Corporate Governance

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Corporate Governance
Rev 10-25-07
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Corporate Governance Setting the Context for
Managing Sustainably

• 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
• used in corporations to establish order
  alignment between the interests of the firms
  owners and its top-level managers

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Separation of Ownership and Managerial Control

• Basis of the modern corporation
• shareholders purchase stock, becoming residual
  claimants in a corporate citizen
• shareholders reduce risk by holding diversified
  portfolios
• professional managers are contracted to provide
  decision-making
• Modern public corporation form leads to efficient
  specialization of tasks
• risk bearing by shareholders
• strategy development and decision-making by
  managers

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Corporate Governance and Ethical/Sustainable
Behavior
It is important to serve the interests of the
firms multiple stakeholder groups! seeBalanced
Scorecard

• In the U.S., shareholders (capital market
  stakeholder group) are viewed as the most
  important stakeholder group
• which are served by the board of directors
• Hence, the focus of governance mechanisms is on
  the control of managerial decisions to ensure
  that shareholders interests will be served

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Corporate Governance and Ethical Behavior
Although the idea is subject to debate, some
believe that ethically responsible, sustainable
companies design and use governance mechanisms
that serve all stakeholders interests!

• Product market stakeholders (customers, suppliers
  and host communities) and organizational
  stakeholders (managerial and non-managerial
  employees) are also important stakeholder groups
• Importance of maintaining ethical behavior
  through governance mechanisms is seen in the
  example of WorldCom, Enron and Arthur Andersen

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Agency Relationship Owners and Managers

• Firm owners

• Decision makers

• Risk bearing specialist (principal) pays
  compensation to
• A managerial decision-making specialist (agent)

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Agency Theory Problem

• 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
  inappropriately/opportunistically
• SOLUTIONS
• principals engage in incentive-based performance
  contracts
• monitoring mechanisms such as the board of
  directors
• Enforcement/accountability mechanisms to mitigate
  the agency problem

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Agency Theory Solution Challenges

• Principals may engage in monitoring behavior to
  assess the activities and decisions of managers
• However, dispersed shareholding makes it
  difficult and inefficient to monitor managements
  sometimes opportunistic behavior
• 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
• Executive incentives should be aligned with
  shareholders
• However, assessing executive performance is
  complex and can be gamed.

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Governance Mechanisms

• Relatively large amounts of stock owned by
  individual shareholders and institutional
  investors
• Large block shareholders have a strong incentive
  to monitor management closely
• Their large stakes make it worth their while to
  spend time, effort and expense to monitor closely
• They may also obtain Board seats which enhances
  their ability to monitor effectively (although
  financial institutions are legally forbidden from
  directly holding board seats)

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Governance Mechanisms

• Individuals responsible for representing the
  firms owners by monitoring top-level managers
  strategic decisions
• Insiders
• The firms CEO and other top-level managers
• Related Outsiders
• Individuals not involved with day-to-day
  operations, but who have a relationship with the
  company
• Outsiders
• Individuals who are independent of the firms
  day-to-day operations and other relationships

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CEO and Board Power

• Board of directors is an important governance
  mechanism for monitoring a firms strategic
  direction
• Higher performance is normally expected when the
  board is more directly involved in shaping a
  firms strategic direction
• Chief executive officers can gain so much power
  that they are virtually independent of oversight
  by the board of directors

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CEO and Board Power

• This is especially true when the CEO is also
  chairman of the board of directors
• CEOs of long tenure can also wield substantial
  power
• The most effective forms of governance share
  power and influence among the CEO and board of
  directors
• Corporate Scandals and Sarbanes-Oxley law have
  increased pressure for due diligence by boards

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Sarbannes-Oxley Act 2002

• You have to document everything
• Rigorous standards for corporate oversight,
  accounting/control processes, transparency
• Quarterly CEO/CFO statements certifying
  financial/operating conditions in all material
  respects
• Intended to boost investor confidence
• Changing boardroom dynamics
• Directors risk personal liability and loss of DO
  insurance coverage
• Increasing independence/activism (particularly by
  Audit Committee members)
• Costly compliance minefield
• 35mil average per large company in 2004-2005

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Governance Mechanisms

• Recommendations for more effective Board
  Governance
• Increase diversity of board members backgrounds
• More outsiders from varied disciplines
  industries
• Strengthen internal management and accounting
  control systems
• Broaden Directors contact with managers/employees
  at all levels
• Establish formal processes for evaluation of the
  boards performance

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Governance Mechanisms

• use of salary, bonuses, and long-term incentives
  to align managers interests with shareholders
  interests
• Executive decisions are complex and non-routine
  and many factors intervene making it difficult to
  establish how managerial decisions are directly
  responsible for outcomes
• Stock ownership (long-term incentive
  compensation) makes managers more susceptible to
  market changes which are partially beyond their
  control
• Incentive systems do not guarantee that managers
  make the right decisions, but do increase the
  likelihood that managers will do the things for
  which they are rewarded

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Governance Mechanisms

• the purchase of a firm that is underperforming
  relative to industry rivals in order to improve
  its strategic competitiveness
• Acts as an important source of discipline over
  managerial incompetence and waste
• Firms face the risk of takeover when they are
  operated inefficiently
• Many firms begin to operate more efficiently as a
  result of the threat of takeover, even though
  the actual incidence of hostile takeovers is
  relatively small
• Changes in regulations have made hostile
  takeovers difficult

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International Corporate Governance
Germany

• Owner and manager are often the same in private
  firms
• Public firms often have a dominant shareholder,
  frequently a bank
• Frequently there is less emphasis on shareholder
  value than in U.S. firms, although this may be
  changing
• Medium to large firms have a two-tiered board
• vorstand monitors and controls managerial
  decisions
• aufsichtsrat selects the Vorstand
• employees, union members and shareholders appoint
  members to the Aufsichtsrat

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International Corporate Governance
Japan

• Obligation, family and consensus are important
  factors
• Keiretsus are strongly interrelated family
  groups of firms tied together by relationships
  and cross-shareholdings
• Banks (especially main papa banks) are highly
  influential with firms managers from each
  keiretsu

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International Corporate Governance
Japan

• Other characteristics
• powerful government intervention
• close relationships between firms and government
  sectors
• passive and stable shareholders who exert little
  control
• virtual absence of external market for corporate
  control