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Corporate GovernanceCorporate 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
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Corporate Governance Corporate Governance MechanismsMechanisms
Ownership concentrationOwnership concentration– relative amounts of stock owned relative amounts of stock owned
by individual shareholders and by individual shareholders and institutional investorsinstitutional investors
Board of DirectorsBoard of Directors– individuals responsible for individuals responsible for
representing the firm’s owners by representing the firm’s owners by monitoring top-level managers’ monitoring top-level managers’ strategic decisionsstrategic decisions
Internal Governance MechanismsInternal Governance Mechanisms
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Corporate Governance Corporate Governance MechanismsMechanisms
Executive CompensationExecutive Compensation– use of salary, bonuses, and long-use of salary, bonuses, and long-
term incentives to align managers’ term incentives to align managers’ interests with shareholders’ interests with shareholders’ interestsinterests
Monitoring by top-level managersMonitoring by top-level managers– they may obtain Board seats (not they may obtain Board seats (not
in financial institutions)in financial institutions)– they may elect Board they may elect Board
representativesrepresentatives
Internal Governance MechanismsInternal Governance Mechanisms
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Corporate Governance Corporate Governance MechanismsMechanisms
Market for Corporate ControlMarket for Corporate Control– the purchase of a firm that is the purchase of a firm that is
underperforming relative to underperforming relative to industry rivals in order to industry rivals in order to improve its strategic improve its strategic competitivenesscompetitiveness
External Governance MechanismsExternal Governance Mechanisms
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Separation of Ownership and Separation of Ownership and Managerial ControlManagerial Control Basis of the modern corporationBasis of the modern corporation– shareholders purchase stock, becoming shareholders purchase stock, becoming
residual claimantsresidual claimants– shareholders reduce risk by holding shareholders reduce risk by holding
diversified portfoliosdiversified portfolios– professional managers are contracted to professional managers are contracted to
provide decision-makingprovide decision-making Modern public corporation form leads to Modern public corporation form leads to
efficient specialization of tasksefficient specialization of tasks– risk bearing by shareholdersrisk bearing by shareholders– strategy development and decision-making by strategy development and decision-making by
managersmanagers
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Agency Theory ProblemAgency Theory Problem The agency problem occurs when:The agency problem occurs when:
– the desires or goals of the principal and agent the desires or goals of the principal and agent conflict and it is difficult or expensive for the conflict and it is difficult or expensive for the principal to verify that the agent has behaved principal to verify that the agent has behaved appropriatelyappropriately
Solution:Solution:– principals engage in incentive-based principals engage in incentive-based
performance contractsperformance contracts– monitoring mechanisms such as the board of monitoring mechanisms such as the board of
directorsdirectors– enforcement mechanisms such as the enforcement mechanisms such as the
managerial labor market to mitigate the agency managerial labor market to mitigate the agency problemproblem
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Manager and Shareholder Risk Manager and Shareholder Risk and Diversificationand Diversification
Risk
Risk
DiversificationDiversification
DominantDominantBusinessBusiness
UnrelatedUnrelatedBusinessesBusinesses
RelatedRelatedConstrainedConstrained
RelatedRelatedLinkedLinked
ManagerialManagerial(employment) (employment)
risk profilerisk profile
BB
Shareholder Shareholder (business) (business) risk profilerisk profileSS
AA
MM
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Agency Theory ConflictsAgency Theory Conflicts Principals may engage in monitoring behavior to Principals may engage in monitoring behavior to
assess the activities and decisions of managersassess the activities and decisions of managers
However, dispersed shareholding makes it However, dispersed shareholding makes it difficult and inefficient to monitor management’s difficult and inefficient to monitor management’s behaviorbehavior
Boards of Directors have a fiduciary duty to Boards of Directors have a fiduciary duty to shareholders to monitor managementshareholders to monitor management
