Corporate governance: Corporate governance


Slide2: Define corporate governance Why it is used to monitor and control managers’ strategic decisions 3 How ownership came to be separated from managerial control in the modern corporation Principal Agency relationship Managerial opportunism, and describe their strategic and organizational implications In this topic you will learn ……


Slide3: Four internal governance mechanisms – ownership concentration, the board of directors, executive compensation and the multi-divisional (M-form) structure Trends among the of compensation executives receive (three types )and their effects on strategic decisions 6 Describe how the external corporate governance mechanism – the market for corporate control – acts as a restraint on top-level managers’ strategic decisions In this topic you will learn ……


Slide4: 7 Corporate governance in Australia, Germany and Japan 8 Describe how corporate governance mechanisms can foster ethical strategic decisions and behaviour on the part of top-level executives Objectives (cont’d)


Slide5: The strategic management process Figure 1.1


CEO remuneration: CEO remuneration Kings were weighed in gold… Tradition Given the price of Gold CEOs should be paid $1.5 Million US average compensation – Just under $20 million 1999 CEO Disney $1.2 Billion for 5 year CEO America Online – $440 million GE $328million


CEO remuneration: CEO remuneration Tiger woods per appearance - $3.8 million Ian Thorpe Natural foods – 7%of the company Severance packages attractive Frank Newman $148 million (banker’s trust)


CEO remuneration: CEO remuneration Steve jobs of apple, pay $1 a month – stock option $180 million Also options to buy 10 million Apple shares


Compensation: Compensation Is used to motivate the CEOs to act in best interest of the firm Pay is linked to performance of firm CEOs receive excessive compensation when corporate governance is the weakest


Slide10: Definition Corporate governance represents the relationship among stakeholders that is used to determine and control the strategic direction and performance of organisations Corporate governance involves oversight in areas where owners, managers and members of boards of directors may have conflicts of interest Corporate governance


Objective : Objective To ensure order between parties whose interests may clash Some CG failed in recent years


Slide12: Internal governance mechanisms Ownership concentration Board of directors Executive compensation Multi-divisional structure External governance mechanism Market for corporate control Corporate governance mechanisms


Slide13: Ownership concentration High relative amounts of shares owned by individual shareholders and institutional investors Board of directors Individuals responsible for representing the firm’s owners by monitoring top-level managers’ strategic decisions Internal governance mechanisms


Slide14: Executive compensation The use of salary, bonuses, and long-term incentives to align managers’ interests with shareholders’ interests Multi-divisional structure The creation of individual business divisions to closely monitor top-level managers’ strategic decisions Internal governance mechanisms (cont’d)


Slide15: Market for corporate control The purchase of a firm that is underperforming relative to industry rivals in order to improve its strategic competitiveness External governance mechanism


Slide16: Historically, firms were managed by the founder-owners and their descendents. The managerial revolution led to a separation of ownership and control, which is the basis of the modern public corporation In the modern corporation: Shareholders and managers become specialized Shareholders purchase shares, which entitles them to income – residual returns – from the operations of the firm after expenses have been paid Separation of ownership and managerial control


Separation of ownership and managerial control: Separation of ownership and managerial control Share holders invest in different companies to reduce risk They expect good dividends Diversification helps mangers and secure their jobs and earnings In small companies owners control Share holder value is reflected by the price of shares, hence CEOs also concentrate on this


Agency relationship: Agency relationship


An agency relationship: An agency relationship Figure 10.1


Slide20: Principal and agent have different interests, and the separation of ownership and control provides potential for divergent interests to surface Shareholders lack direct control of large, publicly traded corporations Problems arise when the agent makes decisions that result in the pursuit of goals that conflict with those of the principal Problems of the agency relationship


Slide21: The principal establishes governance and control mechanisms. It remains difficult or expensive for the principal to verify that the agent has behaved appropriately The agent sometimes exercises managerial opportunism, which is the seeking of self-interest with guile Managerial opportunism prevents the maximisation of shareholder wealth Problems of the agency relationship (cont’d)


