Corporate Governance

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Corporate Governance

• 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 between
  the firms owners and its top-level managers

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Corporate Governance Mechanisms
Internal Governance Mechanisms

• Board of Directors

Managerial Incentive Compensation
Ownership Concentration
External Governance Mechanisms

Market for Corporate Control
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Separation of Ownership and Managerial Control

• Basis of the modern corporation
• shareholders purchase stock, becoming residual
  claimants
• 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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Agency Relationship Owners and Managers

• Firm owners

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Agency Relationship Owners and Managers

• Firm owners

• Decision makers

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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
• Solution
• principals engage in incentive-based performance
  contracts
• monitoring mechanisms such as the board of
  directors
• enforcement mechanisms such as the managerial
  labor market to mitigate the agency problem

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Manager and Shareholder Risk and Diversification
Managerial (employment) risk profile
Shareholder (business) risk profile
Risk
Dominant Business
Unrelated Businesses
Related Constrained
Related Linked
Diversification
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Governance Mechanisms

• Insiders
• The firms CEO and other top-level managers
• Affiliated Outsiders
• Individuals not involved with day-to-day
  operations, but who have a relationship with the
  company
• Independent Outsiders
• Individuals who are independent of the firms
  day-to-day operations and other relationships

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Governance Mechanisms

• Role of the Board of Directors
• Monitor Are managers acting in shareholders
  best interests
• Evaluate Influence examine proposals,
  decisions actions, provide feedback and offer
  direction
• Initiate Determine delineate corporate
  mission, specify strategic options, make decisions

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Governance Mechanisms

• Salary, bonuses, long term incentive compensation
• Executive decisions are complex and non-routine
• Many factors intervene making it difficult to
  establish how managerial decisions are directly
  responsible for outcomes

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Governance Mechanisms

• 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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CEO Pay and Performance

• Classic pay for
• performance
• relationship

• Unfortunately, this
• relationship is weak

CEO Pay

• The stronger
• relationship is with
• firm size

Firm Performance
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CEO Pay and Firm Size

• Relationship between
• pay and firm size is
• curvilinear.

• CEO pay increases at
• a decreasing rate

CEO Pay
Firm Size
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Relationship Between Firm performance and Firm
Size

• Relationship between
• firm performance and
• firm size is curvilinear.

• Beyond some point, as
• size increases, firm
• performance declines

Firm Performance

• BUT
• From the graph of CEO
• pay vs. firm size, pay
• doesnt decline

Firm Size
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Relationship Between Firm performance and Equity
Ownership

• Relationship between
• firm performance
• (Tobins Q) and
• managerial ownership
• is curvilinear.

Firm Value

• Beyond some point, as
• ownership increases,
• firm value declines

Managerial Ownership in
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Governance Mechanisms

• Large block shareholders (often institutional
  owners) have a strong incentive to monitor
  management closely
• Exit vs. Voice Cannot costlessly exit due to
  equity stake (transaction costs) so they press
  for change (exercise voice)
• 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

• Types of institutional investors
• - Mutual funds, pension funds,
• foundations, churches, universities,
• insurance companies
  
• Pressure-resistant versus pressure-sensitive
• - Mutual and pension funds are
• pressure resistant
• Are Institutional investors the same?
• - Short vs. long term
• Components of voice
• - Pension fund hit lists
• - Shareholder liability suits
• - Investor alliances
• - Proxy contests

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Governance Mechanisms

• 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
• Acts as an important source of discipline over
  managerial incompetence and waste

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Managerial Defense Tactics

• Designed to fend off the takeover attempt
• Increase the costs of making the acquisitions
• Causes incumbent management to become entrenched
  while reducing the chances of introducing a new
  management team
• May require asset restructuring
• Institutional investors oppose the use of defense
  tactics

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Takeover Defenses

• Poison pills
• Leveraged recapitalizations
• Greenmail
• Litigation

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Takeover Defenses

• Poison pills
• Leveraged recapitalizations
• Greenmail
• Litigation

• Scorched earth defense
• Crown jewel sales
• Pac-man defense

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Takeover Defenses

• Poison pills
• Leveraged recapitalizations
• Greenmail
• Litigation

• Scorched earth defense
• Crown jewel sales
• Pac-man defense

• White knight defense
• Other bidder (competitive bid situation)