However, Boards of Directors are often accused However, Boards of Directors are often accused of being lax in performing this functionof being lax in performing this function
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Governance MechanismsGovernance MechanismsOwnershipOwnership
ConcentrationConcentration
• Large block shareholders have a Large block shareholders have a strong incentive to monitor strong incentive to monitor management closelymanagement closely
• Their large stakes make it worth Their large stakes make it worth their while to spend time, effort and their while to spend time, effort and expense to monitor closelyexpense to monitor closely
• They may also obtain Board seats They may also obtain Board seats which enhances their ability to which enhances their ability to monitor effectively (although monitor effectively (although financial institutions are legally financial institutions are legally forbidden from directly holding forbidden from directly holding board seats)board seats)
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Governance MechanismsGovernance MechanismsOwnershipOwnership
ConcentrationConcentration
Boards ofBoards ofDirectorsDirectors
InsidersInsiders• The firm’s CEO and other top-level The firm’s CEO and other top-level
managersmanagers
Related OutsidersRelated Outsiders• Individuals not involved with day-Individuals not involved with day-
to-day operations, but who have a to-day operations, but who have a relationship with the companyrelationship with the company
OutsidersOutsiders• Individuals who are independent of Individuals who are independent of
the firm’s day-to-day operations the firm’s day-to-day operations and other relationshipsand other relationships
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Governance MechanismsGovernance MechanismsOwnershipOwnership
ConcentrationConcentration
Boards ofBoards ofDirectorsDirectors
Recommendations for more effective Recommendations for more effective Board Governance:Board Governance:
• Increase diversity of board Increase diversity of board members’ backgroundsmembers’ backgrounds
• Strengthen internal management Strengthen internal management and accounting control systemsand accounting control systems
• Establish formal processes for Establish formal processes for evaluation of the board’s evaluation of the board’s performanceperformance
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Governance MechanismsGovernance MechanismsOwnershipOwnership
ConcentrationConcentration
Boards ofBoards ofDirectorsDirectors
ExecutiveExecutiveCompensationCompensation
• Salary, bonuses, long term incentive Salary, bonuses, long term incentive compensationcompensation
• Executive decisions are complex and Executive decisions are complex and non-routinenon-routine
• Many factors intervene making it Many factors intervene making it difficult to establish how managerial difficult to establish how managerial decisions are directly responsible for decisions are directly responsible for outcomesoutcomes
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Governance MechanismsGovernance MechanismsOwnershipOwnership
ConcentrationConcentration
Boards ofBoards ofDirectorsDirectors
ExecutiveExecutiveCompensationCompensation
• Stock ownership (long-term Stock ownership (long-term incentive compensation) makes incentive compensation) makes managers more susceptible to managers more susceptible to market changes which are partially market changes which are partially beyond their controlbeyond their control
• Incentive systems do not guarantee Incentive systems do not guarantee that managers make the “right” that managers make the “right” decisions, but do increase the decisions, but do increase the likelihood that managers will do the likelihood that managers will do the things for which they are rewardedthings for which they are rewarded
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Governance MechanismsGovernance MechanismsOwnershipOwnership
ConcentrationConcentration
Boards ofBoards ofDirectorsDirectors
ExecutiveExecutiveCompensationCompensation
Market forMarket forCorporate ControlCorporate Control
• Firms face the risk of takeover Firms face the risk of takeover when they are operated inefficientlywhen they are operated inefficiently
• Many firms begin to operate more Many firms begin to operate more efficiently as a result of the “threat” efficiently as a result of the “threat” of takeover, even though the actual of takeover, even though the actual incidence of hostile takeovers is incidence of hostile takeovers is relatively smallrelatively small
• Changes in regulations have made Changes in regulations have made hostile takeovers difficulthostile takeovers difficult
• Acts as an important source of Acts as an important source of discipline over managerial discipline over managerial incompetence and wasteincompetence and waste
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International Corporate International Corporate Governance:Governance: Owner and manager are often the same in Owner and manager are often the same in