Slide22: Increased size and diversification of the firm Managers acting opportunisitically may fail to maximise the firm’s performance and shareholder returns simply because: Growth in the size of the firm leads to an increase in compensation for managers Diversification of the firm reduces the employment risk for top managers Examples of the agency problem


Slide23: Use of free cash flows These are resources generated after investment in all projects Managers prefer to invest the funds in additional product diversification Shareholders prefer the funds as dividends so they control how the funds are invested Examples of the agency problem (cont’d)


Slide24: Manager and shareholder risk and diversification Figure 10.2


Agency costs: Agency costs


Slide26: Definition Agency costs are the sum of incentive costs, monitoring costs, enforcement costs and individual financial losses incurred by principals because it is impossible to use governance mechanisms to guarantee total compliance by the agent Agency costs


Slide27: Boards of directors have a fiduciary duty to shareholders to monitor management However, boards of directors are often accused of being lax in performing this function Agency costs and governance mechanisms


Agency costs and governance mechanisms: Agency costs and governance mechanisms Strong governance mechanisms – must reflect the interests of share holders In spite of more governance mechanisms in 1980 compared to 1960, the percentage of unrelated diversification remained the same. Reflects imperfect means of controlling managerial opportunism.


Agency costs and governance mechanisms: Agency costs and governance mechanisms In many countries share holders tries for removal of 5% limit


Slide30: Internal governance mechanisms Large block shareholders have a strong incentive to monitor management closely: Owning at least 5% of the shares means it is worthwhile spending time, effort and expense on monitoring They may also obtain board seats which enhances their ability to monitor effectively Diffuse ownership – weak Governance Financial institutions are legally forbidden from directly holding board seats


Slide31: The increasing influence of 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 Can influence the firm’s choice of strategies Internal governance mechanisms (cont’d)


Slide32: Shareholder activism: Shareholders can convene to discuss the corporation’s direction - Murdoch If a consensus exists, shareholders can vote as a block to elect their candidates to the board. Institutional activism should create a premium on companies with good corporate governance Managerial share ownership may align their interests with shareholders, but it also increases managers’ power Internal governance mechanisms (cont’d)


Activism: Activism Golden Parachute – guaranteed Money in case of loss of job for a specified period Golden Goodbye- payments if contracts are not renewd


Slide34: Board of directors: Group of elected individuals whose primary responsibility is to act in the owners’ interests by formally monitoring and controlling the corporation’s top-level executives Board has the power to: Direct the affairs of the organisation Punish and reward managers Protect the rights and interests of shareholders Internal governance mechanisms (cont’d)


Slide35: Composition of boards: Insiders: the firm’s CEO and other top-level managers Related outsiders: individuals not involved with the firm’s 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 Internal governance mechanisms (cont’d)


Slide36: Criticisms of boards of directors: They are not fulfilling their primary fiduciary duty to protect shareholders Too readily approve managers’ self-serving initiatives Are exploited by insiders with personal ties to board members Are not vigilant enough in monitoring CEO behaviour Lack of agreement about the number and appropriate role of outside directors Internal governance mechanisms (cont’d)


Slide37: Enhancing the effectiveness of boards and directors: More diversity in the backgrounds of board members Stronger internal management and accounting control systems More formal processes to evaluate the board’s performance More collaborative working and open debate Appointing a reasonable number of outsiders Directors have an ownership stake through share holdings Internal governance mechanisms (cont’d)


Slide38: Forms of compensation: Salary, bonuses, and performance-based long-term incentive compensation such as share 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 affect the firm’s performance over time such as unpredictable economic, social or legal changes Internal governance mechanisms (cont’d)


Slide39: Limits on the effectiveness of executive compensation: Unintended consequences of share options Managers who own more than 1% of the firm’s shares are less likely to be removed Some executives benefit from big increases in the overall value of their shares even though the firm’s shares underperformed the market Internal governance mechanisms (cont’d)


