Chapter 11 Corporate Governance

Transcription

1 CHAPTER SUMMARY Chapter 11 Corporate Governance This chapter describes the relationship between owners and managers, which provides the foundation on which the corporation is built. The majority of this chapter is used to explain various mechanisms owners use to govern managers and to ensure that they comply with their responsibility to maximize shareholder value. Three internal governance mechanisms used by modern corporations are examined, along with the market for corporate control (an external mechanism). The chapter s focus then shifts to the issue of international corporate governance, briefly describing governance approaches used in German and Japanese firms, where traditional governance structures are being affected by global competition. Closing the analysis of corporate governance is a consideration of the need for these control mechanisms to encourage and support ethical behavior in organizations. CHAPTER OUTLINE Separation of Ownership and Managerial Control Agency Relationships Product Diversification as an Example of an Agency Problem Agency Costs and Governance Mechanisms Ownership Concentration Institutional Owners Shareholder Activism Board of Directors Board Independence Board Effectiveness Executive Compensation A Complicated Governance Mechanism The Effectiveness of Executive Compensation Market for Corporate Control Managerial Defense Tactics International Corporate Governance Corporate Governance in Germany Corporate Governance in Japan Global Corporate Governance Governance Mechanisms, Stakeholder Management, and Ethical Behavior Summary KNOWLEDGE OBJECTIVES 1. Define corporate governance and explain why it is used to monitor and control managers strategic decisions. 2. Explain how ownership came to be separated from managerial control in the modern corporation. 3. Define an agency relationship and managerial opportunism and describe their strategic implications. 11 1

2 4. Explain how three internal governance mechanisms ownership concentration, the board of directors, and executive compensation are used to monitor and control managerial decisions. 5. Discuss trends among the three types of compensation executives receive and their effects on strategic decisions. 6. Describe how the external corporate governance mechanism the market for corporate control acts as a restraint on top-level managers strategic decisions. 7. Discuss the use of corporate governance in international settings, in particular in Germany and Japan. 8. Describe how corporate governance fosters ethical strategic decisions and the importance of such behaviors on the part of top-level executives. LECTURE NOTES See slides 1-3. See Table 11.1: Corporate Governance Mechanisms (slide 4). Corporate Governance - set of mechanisms used to manage the relationships (and conflicting interests) among stakeholders and to determine and control the strategic direction and performance of organizations (aligning strategic decisions with company values). 1. Name the internal and external mechanisms used in a wellfunctioning corporate governance and control system. a. Internal i. Ownership concentration ii. Board of directors iii. Executive compensation b. External i. Market for corporate control Separation of Ownership and Managerial Control - This section describes the basis for modern organizations, that emerged as firms began to outgrow their founders and allowed organizations to develop beyond the limitations of their founder-owners. See slide What are the critical issues for family-controlled firms as they grow? a. Owner-managers may not have access to all of the skills needed to effectively manage the growing firm and maximize its returns for the family. Thus, they may need outsiders to help improve management of the firm. b. Owner-managers may need to seek outside capital and thus give up some of the ownership control. 11 2

3 Agency Relationships - This section discusses unique agency relationships between firms owners and top-level managers as they relate to the implementation of firm strategies. Because the separation of ownership and control can result in divergent interests between the two parties, the potential for managerial opportunism is also examined. See slide 6. See Figure 11.1: An Agency Relationship (slide 7). See slide 8. See Additional Notes Below. Agency Relationship - relationships between business owners (principals) and decision-making specialists (agents) hired to manage the principals operations and maximize their returns on investments. Managerial Opportunism - seeking self-interest with guile (i.e., cunning or deceit). 3. What are some examples of agency relationships? a. Shareholder-Executive b. Consultant-Client c. Insured-Insurer d. Manager-Employee 4. What types of problems can surface when ownership and control are separated? a. Principal and the agent having different interests and goals. b. Shareholders lacking direct control of large publiclytraded corporations. c. Agent making decisions that result in the pursuit of goals that conflict with those of the principals. Additional Discussion Notes for Agency Relationships - These notes include additional materials that cover diversification and innovation without agency problems. Owners and Managers How to increase product diversification and how to intensify effort to innovate without increased agency problems? Firms undertake a variety of actions to reduce risk through diversification, including entering diverse lines of business, joining alliances, taking on temporary partners, and outsourcing risky projects, including R&D. The challenge, as explained in the book, is that shareholders do not directly benefit from risk-reducing diversification strategies when they can replicate this diversification on their own. Diversification, therefore, is often seen as managers opportunistic pursuit of their own self-interests at the expense of the shareholders who can, if they so desire, diversify their individual portfolios simply by buying shares in other companies. While this view reflects the influence of agency theory, recently such views have been challenged by stewardship theory (Donaldson, 1990a; 11 3

