1 Corporate Governance Corporate governance is –a relationship among stakeholders that is used to determine and control the strategic direction and performance

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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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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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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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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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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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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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• 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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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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• 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


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• 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


Documents

1 Corporate Governance Corporate governance is –a relationship among stakeholders that is used to determine and control the strategic direction and performance