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1
On the Efficiency of Internal and On the Efficiency of Internal and External Corporate External Corporate
Control MechanismsControl Mechanisms
Walsh, James P. and Seward, James K. (1990), Walsh, James P. and Seward, James K. (1990), Academy of Management ReviewAcademy of Management Review, 15 (3): 421-458, 15 (3): 421-458
Prepared by: Prepared by: Enrique, Lihong, John, Enrique, Lihong, John, JongkukJongkuk
2
Introduction
In modern firms, owners usually diversify their holdings:
Owners usually do not monitor managers themselvesBoards of Directors are hired to monitor the managers for the owners
As the amount of influence of individual shareholders decrease, the influence of top management increases
3
Owner’s Interests
To earn the maximum economic profit with a compatible degree of risk
To distribute the profits generously and equitably among the owners
To maintain market conditions favorable to the owner
(Berle & Means, 1932)
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Manager’s Interests
Unfortunately the management may be motivated by:
PrestigePowerGratification of professional zeal
This is the “agency problem”
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Internal Control Options
These are measures designed to bring the economic interests of managers and shareholders into alignment
Managerial vs. Environmental Assessments must be made:
Bad decisionsUnfavorable business environment
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Assessment
How does the board assess the situation?
From inside directorsBy comparing with other similar firms
Managers can become the scapegoats for poor performance
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Misplaced Misguided
Incompetent Shirking
High
Low
Low High
Effort
Ability
Figure 1: Inferences about top Management Performance
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Internal Control Options
Alter the incentives of top management
Are the incentives structured correctly?Increasing the magnitude of compensationTying compensation to firm results• Accounting rates of return• Use market measures like stock price
Dismiss top management
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Internal Entrenchment Practices
Alter personal assessments of the board
Withholding informationUsing outside consulting reports Set norms where they cannot be questioned
Alter Situation Assessments
Pointing out the environmental difficulties
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Internal Entrenchment PracticesAlter Performance Assessments
Set low expectationsRedefine performance metrics
Avoid Internal Control Mechanisms
Avoid pay-for-performance plansAim for high management salariesUse accounting measures for bonusesBecome non-substitutable (Lee Iacocca)
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Addressing Internal Control Inefficiencies
Include outside directors on the board
Increase the ownership of managers
May increase manager entrenchmentMay also align managers and owners
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External Control Options
The Market for Corporate Control
Assumptions:
• Underperformance will be represented in company stock
• Other management teams will compete for the company’s resources
• The firm will be acquired
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Reasons to Acquire a Firm
Reasons to Acquire
SynergiesTax SavingsWealth transfersHubrisElimination of inefficient management
Target firms usually increase in value
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Dual Class Re-capitalization
Acquisitions and divestitures
Greenmail
Poison Pills
New Securities
Spin offs, Sell offs etc.
Supermajority amendments
Fair Price amendments
State of incorporation
Voting Rights amendments
Litigation by target
Standstill Agreements
Anti-takeover amendments
Golden Parachutes
Shareholder Approval Required
No Shareholder Approval Required
Operating Non-Operating
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Effective GovernanceInternal: Incentives are designed appropriately and management responds appropriatelyExternal: None needed
Board ObstructionInternal: Incentives are designed inappropriately and management is scapegoated
External: Going private
Managerial DeadwoodInternal: Incentives are designed appropriately and management responds inappropriatelyExternal: Tender Offers
Governance FailureInternal: Incentives are designed inappropriately and management exhibits low ability and effortExternal: hostile takeovers
Good
Bad
Board of Directors
Good BadManagement
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International Perspectives
Different countries use different mechanisms
I.E., Japan generally does not use turnover as a control mechanism
Monitoring often comes from banks and capital sources
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Conclusions
Both internal and external controls are used by firms to control managers
Management can use various methods to entrench themselves against these controls
Work by financial economists and organizational theorists can be synthesized