision-making by managers - Shareholders reduce risk efficiently by holding diversified portfolios Shareholders purchase stock, becoming... Residual Claimants Modern public corporation form leads to efficient specialization of tasks Separation of Ownership and Managerial Control

Transparency 10-3 An agency relationship exists when: Shareholders(Principals) Firm Owners Agency Relationship Risk Bearing Specialist (Principal) Managers(Agents) DecisionMakers which creates Managerial Decision- Making Specialist (Agent) Hire Agency Theory

Transparency 10-4 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 appropriately Solution: Principals engage in incentive-based performance Example: Overdiversification because increased product diversification leads to lower employment risk for managers and greater compensation contracts, monitoring mechanisms such as the board of directors and enforcement mechanisms such as the managerial labor market to mitigate the agency problem Agency Theory

Transparency 10-5 Risk Level of Diversification Manager and Shareholder Risk and Diversification DominantBusinessDominantBusinessUnrelatedBusinessesUnrelatedBusinessesRelatedConstrainedRelatedConstrained RelatedLinkedRelatedLinked Shareholder (Business) Risk Profile Managerial (Employment ) Risk Profile S M AA BB

Transparency 10-6 Principals may engage in monitoring behavior to assess the activities and decisions of managers - However, dispersed shareholding makes it difficult and and inefficient to monitor management’s behavior For example: Boards of Directors have a fiduciary duty to shareholders to monitor management - However, Boards of Directors are often accused of being lax in performing this function Agency Theory

Transparency 10-7 Governance Mechanisms Ownership Concentration Boards of Directors Executive Compensation Market for Corporate Control Multidivisional Organizational Structure

Transparency 10-8 Ownership Concentration monitor management closely time, effort and expense to monitor closely - Large block shareholders have a strong incentive to - Their large stakes make it worth their while to spend - They may also obtain Board seats which enhances their ability to monitor effectively (although financial institutions are legally forbidden from directly holding board seats) Governance Mechanisms

Transparency 10-9 Boards of Directors - Review and ratify important decisions - Set compensation of CEO and decide when to replace the CEO - Lack contact with day to day operations - Insiders - Related Outsiders - Outsiders Governance Mechanisms

Transparency Recommendations for more effective Board Governance - Increase diversity of board members backgrounds - Strengthen internal management and accounting control systems - Establish formal processes for evaluation of the board’s performance Governance Mechanisms

Transparency Salary, Bonuses, Long term incentive compensation - Executive decisions are complex and non-routine - Many factors intervene making it difficult to establish for outcomes how managerial decisions are directly responsible Executive Compensation - In addition, stock ownership (long-term incentive market changes which are partially beyond their control compensation) makes managers more susceptible to 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 Governance Mechanisms

Transparency Designed to control managerial opportunism - Corporate office and Board monitor managers’ - Increased managerial interest in wealth maximization strategic decisions Multidivisional Organizational Structure Governance Mechanisms M-form structure does not necessarily limit corporate- - May lead to greater rather than less diversification Broadly diversified product lines makes it difficult for top-level managers to evaluate the strategic decisions of divisional managers level managers’ self-serving actions

Transparency Market for Corporate Control Operates when firms face the risk of takeover when they are operated inefficiently The market for corporate control acts as an important source of discipline over managerial incompetence and waste - Changes in regulations have made hostile takeovers difficult - Many firms began to operate more efficiently as a result of - The 1980s saw active market for corporate control, largely as a result of available pools of capital (junk bonds) the “threat” of takeover, even though the actual incidence of hostile takeovers was relatively small Governance Mechanisms

Transparency Stakeholders Firm Groups who are affected by a firm’s performance and who have claims on its performance Product Market Organizational Capital Market Stock market/Investors Debt suppliers/Banks Employees Managers Non-Managers Employees Managers Non-Managers The firm must maintain performance at an adequate level in order to maintain the participation of key stakeholders Primary Customers Suppliers Primary Customers Suppliers

Transparency Stakeholder Involvement Each of the key stakeholders involved wants a piece of the same pie 1 1 How do you divide the pie in order to keep all of the stakeholders involved? 2 2 How do you increase the size of the pie so that there is more to go around?