Corporate governance: Why it matters for strategy and ethics

Harry J. Van Buren IIIAnderson School of Management

University of New Mexico

Corporate governance: What is it and why does it matter?

• Corporate governance represents the relationship among stakeholders that is used to determine and control the strategic direction and performance of organizations.

• Corporate governance has both strategic and ethical implications.

Strategic implications of corporate governance

• Simply put, bad corporate governance leads to bad strategy formulation and implementation.

• If strategy is about matching the firm’s internal resources and capabilities with opportunities from the external environment, then corporate governance should ask the following sorts of questions…

Strategic implications of corporate governance (2)

1. Do we have the right strategy, given what we do well?

2. Is our strategy matched to the external environment (economy, social expectations, etc.)?

3. Are we capable of executing the strategy?

4. Do we have the right top management team?

5. If the answer to one or more of these questions is “no,” what do we need to change?

Strategic implications of corporate governance (3)

Bad strategy makes it harder for firms to fulfill their economic and ethical responsibilities to stakeholders, including shareholders and employees!

Ethical issues in corporate governance

There are several key strategic and ethical issues in corporate governance, including

• how to align the interests of top managers and shareholders,

• the proper level and function of executive compensation,

• who monitors the top management team and how that monitoring occurs, and

• inclusion of shareholders and non-shareholder stakeholders.

Aligning the interests of shareholders and managers

One of the primary issues in corporate governance is how to align the interests of shareholders and managers.

– While most people don’t object to high levels of pay for top managers (such as CEOs and CFOs), they expect pay to be connected to performance and stock price.

Why do we need to align the interests of shareholders and managers?

At one time in U.S. history, firms were owned and managed by founders and their descendents. As firms grew larger, they needed more capital than could easily be provided by one person or family, and so the public corporation became more common.

Why do we need to align the interests of shareholders and managers? (2)

Corporations have two important virtues:

• They allow shareholders (investors) to reduce risk by limiting their liability to the value of their investment.

• They allow shareholders to buy and sell their ownership interests easily.

But there is a big problem that creates a potential misalignment of interests between shareholders and managers:

The Separation of Ownership and Control!

Why do we need to align the interests of shareholders and managers? (3)

• Managers have day-to-day control of the company. The top management team, for example, is in charge of things such as strategy, hiring and firing employees, and so on.

• Shareholders don’t “own” the corporation in the same way that you own your car: they don’t have physical possession of a part of the corporation. Rather, what they own is a limited set of decision rights, the right to share financially in the company’s success, and a pro-rata share of the company after all of its debts are paid if the company is liquidated.

Why do we need to align the interests of shareholders and managers? (4)

The separation of ownership and control leads to a principal-agent relationship.

• The principal directs the activities of the agent.

• The agent acts on behalf of the principal, based on the principal’s direction. The agent owes a duty of loyalty to the principal.

For public corporations, shareholders are principals and managers are agents; an agency problem exists when agents have incentives to act in ways that are contrary to the interests of their principals.

Why do we need to align the interests of shareholders and managers? (5)

What makes agency problems particularly likely in public corporations is the large number of ever-changing principals (shareholders holding their stock for varying periods of time), all of whom would be better off if some shareholders would monitor the firm’s managers.

Less monitoring of managers by shareholders than is optimal occurs because monitoring is costly, but all shareholders benefit from the actions of the few that engage in monitoring (the free-rider problem). Think of it this way: Would you always behave perfectly if no one was watching you?

How do top managers misbehave?

Because of agency problems, managers have incentives to do things that benefit themselves at the expense of shareholders and other stakeholders (too high compensation, over-diversification, mergers, etc.).

Alignment Mechanism 1Executive compensation

• The average compensation of a Fortune 500 CEO in 2007 was 364 times that of the average worker. An Economic Policy Institute study found that between 1989 and 2007, CEO pay increased by 163 percent, compared with only 10 percent for the average worker (both adjusted for inflation).

