SMJ#9 Chapter 10 Corporate Governance The purpose of this chapter is to present and discuss how shareholders (owners) can ensure that managers develop and implement strategic decisions in the best interests of the shareholders (owners) and not be primarily self-serving (working for the best interests of managers only, to the detriment of shareholders). In the absence of effective internal governance mechanisms, the market for corporate control—an external governance mechanism—may be activated. Though it is a subject most frequently associated with firms in the US and the U.K., the effectiveness of governance is gaining attention throughout the world. − Why is it a good idea to separate ownership from management in modern corporations? The growth of the large, modern public corporation is based primarily on the efficient separation of ownership and managerial control. In small firms, managers and owners are often one in the same—less separation of ownership and control. As familycontrolled firms grow, the owners generally do not have sufficient capital or managerial skills to grow the business and seek other sources of capital and skills to support this expansion. Shareholders make investments by purchasing stock (representing ownership), leading to the separation of ownership and managerial control. − How can we align the interests between managers and owners? An agency relationship exists when one party (the principal[s]) delegates decision making to another party (the agent[s]) in return for compensation as a decision-making specialist who performs a service. This relationship can be broader than just owners and managers—e.g., consultants and clients or insured and insurer. An agency relationship enables the possibility of managerial opportunism, the seeking of self-interest with guile (i.e., with cunning or deceit), where opportunism is represented by an attitude or inclination and a set of behaviors. Three internal governance mechanisms—ownership concentration, boards of directors, and executive compensation, are used in modern corporations to align the interests between managers and owners. Discuss the case of Wells Fargo’s fake accounts. How can each of the internal corporate governance mechanism foster ethical decisions and behaviors to prevent a case like this? ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ SMJ#9 ___________________________________________________________________________ ___________________________________________________________________________ − What’s hostile takeover? The market for corporate control is an external governance mechanism that becomes active when a firm’s internal controls fail. It is composed of individuals and firms who buy ownership positions in (or take over) potentially undervalued firms. They do this in order to form a new division in an established diversified firm, merge two previously separate firms, and usually replace the target firm’s management team to revamp the strategy that caused low firm performance. A hostile takeover is the acquisition of one company (called the target company) by another (called the acquirer) that is accomplished by going directly to the company's shareholders or fighting to replace management to get the acquisition approved. Most of the hostile takeover attempts are due to the target firm’s poor performance. Therefore, target firm managers and members of the boards of directors are highly sensitive about hostile takeover bids. It often means that they have not done an effective job managing the company because of the performance level inviting the bid. If they accept the offer, they are likely to lose their jobs; the acquiring firm will insert its own management. What are the common defense strategies used to fight hostile takeover? ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ Reference: Hitt, M. A., Ireland, R. D., & Hoskisson, R. E. (2017). Strategic management cases: competitiveness and globalization. Cengage Learning. CHAPTER 10 CORPORATE GOVERNANCE Mgt431, 2018 Fall SEPARATION OF OWNERSHIP AND MANAGERIAL CONTROL Modern public corporation form leads to efficient specialization of tasks  Risk bearing by shareholders/owners  Strategy development and decision making by managers Corporate governance is:  to manage relationships among stakeholders and to determine and control the strategic direction of organizations.  to establish harmony between the firm’s owners and its top-level managers whose interests may be in conflict. Managerial opportunism is:  an attitude (inclination)  a set of behaviors (specific acts of selfinterest)  The seeking of self-interest with guile (cunning or deceit) Product Diversification  Increased size and the relationship of size to managerial compensation  Reduction of managerial employment risk Use of Free Cash Flows  Managers prefer to invest these funds in additional product diversification (see above) AGENCY PROBLEM  Shareholders prefer the funds as dividends so they control how the funds are invested CORPORATE GOVERNANCE MECHANISM Internal Governance Mechanism  Ownership Concentration  Board of Directors  Executive Compensation Large block shareholder >=5% Institutional owners (stock mutual funds and pension funds): • have the size (proxy voting power) and incentive demand for returns to funds) to discipline ineffective top-level managers. • “long-term, patient capital Shareholder activism • Shareholders can convene to discuss corporation’s direction Proxy fights • Minority stakeholders; State-ownership; family ownership BOARD OF DIRECTORS Board of directors  Group of elected individuals that acts in the owners’ interests to formally monitor and control the firm’s top-level executives Board has the power to:  direct the affairs of the organization  punish and reward managers  protect owners from managerial opportunism Composition of Boards Insiders: the firm’s CEO and other toplevel managers. Related Outsiders: individuals uninvolved with day-to-day operations, but who have a relationship with the firm. Outsiders: individuals who are independent of the firm’s day-to-day operations and other relationships. EXECUTIVE COMPENSATION Forms of compensation  Salaries, bonuses, long-term performance incentives, stock awards, stock options Factors complicating executive compensation  Strategic decisions by top-level managers are complex, non-routine and affect the firm over an extended period  Other variables affecting the firm’s performance over time  Cross border acquisitions a golden parachute is a type of managerial protection that pays a guaranteed salary for a specified period of time in the event of a takeover and the loss of one’s job. A golden goodbye provides automatic payments to top executives if their contracts are not renewed, regardless of the reason for nonrenewal. Limits on the effectiveness of executive compensation  Unintended consequences of stock options   Balance sheet not showing executive wealth Options not expensed at the time they are awarded  Firm performance not as important as firm size EXTERNAL MARKET FOR CORPORATE CONTROL Individuals and firms buy or take over undervalued firms  Ineffective managers are usually replaced in such takeovers.  Threat of takeover may lead firm to operate more efficiently Changes in regulations have made hostile takeovers difficult Managerial defense tactics increase the costs of mounting a takeover • Defense tactics (Table 10.2) Asset restructuring Changes in the financial structure of the firm Shareholder approval • Market for corporate control lacks the precision of internal governance mechanisms INTERNATIONAL CORPORATE GOVERNANCE Germany: Two-tiered Board Germany  Owner and manager are often the same in private firms  Public firms often have a dominant shareholder, frequently a bank  less emphasis on shareholder value than in U.S. firms  Important governance factors  Obligation  “Family”  Consensus  Keiretsus: strongly interrelated groups of firms tied together by cross-shareholdings.  Banks (especially “main bank”) are highly influential with firm’s managers.  Powerful government intervention  Passive and stable shareholders who exert little control CORPORATE GOVERNANCE IN JAPAN  Virtual absence of external market for corporate control GLOBAL CORPORATE GOVERNANCE  Organizations worldwide are adopting a relatively uniform governance structure.  Boards of directors are becoming smaller, with more independent and outside members.  Investors are becoming more active.  In rapidly developing market economies, minority shareholder rights are not protected by adequate governance controls.  The ultimate goal for corporate governance is to align all interests from multiple stakeholders! Global Trends in Corporate Governance 2017 | Farient Advisors GOVERNANCE MECHANISMS AND ETHICAL BEHAVIOR Capital Market Stakeholders Product Market Stakeholders Organizational Stakeholders • Ethically responsible companies design and use governance mechanisms that serve all stakeholders’ interests. • Importance of maintaining ethical behavior is seen in the examples of Enron, WorldCom, HealthSouth and Tyco.
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