4 Donaldson & Davis, 1991), a framework presuming that managers are actually seeking to maximize organizational performance. For instance, one reason for diversifying would be to enhance company profit and growth prospects by reducing dependence on static or declining products, markets, and even industries. In the parlance of the I/O model discussed in Chapter 1, such a motive might lead companies to increase diversification into technologies or industries where profit rates are increasing most and to those where the competitive dynamism is relatively more stable. Managers might also opt to diversify for earnings stability and economies of scale. In short, diversification strategies might represent opportunism, but they might also reflect management rational and genuine response to financial adversity and/or the need for improved financial performance for their company. Product Diversification as an Example of an Agency Problem - This section discusses and illustrates the different levels of preference for diversification that exist between owners and managers and the potential for conflict that results. See slide 9. Free Cash Flows - resources remaining after the firm has invested in all projects that have positive net present values within its current businesses. 11 4

5 See slides See slide 12. See Figure 11.2: Manager and Shareholder Risk and Diversification (slide 13). 5. Why might top executives prefer more product diversification than shareholders? a. Increased product diversification provides an opportunity for top executives to increase their compensation. i. Diversification usually increases the size of a firm, and size is positively related to executive compensation. ii. Diversification increases the complexity of managing a firm and its network of businesses and may therefore require more pay because of this complexity. b. Product diversification and the resulting diversification of the firm s portfolio of businesses can reduce top executives employment risk. i. Managerial employment risk includes the risk of managers losing their jobs, compensation, or reputations. ii. These risks are reduced with increased diversification because a firm and its upperlevel managers are less vulnerable to the reduction in demand associated with a single or limited number of product lines or businesses. 6. How do managerial decisions to use free cash flows demonstrate a conflict in diversification interest? a. The managerial inclination to overdiversify can be acted upon when free cash flows are available. b. Shareholders may prefer that free cash flows be distributed to them as dividends, so they can control how the cash is invested. 7. Figure 11.2 illustrates the different optimal levels of diversification held by shareholders and managers. What factors affect the preferences of each of these parties? a. Owners seek the level of diversification that reduces risk of failure while increasing value through economies. Factors that affect their preference include: i. Firm s primary industry ii. Intensity of rivalry among competitors in that industry iii. Top management team s experience with implementing diversification strategies b. Upper-level executives seek the level of diversification that maximizes the firm s size and their compensation (and minimizes employment risk) while maintaining a performance level that discourages external acquisition of corporate control. 11 5

6 Agency Costs and Governance Mechanisms - This section introduces the costs associated with agency relationships and the impact that effective governance mechanisms have on managerial decision making and strategic effectiveness. The Sarbanes-Oxley Act (SOX) of 2002 is presented, along with a discussion of the costs of compliance and the impact the act has begun to have on strategic formulation and implementation. See slide 14. Refer to Table 11.1: Corporate Governance Mechanisms (slide 4). Agency Costs - sum of incentive costs, monitoring costs, enforcement costs, and individual financial losses incurred by principals, because governance mechanisms cannot guarantee total compliance by the agent. 8. Name the internal and external mechanisms used in a wellfunctioning corporate governance and control system. a. Internal i. Ownership concentration ii. Board of directors iii. Executive compensation b. External c. Market for corporate control Ownership Concentration - This section defines the governance mechanism of ownership concentration and describes the effect that diffused ownership has on shareholder ability to monitor managers, effectively coordinate their efforts, and ensure maximum shareholder value. See slide 15. Ownership Concentration - governance mechanism defined by both the number of large-block shareholders and the total percentage of shares they own. Large Block Shareholders - shareholders owning a concentration of at least 5 percent of a corporation s issued shares. Institutional Owners - financial institutions such as stock mutual funds and pension funds that control large-block shareholder positions. See slide What trends have improved ownership concentration and shareholder effectiveness? a. Increased equity ownership by institutional owners - provides the size to influence strategy and an incentive to discipline ineffective managers. b. Increased shareholder activism supported by SEC rulings in support of shareholder involvement and 11 6