Slide40: The corporate office, along with the firm’s board of directors, closely monitor performance of the business units or divisions When used as a single governance mechanism, the M-form structure may actually facilitate over-diversification and inappropriately high compensation for corporate executives Internal governance mechanisms (cont’d)


Slide41: External governance mechanism Individuals and firms buy or take over undervalued corporations Ineffective managers are usually replaced in such takeovers The threat of takeover may lead firm to operate more efficiently Changes in regulations have made hostile takeovers difficult


Slide42: Managerial defence tactics increase the costs of mounting a takeover. These tactics may involve: Asset restructuring through divestments Changes in the financial structure of the firm such as repurchasing shares Mobilising shareholders to not approve takeover Market for corporate control lacks the precision possible with internal governance mechanisms External governance mechanism (cont’d)


Slide43: Legislation Trade Practices Act 1974 (TPA) Promotes competition and fair trading and provision for consumer protection Prices Surveillance Act 1983 (PSA) Serves three functions: 1 Vet proposed price rises in organisation under surveillance 2 Hold inquiries into pricing practices and report findings to a Commonwealth minister 3 Monitor prices, costs and profits of an industry or business and report findings to a minister Corporate governance in Australia


Slide44: The Australian Competition and Consumer Commission (ACCC) Formed in 1995 by merger of the Trade Practices Commission and the Prices Surveillance Authority Deals with competition matters and enforcement of the TPA The Act covers anticompetitive and unfair market practices, mergers or acquisitions of companies, product safety/liability, and third-party access to facilities of national significance Corporate governance in Australia (cont’d)


Slide45: The Australian Securities and Investments Commission (ASIC) Established in 1991 to administer the Corporations Law ASIC is the single national regulator of Australia’s 1.2 million companies Australian Stock Exchange Listing Rules (ASX) The Australian Stock Exchange imposes a series of important regulatory guidelines for all listed companies in Australia Corporate governance in Australia (cont’d)


Slide46: Standards Australia Has published a set of corporate governance standards which complement the ASX Best Practice Recommendations and target small and medium size enterprises and the not-for-profit sector Corporate governance in Australia (cont’d)


Slide47: Shareholder activists Shareholder activism refers to the extent to which individual shareholders (albeit as a group) are willing (or even perhaps able) to influence a corporation’s board of directors The Australian Shareholders Association (ASA) now has policies on: Poor performance, executive remuneration, accounting policies, conflict of interest, disclosure, share ownership limits Corporate governance in Australia (cont’d)


Corporate governance in Australia (cont’d): The financial media In the small Australian marketplace, the media are a powerful element of the governance system. Print news media, such as the Australian Financial Review and Business Review Weekly, along with television’s Business Sunday, freely report Australian corporate activities Corporate governance in Australia (cont’d)


Slide49: Owner and manager are often the same in private firms Public firms often have a dominant shareholder, frequently a bank There is less emphasis on shareholder value than in US firms, although this may be changing Corporate governance in Germany


Slide50: Responsible for the functions of direction and management Responsible for appointing members to the Vorstand Responsible for appointing members to the Aufsichtsrat Two-tiered board Corporate governance in Germany (cont’d)


Slide51: Important governance factors: Obligation Family Consensus Banks (especially the ‘main bank’) are highly influential with the firm’s managers Keiretsu: Strongly interrelated groups of firms tied together by cross-shareholdings Corporate governance in Japan


Slide52: It is important to serve the interests of the firm’s multiple stakeholder groups: Capital market stakeholders Shareholders in this group are viewed as the most important The focus of governance mechanisms is to control managerial decisions to assure shareholder interests Interests of shareholders is served by the board of directors Governance mechanisms and ethical behaviour


Slide53: Product market stakeholders Customers, suppliers and host communities may withdraw their support of the firm if their needs are not met, at least minimally Organisational stakeholders Managers and non-managerial employees similarly may withdraw support, reduce their work effort or even quit Effective governance produces ethical behaviour in the formulation and implementation of strategies Governance mechanisms and ethical behaviour (cont’d)