Chapter 11Corporate Governance

Chapter 11Corporate Governance CHAPTER SUMMARY This chapter describes the relationship between owners and managers, which provides the foundation on which the corporation is built. The majority of this chapter is used to explain various mechanisms owners use to govern managers and to ensure that they comply with their responsibility to maximize shareholder value.

Three internal governance mechanisms used by modern corporations are examined, along with the market for corporate control (an external mechanism).

The chapters focus then shifts to the issue of international corporate governance, briefly describing governance approaches used in German and Japanese firms, where traditional governance structures are being affected by global competition.

Closing the analysis of corporate governance is a consideration of the need for these control mechanisms to encourage and support ethical behavior in organizations. CHAPTER OUTLINE Separation of Ownership and Managerial Control Agency Relationships Product Diversification as an Example of an Agency Problem Agency Costs and Governance Mechanisms Ownership Concentration Institutional Owners Shareholder Activism Board of Directors Board Independence Board Effectiveness Executive Compensation A Complicated Governance Mechanism The Effectiveness of Executive Compensation Market for Corporate Control Managerial Defense Tactics International Corporate Governance Corporate Governance in Germany Corporate Governance in Japan Global Corporate Governance Governance Mechanisms, Stakeholder Management, and Ethical Behavior Summary KNOWLEDGE OBJECTIVES

1. Define corporate governance and explain why it is used to monitor and control managers strategic decisions.

2. Explain how ownership came to be separated from managerial control in the modern corporation.

3. Define an agency relationship and managerial opportunism and describe their strategic implications.

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4. Explain how three internal governance mechanismsownership concentration, the board of directors, and executive compensationare used to monitor and control managerial decisions.

5. Discuss trends among the three types of compensation executives receive and their effects on strategic decisions.

6. Describe how the external corporate governance mechanismthe market for corporate controlacts as a restraint on top-level managers strategic decisions.

7. Discuss the use of corporate governance in international settings, in particular in Germany and Japan.

8. Describe how corporate governance fosters ethical strategic decisions and the importance of such behaviors on the part of top-level executives.

LECTURE NOTES

See slides 1-3. Key Terms Corporate Governance - set of mechanisms used to manage the

relationships (and conflicting interests) among stakeholders and to determine and control the strategic direction and performance of organizations (aligning strategic decisions with company values).

See Table 11.1: Corporate Governance Mechanisms (slide 4).

1. Name the internal and external mechanisms used in a well-functioning corporate governance and control system.

a. Internal i. Ownership concentration

ii. Board of directors iii. Executive compensation

b. External i. Market for corporate control

Separation of Ownership and Managerial Control - This section describes the basis for modern organizations, that emerged as firms began to outgrow their founders and allowed organizations to develop beyond the limitations of their founder-owners.

See slide 5.

2. What are the critical issues for family-controlled firms as they grow?

a. Owner-managers may not have access to all of the skills needed to effectively manage the growing firm and maximize its returns for the family. Thus, they may need outsiders to help improve management of the firm.

b. Owner-managers may need to seek outside capital and thus give up some of the ownership control.

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Agency Relationships - This section discusses unique agency relationships between firms owners and top-level managers as they relate to the implementation of firm strategies. Because the separation of ownership and control can result in divergent interests between the two parties, the potential for managerial opportunism is also examined.

See slide 6. Key Terms Agency Relationship - relationships between business owners

(principals) and decision-making specialists (agents) hired to manage the principals operations and maximize their returns on investments.

Managerial Opportunism - seeking self-interest with guile (i.e., cunning or deceit).

See Figure 11.1: An Agency Relationship (slide 7). See slide 8. See Additional Notes Below.

3. What are some examples of agency relationships? a. Shareholder-Executive b. Consultant-Client c. Insured-Insurer d. Manager-Employee

4. What types of problems can surface when ownership and control are separated?

a. Principal and the agent having different interests and goals.

b. Shareholders lacking direct control of large publicly-traded corporations.

c. Agent making decisions that result in the pursuit of goals that conflict with those of the principals.

Additional Discussion Notes for Agency Relationships - These notes include additional materials that cover diversification and innovation without agency problems. Owners and Managers How to increase product diversification and how to intensify effort to innovate without increased agency problems? Firms undertake a variety of actions to reduce risk through diversification, including entering diverse lines of business, joining alliances, taking on temporary partners, and outsourcing risky projects, including R&D. The challenge, as explained in the book, is that shareholders do not directly benefit from risk-reducing diversification strategies when they can replicate this diversification on their own. Diversification, therefore, is often seen as managers opportunistic pursuit of their own self-interests at the expense of the shareholders who can, if they so desire, diversify their individual portfolios simply by buying shares in other companies. While this view reflects the influence of agency theory, recently such views have been challenged by stewardship theory (Donaldson, 1990a;

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Donaldson & Davis, 1991), a framework presuming that managers are actually seeking to maximize organizational performance. For instance, one reason for diversifying would be to enhance company profit and growth prospects by reducing dependence on static or declining products, markets, and even industries. In the parlance of the I/O model discussed in Chapter 1, such a motive might lead companies to increase diversification into technologies or industries where profit rates are increasing most and to those where the competitive dynamism is relatively more stable. Managers might also opt to diversify for earnings stability and economies of scale. In short, diversification strategies might represent opportunism, but they might also reflect management rational and genuine response to financial adversity and/or the need for improved financial performance for their company.

Product Diversification as an Example of an Agency Problem - This section discusses and illustrates the different levels of preference for diversification that exist between owners and managers and the potential for conflict that results.

See slide 9. Key Terms Free Cash Flows - resources remaining after the firm has

invested in all projects that have positive net present values within its current businesses.

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See slides 10-11. See slide 12. See Figure 11.2: Manager and Shareholder Risk and Diversification (slide 13).

5. Why might top executives prefer more product diversification than shareholders?

a. Increased product diversification provides an opportunity for top executives to increase their compensation.

i. Diversification usually increases the size of a firm, and size is positively related to executive compensation.

ii. Diversification increases the complexity of managing a firm and its network of businesses and may therefore require more pay because of this complexity.

b. Product diversification and the resulting diversification of the firms portfolio of businesses can reduce top executives employment risk.

i. Managerial employment risk includes the risk of managers losing their jobs, compensation, or reputations.

ii. These risks are reduced with increased diversification because a firm and its upper-level managers are less vulnerable to the reduction in demand associated with a single or limited number of product lines or businesses.

6. How do managerial decisions to use free cash flows demonstrate a conflict in diversification interest?

a. The managerial inclination to overdiversify can be acted upon when free cash flows are available.

b. Shareholders may prefer that free cash flows be distributed to them as dividends, so they can control how the cash is invested.

7. Figure 11.2 illustrates the different optimal levels of diversification held by shareholders and managers. What factors affect the preferences of each of these parties?

a. Owners seek the level of diversification that reduces risk of failure while increasing value through economies. Factors that affect their preference include:

i. Firms primary