7 See slide 17. See Additional Notes Below. control of managerial decisions. 10. What types of actions to control manager behavior have active shareholders begun to employ? a. Threats or initiations of a proxy battle to unseat the current board of directors. b. Organization of press conferences. c. Threats of a takeover bid. d. Creation of shareholder proposals for the board of directors to address at the next board meeting. Additional Discussion Notes for Governance Mechanisms - These notes include additional materials that cover the growing influence of institutional owners. The Growing Influence of Institutional Owners The discussion on the relationship between corporate ownership and performance was initiated as far back as the 1930s, but it remains an issue today. Pioneering researchers in corporate governance show that companies with separate ownership and control functions operate with different managerial rules in investment decision-making from those in which ownership and control are combined in a single decision-maker. Different managerial rules are caused by the different basis on which the stakeholders optimize the trade-off between their profit and utility maximization and the distribution of decision-making and risk-bearing functions. With diffused ownership and a lesser number of shares, an individual shareholder s control is diluted while a manager s control increases. This gives rise to conflict of interests resulting in less than optimal value for the shareholders. Erosion of value also comes from agency costs arising from ensuring that management acts in shareholders interests. A manager may behave opportunistically by choosing to exchange profits for personal benefits, such as on-the-job consumption. Thus consuming away the economic goods today rather than preserving them for the future. It is assumed that large-block investors and institutional ownership have both the size and the incentive to discipline ineffective managers and thus to influence a firm s strategic choice. The shift in governance whereby ownership of many modern corporations is concentrated in the hands of institutional investors might come with a high price tag vis-àvis strategic choice and long term planning. For example, institutional investors are overly focused on current profitability, which at time might conflict with future period earnings due to investments in risky R&D projects, and exploration of new business models. Moreover, as suggested in the book, even very strong institutional investors might not avert financial disaster. For example, CalPERS, which provides retirement and health coverage to over 1.3 million employees and is one of the largest public employee pension funds in the United States, had invested in Enron! Interestingly, over the past decade the world s leading private 11 7

8 equity firms consistently have delivered internal rates of return twice as large as the S&P 500 s. They ve achieved this by adding value to the underlying operations (Rogers, Holland, & Haas, 2002). For example, private equity firms: Clearly define their investment thesis and its time frame to fruition Hire managers who act like owners Focus on a few measures of success that all employees understand Make capital work hard or otherwise re-deploy under-performing assets quickly Make the center an active shareholder Ask Can institutional owners understand and act like managers of private equity firms? Board of Directors - This section introduces the Board of Directors governance mechanism and describes some of the powers that boards possess. See slide 18. Board of Directors - group of shareholder-elected individuals whose primary responsibility is to act in the owners interests by formally monitoring and controlling the corporation s top-level executives. See slide As stewards of an organization s resources, how can an effective and well-structure board of directors influence the performance of a firm? a. Direct the affairs of the organization b. Punish and reward managers c. Protect shareholders rights and interests d. Protect owners from managerial opportunism Board Independence - This section categorizes boards into three groups based on the relationships of their members to the firms that they serve. The effectiveness of these groups is also discussed. See Table 11.2: Classification of Boards of Directors Members (slide 20). 12. Describe the three types of Board of Directors. a. Insiders - active top-level managers in the corporation who are elected to the board because they are a source of information about the firm s day-to-day operations. b. Related outsiders - board members who have some relationship with the firm, contractual or otherwise, that may create questions about their independence, but these individuals are not involved with the corporation s day-to-day activities. 11 8

