Harry J. Van Buren III

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Corporate governance Why it matters for strategy
and ethics

• Harry J. Van Buren III
• Anderson School of Management
• University of New Mexico

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Corporate governance What is it and why does it
matter?

• Corporate governance represents the relationship
  among stakeholders that is used to determine and
  control the strategic direction and performance
  of organizations.
• Corporate governance has both strategic and
  ethical implications.

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Strategic implications of corporate governance

• Simply put, bad corporate governance leads to bad
  strategy formulation and implementation.
• If strategy is about matching the firms internal
  resources and capabilities with opportunities
  from the external environment, then corporate
  governance should ask the following sorts of
  questions

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Strategic implications of corporate governance (2)

• Do we have the right strategy, given what we do
  well?
• Is our strategy matched to the external
  environment (economy, social expectations, etc.)?
• Are we capable of executing the strategy?
• Do we have the right top management team?
• If the answer to one or more of these questions
  is no, what do we need to change?

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Strategic implications of corporate governance (3)

• Bad strategy makes it harder for firms to
  fulfill their economic and ethical
  responsibilities to stakeholders, including
  shareholders and employees!

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Ethical issues in corporate governance

• There are several key strategic and ethical
  issues in corporate governance, including
• how to align the interests of top managers and
  shareholders,
• the proper level and function of executive
  compensation,
• who monitors the top management team and how that
  monitoring occurs, and
• inclusion of shareholders and non-shareholder
  stakeholders.

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Aligning the interests of shareholders and
managers

• One of the primary issues in corporate
  governance is how to align the interests of
  shareholders and managers.
• While most people dont object to high levels of
  pay for top managers (such as CEOs and CFOs),
  they expect pay to be connected to performance
  and stock price.

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Why do we need to align the interests of
shareholders and managers?

• At one time in U.S. history, firms were owned
  and managed by founders and their descendents. As
  firms grew larger, they needed more capital than
  could easily be provided by one person or family,
  and so the public corporation became more common.

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Why do we need to align the interests of
shareholders and managers? (2)

• Corporations have two important virtues
• They allow shareholders (investors) to reduce
  risk by limiting their liability to the value of
  their investment.
• They allow shareholders to buy and sell their
  ownership interests easily.
• But there is a big problem that creates a
  potential misalignment of interests between
  shareholders and managers
• The Separation of Ownership and Control!

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Why do we need to align the interests of
shareholders and managers? (3)

• Managers have day-to-day control of the company.
  The top management team, for example, is in
  charge of things such as strategy, hiring and
  firing employees, and so on.
• Shareholders dont own the corporation in the
  same way that you own your car they dont have
  physical possession of a part of the corporation.
  Rather, what they own is a limited set of
  decision rights, the right to share financially
  in the companys success, and a pro-rata share of
  the company after all of its debts are paid if
  the company is liquidated.

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Why do we need to align the interests of
shareholders and managers? (4)

• The separation of ownership and control leads to
  a principal-agent relationship.
• The principal directs the activities of the
  agent.
• The agent acts on behalf of the principal, based
  on the principals direction. The agent owes a
  duty of loyalty to the principal.
• For public corporations, shareholders are
  principals and managers are agents an agency
  problem exists when agents have incentives to act
  in ways that are contrary to the interests of
  their principals.

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Why do we need to align the interests of
shareholders and managers? (5)

• What makes agency problems particularly likely
  in public corporations is the large number of
  ever-changing principals (shareholders holding
  their stock for varying periods of time), all of
  whom would be better off if some shareholders
  would monitor the firms managers.
• Less monitoring of managers by shareholders than
  is optimal occurs because monitoring is costly,
  but all shareholders benefit from the actions of
  the few that engage in monitoring (the free-rider
  problem). Think of it this way Would you always
  behave perfectly if no one was watching you?

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How do top managers misbehave?

• Because of agency problems, managers have
  incentives to do things that benefit themselves
  at the expense of shareholders and other
  stakeholders (too high compensation,
  over-diversification, mergers, etc.).

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Alignment Mechanism 1Executive compensation

• The average compensation of a Fortune 500 CEO in
  2007 was 364 times that of the average worker. An
  Economic Policy Institute study found that
  between 1989 and 2007, CEO pay increased by 163
  percent, compared with only 10 percent for the
  average worker (both adjusted for inflation).
• A number of studies have found that there is no
  correlation between executive compensation and
  firm performance, and recent work by Erickson,
  Hanlon, and Maydew (2003) found that executive
  compensation plans weighted more heavily toward
  stock compensation were related to the incidence
  of accounting fraud.