private firmsprivate firms Public firms often have a dominant Public firms often have a dominant
shareholder, frequently a bankshareholder, frequently a bank Frequently there is less emphasis on Frequently there is less emphasis on
shareholder value than in U.S. firms, shareholder value than in U.S. firms, although this may be changingalthough this may be changing
GermanyGermany
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International Corporate International Corporate Governance:Governance: Medium to large firms have a two-tiered Medium to large firms have a two-tiered
boardboard– vorstand monitors and controls managerial vorstand monitors and controls managerial
decisionsdecisions– aufsichtsrat selects the Vorstandaufsichtsrat selects the Vorstand– employees, union members and shareholders employees, union members and shareholders
appoint members to the Aufsichtsratappoint members to the Aufsichtsrat
GermanyGermany
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International Corporate International Corporate Governance:Governance: Obligation, “family” and consensus are Obligation, “family” and consensus are
important factorsimportant factors Banks (especially “main bank”) are highly Banks (especially “main bank”) are highly
influential with firm’s managersinfluential with firm’s managers Keiretsus are strongly interrelated groups Keiretsus are strongly interrelated groups
of firms tied together by cross-of firms tied together by cross-shareholdingsshareholdings
JapanJapan
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International Corporate International Corporate Governance:Governance: Other characteristics:Other characteristics:– powerful government interventionpowerful government intervention– close relationships between firms and close relationships between firms and
government sectorsgovernment sectors– passive and stable shareholders who exert passive and stable shareholders who exert
little controllittle control– virtual absence of external market for virtual absence of external market for
corporate controlcorporate control
JapanJapan
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Corporate Governance and Corporate Governance and Ethical BehaviorEthical Behavior
• In the U.S., shareholders (in the capital In the U.S., shareholders (in the capital market stakeholder group) are viewed as market stakeholder group) are viewed as the most important stakeholder groupthe most important stakeholder group
• which are served by the board of which are served by the board of directorsdirectors
• Hence, the focus of governance Hence, the focus of governance mechanisms is on the control of mechanisms is on the control of managerial decisions to ensure that managerial decisions to ensure that shareholders’ interests will be servedshareholders’ interests will be served
It is important to serve the interests It is important to serve the interests of the firm’s multiple stakeholder of the firm’s multiple stakeholder groups!groups!
Capital MarketCapital MarketStakeholdersStakeholders
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It is important to serve the interests It is important to serve the interests of the firm’s multiple stakeholder of the firm’s multiple stakeholder groups!groups!
Corporate Governance and Corporate Governance and Ethical BehaviorEthical Behavior
• Product market stakeholders (customers, Product market stakeholders (customers, suppliers and host communities) and suppliers and host communities) and organizational stakeholders (managerial organizational stakeholders (managerial and non-managerial employees) are also and non-managerial employees) are also important stakeholder groupsimportant stakeholder groupsProduct MarketProduct Market
StakeholdersStakeholders
Capital MarketCapital MarketStakeholdersStakeholders
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It is important to serve the interests It is important to serve the interests of the firm’s multiple stakeholder of the firm’s multiple stakeholder groups!groups!
Corporate Governance and Corporate Governance and Ethical BehaviorEthical Behavior
• Although the idea is subject to debate, Although the idea is subject to debate, some believe that ethically responsible some believe that ethically responsible companies design and use governance companies design and use governance mechanisms that serve all stakeholders’ mechanisms that serve all stakeholders’ interestsinterests
• Importance of maintaining ethical Importance of maintaining ethical behavior through governance behavior through governance mechanisms is seen in the example of mechanisms is seen in the example of Enron and Arthur AndersenEnron and Arthur Andersen
Product MarketProduct MarketStakeholdersStakeholders
OrganizationalOrganizationalStakeholdersStakeholders
Capital MarketCapital MarketStakeholdersStakeholders