9 See slide 21. See Additional Notes Below. c. Outsiders - board members who provide independent counsel to the firm and may hold top-level managerial positions in other companies or may have been elected to the board before the beginning of the current CEO s tenure. 13. What are some of the benefits and weaknesses of the trend to elect a higher percentage of outside directors to boards? a. Improves upon the weak managerial monitoring and control that corresponds to inside directors. b. Without access to daily operations and a high level of information about managers and strategy, outside directors tend to emphasize financial controls, to the detriment of risk-related decisions by managers. Additional Discussion Notes for Governance Mechanisms - These notes include additional materials that cover the risks associated with boards dominated by outside members. Board of Directors Much of the governance literature advocates boards dominated by outsiders. What might be some of the risks associated with boards dominated by outsiders? As discussed in the book, a large number of outsiders can create several problems. First, outsiders have limited contact with the firm s day-to-day operations and incomplete information about managers. This, in turn, leads to ineffective assessments of managerial decisions and initiatives. Second, in the absence of full information, outsiderdominated boards emphasize the use of financial, as opposed to strategic, controls to gather performance information to evaluate managers and business units performances. Strong reliance on financial evaluations shifts risk to managers, who, in turn, may reduce R&D investments, increase diversification, and pursue higher compensation to offset their employment risk. Recently, Phan and his colleagues (2002) explained the relationships between corporate governance and innovation (R&D expenditures, patents, and new products) in 86 publicly listed pharmaceutical firms. Consistent with agency theory, they found that the presence of large block private and institutional shareholders controlling for firm size and performance positively influenced innovation. They demonstrated that CEO duality was positively related to R&D expenditures, and that boards with more insiders were positively associated with the number of new products. In short, in the highly turbulent pharmaceutical industry, where risky decisions have to be made under substantial uncertainty, active ownership, unitary command structures, and strategically involved boards provide superior explanatory power for the governance-innovation link. 11 9

10 Board Effectiveness - This section discusses trends among boards that respond to demands for greater accountability and improved performance. The board s role in creating social networks to link external stakeholders and the power of collaborative, diverse boards to effectively advise managers are also discussed. See slide 22. See slide Describe the trends among boards to monitor managerial behavior. a. Increases in the diversity of the backgrounds of board members (for example, a greater number of directors from public service, academic, and scientific settings; a greater percentage on boards of ethnic minorities and women; and members from different countries on boards of U.S. firms). b. The establishment and consistent use of formal processes to evaluate the board s performance. c. The creation of a lead director role that has strong powers with regard to the setting of the board s agenda and oversight of the activities of nonmanagement board members. d. Modifications of the compensation of directors, especially reducing or eliminating stock options as a part of the package. e. Requirements that directors own significant stakes in the company in order to keep them focused on shareholder interests. 15. What types of behavior should newly-appointed, non-executive directors use to increase their effectiveness? a. Become engaged in the firm, without trying to micromanage it. b. Challenge the reasoning behind decisions, but be supportive of decisions that are made. c. Provide an independent perspective on important decisions. Executive Compensation - This section presents a discussion of executive compensation, emphasizing the complications and effectiveness of this governance mechanism. The challenge of implementing executive compensations in firms with international strategies is covered. See slide 24. Executive Compensation - governance mechanism that seeks to align the interests of top managers and owners through salaries, bonuses, and long-term incentive compensation, such as stock awards and stock options

11 See slide 25. See slides See slide Why is the topic of executive compensation of interest and controversial? a. Executive compensation is thought to be excessive and out of line with performance. b. Alignment of pay and performance is a complicated board responsibility. c. The effectiveness of compensation plans as a governance mechanism is suspect. 17. What are some of the complications of using executive compensation to govern corporations? a. The strategic decisions that top-level managers make are typically complex and nonroutine, so it is difficult to evaluate the quality of those decisions. b. An executive s decision often affects a firm s financial outcomes over an extended period, making it difficult to assess the effect of current decisions on the corporation s performance. c. A number of other factors affect a firm s performance besides top-level managerial decisions and behavior, such as unpredictable economic, social, or legal changes (see Chapter 3), making it difficult to discern the effects of strategic decisions. d. Although performance-based compensation may provide incentives to top management teams to make decisions that best serve shareholders interests, such compensation plans alone are imperfect in their ability to monitor and control managers. e. Even incentive compensation plans that are intended to increase the value of a firm in line with shareholder expectations are subject to managerial manipulation to maximize managerial interests. 18. What are some of the practices that make the effectiveness of compensating with stock issues questionable? a. Many plans seem to be designed to maximize manager wealth rather than guarantee a high stock price that aligns the interests of managers and shareholders. b. Repricing - strike price value of options is lowered from its original position is common. c. Backdating - options grant is dated earlier than it was actually drawn up to ensure an attractive exercise price is common. Market for Corporate Control - This section explains the need for external mechanisms to address weak internal corporate governance, correct suboptimal performance relative to competitors, and discipline ineffective or opportunistic managers. Although it is less precise than internal governance mechanisms, this market has been active over the past few decades, and current takeover practices demonstrate its role in promoting responsible managerial behavior