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Alignment mechanism 1Executive compensation (2)

• There is evidence that (1) top managers have too
  much influence on setting their own pay and (2)
  boards have not done a good job of connecting
  executive compensation to performance (however
  performance is defined).
• Recent scandals involving insider trading have
  added to cynicism about business, and pay that is
  too high relative to performance may make the
  company a target of criticism.

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Alignment mechanism 1Executive compensation (3)

• Good executive compensation plans take into
  account a variety of strategic and financial
  indicators and then reward for superior
  performance relative to industry peers, rather
  than absolute levels of stock performance.
• In the absence of good information about a
  corporations performance and strategies,
  shareholders and other stakeholders are unable to
  adequately evaluate top-manager performanceand
  over-compensation of top managers is a likely
  result.

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Alignment mechanism 2 Boards of directors

• Remember that shareholders are not in charge of
  the day-to-day operations of a corporation.
  Rather, they elect directors who then hire
  managers charged with formulating and
  implementing the companys strategy.
• However, shareholders have little control over
  who is nominated to the board of directors. Only
  under very limited circumstances can they even
  nominate a minority of the companys directors.

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Alignment mechanism 2Boards of directors (2)

• As a result, members of a companys board of
  directors may feel more beholden to the CEO and
  the top management team than to the shareholders
  in whose interests they are supposed to be
  acting.
• Boards should be focused on evaluating the
  organizations (strategic and financial)
  performance and firing top managers when that
  performance is substandard and unlikely to
  improve.

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Alignment mechanism 2Boards of directors (3)

• Boards should also have a respectful relationship
  with the top management team, think of themselves
  as independent from the CEO, and evaluate their
  own performance on a regular basis. Such boards
  do a better job of protecting shareholder value.

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Alignment mechanism 3The market for corporate
control

• When a company is perceived to be financially
  undervalued, there is the possibility that it can
  be taken over (often through a hostile takeover).
  When this happens, there is often a new
  management team and strategy put into place.
• Some observers propose that the threat of being
  taken over if the corporation is
  underperformingwhat is called the market for
  corporate controlprovides an additional means of
  aligning the interests of shareholders and
  managers.

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The role of institutional failures in corporate
governance

• Many of the well-known corporate-governance
  failures are due to widespread institutional
  failures, including failures by regulators,
  accounting firms, and financial analysts. Take
  one of these failures out of the equation, and
  perhaps some of the problems observed in the last
  ten years might not have occurred.
• In particular, the incentive structures of
  accounting firms and financial analysts caused
  many of them not to provide appropriate oversight
  and criticism of corporate managers. In the
  absence of effective monitoring of managers, bad
  things tend to happen to companies.

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Including non-shareholder stakeholders in
corporate governance

• Ethicists argue that although non-shareholder
  stakeholders do not get to vote like shareholders
  do (and as was noted before, that vote is limited
  in its scope), their interests should be taken
  into account in corporate governance processes.
• Companies, managers, and boards that take a
  long-term view of the organizations strategy
  might want to consider the interests of
  non-shareholder stakeholders very directly, as
  they can affect (positively or negatively) the
  organizations ability to create value for
  shareholders.

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Ethical duties managers and boards owe
shareholders

• Accurate and timely information about the
  corporations performance and business prospects,
  so shareholders can make informed decisions about
  their investments.
• Best efforts to enhance shareholder wealth
• Avoidance of self-serving behavior.

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A final comment. . .

• Its pretty apparent that many boards have failed
  to do their jobs. That said, shareholders and
  non-shareholder stakeholders have a role to play
  in corporate governanceand part of the blame for
  recent corporate governance debacles rests with
  them. Shareholders should demand more of managers
  and boards.

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Whats likely to happen with corporate governance
in the future?

1. Greater expectations for transparency in
   financial and social reporting.
2. Increased expectations for board involvement in
   strategy setting and developing responses to
   social issues.

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The role of government, accounting firms, and
other parties

• Bills like the Sarbanes-Oxley Act of 2003
  represent attempts to deal with inherent agency
  problems and conflicts of interest (on the
  latter, issues like auditor independence). Boards
  and senior managers are much more accountable for
  the accuracy of their financial reporting than
  before.

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Whats likely to happen with corporate governance
in the future? (2)

1. Greater involvement by institutional shareholders
   (pension funds, mutual funds) in corporate
   governance processes.
2. Greater oversight of corporate boards and
   managers by regulators, shareholders, and
   non-shareholder stakeholders.