Ch 12 Owner Stakeholders

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Ch 12- Owner Stakeholders Corporate Governance

• Guidelines for the interim report
• Essentially a snapshot of your final report
• Contents
• Your proposed research topic
• Background and introduction to the topic (Define
  the issue. Why is it interesting? Is there a
  controversy surrounding it? Why should
  society/firms care about this issue? How is this
  related to the course content BGS?)
• Ideally, 1 to 2 pages long

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Ch 12- Owner Stakeholders Corporate Governance

• Guidelines for the interim report
• Main body
• Document whatever research youve carried out so
  far
• Identify main data sources (primary/secondary,
  will you be interviewing any institutional
  representatives)
• Mode of analysis (are you going to apply specific
  frameworks to the analysis? say, ethical
  principles, legal principles, economic
  principles, all of these)
• Ideally 2 to 3 pages
• Maximum length allowed is 5 pages
• Ask instructor if you have questions as you
  proceed
• Underlying idea behind the report is to provide
  you with feedback

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Ch 12- Owner Stakeholders Corporate Governance

• The role of corporate governance
• The origin of agency problems
• Resolution mechanisms
• Symptoms of governance problems runaway
  executive compensation
• The market for corporate control as a resolution
  mechanism

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Ch 12- Owner Stakeholders Corporate Governance

• Corporate governance
• how a corporation is governed
• Key question
• We presume that the firm, in a free-market
  system, will be managed with a view to meet
  obligations to its owners (shareholders). In
  practice, however, is this really true? Are firms
  run for the benefit of shareholders? Or are there
  imperfections in the system that may be
  detrimental to shareholder interests?

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Ch 12- Owner Stakeholders Corporate Governance

• The breakdown of governance systems at Enron,
  Worldcom, Tyco and other companies has attracted
  the attention of regulators to the importance of
  these systems in the context of a functioning
  capitalist system
• The passage of the Sarbanes-Oxley Act is a direct
  result of the governance breakdowns

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Ch 12- Owner Stakeholders Corporate Governance

• What is a corporation?
• An artificial legal person
• Same rights privileges
• 14th amendment - legal safeguards,
• 1st amendment - free speech
• Corporate charter certificate of incorporation
  issued by state
• Sets out rights / responsibilities of
  stockholders, board of directors, and officers.
• Governance ProblemDangers of state regulation
• The Delaware phenomenon

7

• shareholders
• directors (board)
• management
• employees

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Governance Problems

• Separation of ownership and control in large
  corporations leads to the potential for AGENCY
  conflicts in the relationship between
  shareholders and management
• Empire building
• Management has an incentive to increase firm size
  through internal growth which may not create
  value
• Inefficient diversification
• Incentives to diversify into unrelated businesses
  in pursuit of growth. E.g. Sara Lee
• On-the-job consumption
• Managers use their position to award themselves
  perquisites
• Tycos CEO threw his anniversary party with
  company money

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Governance Problems

• Agency problems are sought to be solved via
  resolution mechanisms
• Monitoring mechanisms
• Board of directors
• Auditors
• Institutional investors
• Bonding mechanisms
• Incentive alignment schemes in executive
  compensation
• Stock options, performance-linked bonuses
• The market for corporate control
• Takeovers, mergers and acquisitions

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Governance Problems

• Monitoring mechanisms
• Board of directors
• What role does the board play in ensuring
  governance quality?
• Auditors
• How do auditors enable proper governance?
• Institutional investors
• Institutional investors are large professional
  investors like pension and mutual funds
• Can institutional investors overcome the problem
  of separation of ownership and governance?

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Governance Problems

• Monitoring mechanisms
• Board of directors
• The board performs an overseeing function by
  debating strategic decisions like takeovers,
  diversification, CEO compensation, etc.
• Outside directors on the board are particularly
  independent
• Auditors
• Auditors verify the truthfulness of financial
  reporting to investors
• Institutional investors
• Institutional investors have comparatively large
  shareholdings within individual firms
• They have the research abilities to track firm
  performance and take action when managements take
  actions that are value-destroying
• GM was forced to remove Bob Stempel under
  shareholder activism by Calpers