12 See slides Market for Corporate Control - external governance mechanism consisting of a set of potential owners, seeking to acquire undervalued firms and earn above-average returns on their investments, that becomes active when a firm s internal controls fail. Managerial Defense Tactics - This section discusses the increased risk to managers posed by external corporate governance mechanisms and the tactics used by managers to discourage takeover activity. The controversial nature and inconclusive results of these tactics are also mentioned. See Table 11.3: Example of a Hostile Takeover Defense Tactics (slide 31). 19. Discuss some of the defense tactics used by managers (and their effectiveness) to reduce the risk of external influence on their firms. a. Preventative i. Poison pill (High) ii. Corporate charter amendment (Very low) iii. Golden parachute (Low) b. Reactive i. Litigation (Low) ii. Greenmail (Medium) iii. Standstill agreement (Low) iv. Capital structure change (Medium) International Corporate Governance - This section introduces the importance of studying the similarities and differences among governance structures across nations to effectively implement an international strategy, highlighting essential features found in Germany and Japan and global implications. See slide 32. See slide Describe some of the corporate governance features seen in Germany. a. Concentration of ownership is strong. b. Banks exercise significant power as a source of financing for firms. c. Two-tiered board structures, required for larger employers, place responsibility for monitoring and controlling managerial decisions and actions with separate groups. d. Power sharing includes representation from the community as well as unions. 21. Describe some of the corporate governance features seen in 11 12

13 See slide 34. Japan. a. Cultural concepts of obligation, family and consensus affect attitudes toward governance. b. Close relationships between stakeholders and a company are manifested in cross-shareholding and can negatively impact efficiencies. c. Banks play an important role in financing and monitoring large public firms. d. Despite the counter-cultural nature of corporate takeovers, changes in corporate governance have introduced this practice. 22. What are some global corporate governance trends? a. Relatively uniform governance structures are evolving. b. These structures are moving closer to the U.S. model of corporate governance. c. Although implementation is slower, this merging with U.S. practices is occurring even in transitional economies. Governance Mechanisms, Stakeholder Management, and Ethical Behavior - This closing section is a reminder of the importance of market and organizational stakeholders (in addition to investors). The likelihood of ethical actions in companies that design and use governance mechanisms to address the interests of all stakeholders is emphasized. The deterrent nature of board decisions and actions is also noted. (See slides and Additional Notes Below.) Additional Discussion Notes for Corporate Governance and Ethical Behavior - These notes include additional materials that cover statistics on the separation of chairperson and CEO. Corporate Governance and Ethical Behavior To improve corporate governance, watchdog groups advocate separating the chairperson and the chief executive positions and creating corporate boards that are dominated by outsiders. Here is where the S&P 500 currently stands in relation to this issue: Fifteen instances where Chairperson is not CEO and is an Independent Director, 16 instances where Chairperson is not CEO and is an Outside Related Director, 65 instances where Chairperson is Former CEO, three instances where Chairperson is not CEO and is An Executive, six instances where Chairperson is not CEO and is A Former Executive, 392 instances (78%) where Chairperson is ALSO the CEO (CEO duality). Source: The Corporate Library Exclusive special report on CEO/Chairman splits in the S&P 500: How Many and How Independent? ( com/spotlight/boardsanddirectors/splitchairs.html) 11 13

14 Ethical Questions - Recognizing the need for firms to effectively interact with stakeholders during the strategic management process, all strategic management topics have an ethical dimension. A list of ethical questions appears after the Summary section of each chapter in the textbook. The topic of ethics is best covered throughout the course to emphasize its prevalence and importance. We recommend posing at least one of these questions during your class time to stimulate discussion of ethical issues relevant to the chapter material that you are covering (See slides 38-43)