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 firm’s owners and its top-level
managers

1
 Corporate Governance Mechanisms

Internal Governance Mechanisms

Board of Directors

Managerial Incentive Compensation

Ownership Concentration

External Governance Mechanisms

Market for Corporate Control

2
 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
3
 Agency Relationship: Owners and
Managers

Shareholders
(Principals)
• Firm owners

4
 Agency Relationship: Owners and
Managers

Shareholders
(Principals)
• Firm owners

Managers
• Decision makers
(Agents)

5
 Agency Relationship: Owners and
Managers

Shareholders
(Principals)
• Firm owners

Managers
• Decision makers
(Agents)

• Risk bearing specialist (principal)

pays compensation to a An Agency
managerial decision-making Relationship
specialist (agent)
6
 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
7
 Manager and Shareholder Risk and
Diversification

Shareholder Managerial
(business) (employment)
S risk profile risk profile M
Risk

A B
Dominant Related Related Unrelated
Business Constrained Linked Businesses
Diversification
8
 Governance Mechanisms

Board of Insiders
• The firm’s CEO and other top-level
Directors 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 firm’s day-to-day
operations and other relationships

9
 Governance Mechanisms

Board of Role of the Board of Directors

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

10
 Governance Mechanisms
• Salary, bonuses, long term incentive
Board of compensation
Directors • Executive decisions are complex and
non-routine
Executive • Many factors intervene making it
Compensation difficult to establish how managerial
decisions are directly responsible for
outcomes

11
 Governance Mechanisms
• Stock ownership (long-term
Board of incentive compensation) makes
Directors managers more susceptible to
market changes which are partially
Executive beyond their control
Compensation • 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

12
 CEO Pay and Performance

Classic pay for

performance
relationship

Unfortunately, this
CEO Pay
relationship is weak

The stronger
relationship is with
firm size
Firm Performance
13
 CEO Pay and Firm Size

Relationship between
pay and firm size is
curvilinear.

CEO pay increases at

CEO Pay a decreasing rate

Firm Size
14
 Relationship Between Firm
performance and Firm Size
Relationship between
firm performance and
firm size is curvilinear.
Performance

Beyond some point, as

size increases, firm
performance declines
Firm

BUT…
From the graph of CEO
pay vs. firm size, pay
doesn’t decline
Firm Size
15
 Relationship Between Firm
performance and Equity Ownership
Relationship between
firm performance
(Tobin’s Q) and
managerial ownership
is curvilinear.
Firm Value

Beyond some point, as

ownership increases,
firm value declines

Managerial Ownership in %
16
 Governance Mechanisms
• Large block shareholders (often
Board of institutional owners) have a
Directors strong incentive to monitor
management closely
Executive
Compensation • Exit vs. Voice – Cannot costlessly
exit due to equity stake
(transaction costs) so they press
Ownership for change (exercise voice)
Concentration
• They may also obtain Board seats
which enhances their ability to
monitor effectively (although
financial institutions are legally
forbidden from directly holding
board seats)
17
 Governance Mechanisms
• Types of institutional investors
Board of - Mutual funds, pension funds,
Directors foundations, churches,
universities,
Executive insurance companies
Compensation
• Pressure-resistant versus
Ownership pressure-sensitive
Concentration - 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 18
 Governance Mechanisms
• Firms face the risk of takeover
Board of when they are operated inefficiently
Directors • Many firms begin to operate more
efficiently as a result of the “threat”
Executive of takeover, even though the actual
Compensation incidence of hostile takeovers is
relatively small
Ownership • Changes in regulations have made
Concentration hostile takeovers difficult
• Acts as an important source of
Market for discipline over managerial
Corporate Control incompetence and waste

19
 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

20
 Takeover Defenses:

 Poison pills
Financial
 Leveraged recapitalizations
Mechanisms
 Greenmail
 Litigation

21
 Takeover Defenses:

 Poison pills
Financial  Leveraged recapitalizations
Mechanisms  Greenmail
 Litigation

Asset-Based  Scorched earth defense

Mechanisms  Crown jewel sales
 Pac-man defense

22
 Takeover Defenses:

 Poison pills
Financial  Leveraged recapitalizations
Mechanisms  Greenmail
 Litigation

Asset-Based  Scorched earth defense

Mechanisms  Crown jewel sales
 Pac-man defense

 White knight defense

Third Party  Other bidder (competitive bid situation)
Mechanisms

23