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Governance Problems

• Do monitoring mechanisms always work?
• Board of directors
• CEO is often also chairman of the board
• Inside Directors are obliged to the CEO
• Outside directors can be bought with sweeteners
  like consulting contracts
• Auditors
• Most auditors receive consulting business from
  their clients, which is more lucrative than
  traditional accounting assignments
• Institutional investors
• In many cases, institutional investors hold less
  than 1 of the firms shares in practice, it is
  very difficult for them to influence management
  direction

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Governance Problems

• Bonding mechanisms
• Incentive alignment schemes in executive
  compensation
• Stock options, performance-linked bonuses
• Options link executive compensation to
  shareholder value creation
• A manager receives options to buy company stock
  at 80. If the market price is 100, he makes 20
  per share. If it is 200, he makes 40. So the
  higher he is able to keep the share price, the
  greater his pay will be.
• What happens if the price goes below 80? How
  much will he make/lose then?
• So there is a phenomenal upside, but limited
  downside risk

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Governance Problems

• Do Bonding mechanisms work?
• Stock options
• We saw there is a phenomenal upside, but limited
  downside risk
• This may lead to behavior by managers aimed at
  keeping stock prices high at all costs
• Auditors may be induced to look the other way
  while the firm follows questionable accounting
  practices
• Bad news may be suppressed while management
  attempts to profit from inside information

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Governance Problems

• Bonding mechanisms
• The market for corporate control
• Takeovers, mergers and acquisitions
• What happens if the other resolution mechanisms
  dont work?

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Governance Problems

• Bonding mechanisms
• The market for corporate control
• What happens if the other resolution mechanisms
  dont work?
• The firm is poorly managed and its market price
  falls below its intrinsic value
• It becomes an attractive target for a corporate
  raider, because it is now cheaper to buy a
  business than set up a new one
• The aggressor firm, post-takeover, replaces the
  targets management and board with its own people
• The target may be retained or sold within a few
  years

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Ch 12- Owner Stakeholders Corporate Governance

• Shareholders Rights
• Approve fundamental changes in the corporation
• Directors (Board)
• appointed initially by incorporators
  subsequently, elected by stockholders
• inside and outside directors
• hires fires CEO, but
• CEO is often also chairmanof the board (the
  duality phenomenon)

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Ch 12- Owner Stakeholders Corporate Governance

• Criticism of Boards
• Rubber stamp
• Close to management
• Proxy control
• CEO domination
• Conflicts of interest
• Business affiliations

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Ch 12- Owner Stakeholders Corporate Governance

• The controversy over executive pay
• American executives receive pay packets
  astronomically higher than counterparts in
  comparable economies
• Increasing disparity between executive and worker
  pay
• Are American CEOs overpaid?
• Is the pay system ethical?
• Equally importantly, is it economically
  efficient?

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Ch 12- Owner Stakeholders Corporate Governance

• The peculiar position of institutional investors
• Institutional investors
• Particularly pension funds, mutual funds
  insurance companies
• growing share of investment
• long -term investors
• Large holdings lead to liquidation problems
• Asset - liability mismatch
• The insidious role of investment banks
• Mergers and acquisitions driven by I-banks
  hunger for deals, not necessarily economic motives

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Ch 12- Owner Stakeholders Corporate Governance

• Takeovers
• External effects on corporations
• control of shares
• friendly hostile
• Takeover Tactics
• a. Tender offers
• Public offer to all shareholders
• exchange v. cash
• b. Beach head acquisitions proxy fights
• Initial purchase of a block of shares
• Secure proxies
• Elect favorable Board

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Ch 12- Owner Stakeholders Corporate Governance

• c. LBO
• Make public company private
• usually by management
• interest burden
• d. Greenmail
• Aggressor sells back his acquisition to target
  at a premium
• Profitable (green) blackmail

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Ch 12- Owner Stakeholders Corporate Governance

• Takeover Defenses
• a. Crown jewel defense
• b. Scorched Earth e.g.. Long- term loan
• c. poison pill defense
• issue shareholders shares to be exchanged for
  cash on takeover
• d. Pac Man defense
• e.White Knight defense
• f. Golden Parachute

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Ch 12- Owner Stakeholders Corporate Governance

• Limitations of takeover defenses
• Acceptance/resistance of takeover responsibility
  of the board
• Board expected to meet standards of loyalty and
  care
• Fending off takeovers may have serious legal
  repercussions
• Delicate balance
• Keeping the firm viable while satisfying
  societys displeasure with some aspects of
  governance