1. Managerial Economics and Organizational Architecture, 5e Managerial Economics and Organizational Architecture, 5e Chapter 18: Corporate Governance McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

2. Managerial Economics and Organizational Architecture, 5e Corporate Governance Describes the organizational structure at the top of the firm Includes –Top-level incentives –Partitioning of decision rights –Board of directors –Top management –Outside monitors 18-2

3. Managerial Economics and Organizational Architecture, 5e Corporate Structure Corporations have the legal standing of an individual Shareholders elect a board of directors with primary decision control rights Shareholder-owners have limited liability Corporations may establish governance procedures within legal boundaries 18-3

4. Managerial Economics and Organizational Architecture, 5e Corporate Ownership Stock in closely-held corporations is not freely traded Stock of publicly-traded corporations may be freely bought and sold –Widely held corporation No one owner controls more than 10 percent of the shares 18-4

5. Managerial Economics and Organizational Architecture, 5e Corporate Governance Objectives Maximizing value Protecting assets Production of proper financial statements that meet legal requirements 18-5

6. Managerial Economics and Organizational Architecture, 5e Separation of Ownership and Control Incentive issues Are executive interests aligned with those of stockholders? Survival of corporations Despite governance concerns, the corporate form seems both productive and resilient Benefit of publicly-traded corporations Ability to raise large amounts of capital 18-6

7. Managerial Economics and Organizational Architecture, 5e Top-level Architecture US corporations Decision rights divided among selected stakeholders Shareholders Governing board Top management External monitors 18-7

8. Managerial Economics and Organizational Architecture, 5e Government Impacts on Decision Rights State regulations affect firms incorporated within those states Federal laws and regulations further stipulate decision rights Courts have impact through interpretations of laws 18-8

9. Managerial Economics and Organizational Architecture, 5e Shareholders Ultimate owners Limited participation in management –Elect board –Board oversees management –Some ratification rights 18-9

10. Managerial Economics and Organizational Architecture, 5e Shareholder Incentives Small shareholders (individuals) have incentive to free ride rather than be actively involved Institutional investors (e.g. pension funds) differ in incentives to challenge management Blockholders internalize more of the benefits of active involvement 18-10

11. Managerial Economics and Organizational Architecture, 5e Board of Directors Delegates legal authority to professional managers Primary function is top-level decision control Other responsibilities –Hire, monitor, fire CEO –Authorize strategic directions –Approve large capital outlays 18-11

12. Managerial Economics and Organizational Architecture, 5e Board of Directors Fiduciary responsibilities –Represent the interests of the corporation and shareholders –Good faith efforts –Loyalty Legal protection through business judgment rule 18-12

13. Managerial Economics and Organizational Architecture, 5e Board Composition and Work Size can vary from 4 to 33+ Over half are outside directors CEO usually sits on board –Frequently chairs the board Much work done in committees –Audit –Compensation –Nominating 18-13

14. Managerial Economics and Organizational Architecture, 5e Board Member Incentives Some stock ownership aligns financial interests with other shareholders High-profile board members have reputational concerns Are members independent of top management? –Incentives to back management for self- interested reasons 18-14

15. Managerial Economics and Organizational Architecture, 5e Top Management CEO’s decision authority flows from the board More decision rights are delegated as firm size and complexity increase Senior management retains important decision rights –Shape strategic direction –Establish overall architecture –Recruiting and retaining key personnel 18-15

16. Managerial Economics and Organizational Architecture, 5e Top Management CEO often deals with investor relations, media, and customers COO manages internal operations CFO supervises senior financial managers 18-16

17. Managerial Economics and Organizational Architecture, 5e Top Management Incentives Straight salary Performance-based compensation –Bonuses –Stock options –Stock ownership 18-17

18. Managerial Economics and Organizational Architecture, 5e External Monitors Public accounting firms –Annual independent audits increase shareholder confidence Stock market analysts –May have incentives to promote stocks that use their firm’s banking services Commercial banks Credit-rating agencies Regulatory authorities 18-18

19. Managerial Economics and Organizational Architecture, 5e International Corporate Governance Historical emphasis on broader set of stakeholders –Employees –Lenders –Affiliated companies –Broader public Gradual shift toward US architecture 18-19

20. Managerial Economics and Organizational Architecture, 5e Monitoring Effect of Market Forces Management failure opens door to hostile takeover Management failure closes door to further professional opportunities Inefficiency places firm’s products at competitive disadvantage 18-20

21. Managerial Economics and Organizational Architecture, 5e Sarbanes-Oxley Act of 2002 Establishes Public Companies Accounting Oversight Board Prohibits certain transactions between companies and managers Holds CEOs and CFOs accountable for financial statements Establishes civil and criminal penalties for violations 18-21

22. Managerial Economics and Organizational Architecture, 5e Chapter 18 Appendix Legal Forms of Organization

23. Managerial Economics and Organizational Architecture, 5e Organizational Form For profit Residual claimants Nonprofit Nondistribution constraint 18-23

24. Managerial Economics and Organizational Architecture, 5e For-profit Organizations Individual proprietorships General partnerships Limited liability partnerships Limited partnerships S corporations C corporations 18-24

25. Managerial Economics and Organizational Architecture, 5e Individual Proprietorships Resolve owner-top management conflict Limited ability to raise capital Income passes through to owner’s tax return 18-25

26. Managerial Economics and Organizational Architecture, 5e General Partnership Income passes through to partners’ individual tax returns Partners exposed individually and jointly to unlimited liability fosters mutual monitoring Take advantage of teamwork opportunities 18-26

27. Managerial Economics and Organizational Architecture, 5e S Corporation Attractive choice for some small companies Same tax treatment as proprietorships and partnerships Limited liability Entails incorporation fees Lenders still require personal guarantees 18-27

28. Managerial Economics and Organizational Architecture, 5e C Corporations Attractive for large companies Easier to raise capital Shareholders subject to “double taxation” Limited liability for shareholders Small risk-bearing costs shareholders have diversified portfolios 18-28