• A number of studies have found that there is no correlation between executive compensation and firm performance, and recent work by Erickson, Hanlon, and Maydew (2003) found that executive compensation plans weighted more heavily toward stock compensation were related to the incidence of accounting fraud.

Alignment mechanism 1Executive compensation (2)

• There is evidence that (1) top managers have too much influence on setting their own pay and (2) boards have not done a good job of connecting executive compensation to performance (however performance is defined).

• Recent scandals involving insider trading have added to cynicism about business, and pay that is too high relative to performance may make the company a target of criticism.

Alignment mechanism 1Executive compensation (3)

• Good executive compensation plans take into account a

variety of strategic and financial indicators and then

reward for superior performance relative to industry

peers, rather than absolute levels of stock performance.

• In the absence of good information about a corporation’s

performance and strategies, shareholders and other

stakeholders are unable to adequately evaluate top-

manager performance—and over-compensation of top

managers is a likely result.

Alignment mechanism 2 Boards of directors

• Remember that shareholders are not in charge of the day-to-day operations of a corporation. Rather, they elect directors who then hire managers charged with formulating and implementing the company’s strategy.

• However, shareholders have little control over who is nominated to the board of directors. Only under very limited circumstances can they even nominate a minority of the company’s directors.

Alignment mechanism 2Boards of directors (2)

• As a result, members of a company’s board of directors may feel more beholden to the CEO and the top management team than to the shareholders in whose interests they are supposed to be acting.

• Boards should be focused on evaluating the organization’s (strategic and financial) performance and firing top managers when that performance is substandard and unlikely to improve.

Alignment mechanism 2Boards of directors (3)

• Boards should also have a respectful relationship with the top management team, think of themselves as independent from the CEO, and evaluate their own performance on a regular basis. Such boards do a better job of protecting shareholder value.

Alignment mechanism 3The market for corporate control

• When a company is perceived to be financially undervalued, there is the possibility that it can be taken over (often through a hostile takeover). When this happens, there is often a new management team and strategy put into place.

• Some observers propose that the threat of being taken over if the corporation is underperforming—what is called the market for corporate control—provides an additional means of aligning the interests of shareholders and managers.

The role of institutional failures in corporate governance

• Many of the well-known corporate-governance failures are due to widespread institutional failures, including failures by regulators, accounting firms, and financial analysts. Take one of these failures out of the equation, and perhaps some of the problems observed in the last ten years might not have occurred.

• In particular, the incentive structures of accounting firms and financial analysts caused many of them not to provide appropriate oversight and criticism of corporate managers. In the absence of effective monitoring of managers, bad things tend to happen to companies.

Including non-shareholder stakeholders in corporate governance

• Ethicists argue that although non-shareholder stakeholders do not get to vote like shareholders do (and as was noted before, that vote is limited in its scope), their interests should be taken into account in corporate governance processes.

• Companies, managers, and boards that take a long-term view of the organization’s strategy might want to consider the interests of non-shareholder stakeholders very directly, as they can affect (positively or negatively) the organization’s ability to create value for shareholders.

Ethical duties managers and boards owe shareholders

• Accurate and timely information about the corporation’s performance and business prospects, so shareholders can make informed decisions about their investments.

• Best efforts to enhance shareholder wealth

• Avoidance of self-serving behavior.

A final comment. . .

It’s pretty apparent that many boards have failed to do their jobs. That said, shareholders and non-shareholder stakeholders have a role to play in corporate governance—and part of the blame for recent corporate governance debacles rests with them. Shareholders should demand more of managers and boards.

What’s likely to happen with corporate governance in the future?

1) Greater expectations for transparency in financial and social reporting.

2) Increased expectations for board involvement in strategy setting and developing responses to social issues.

The role of government, accounting firms, and other parties

• Bills like the Sarbanes-Oxley Act of 2003 represent attempts to deal with inherent agency problems and conflicts of interest (on the latter, issues like auditor independence). Boards and senior managers are much more accountable for the accuracy of their financial reporting than before.

What’s likely to happen with corporate governance in the future? (2)

3) Greater involvement by institutional shareholders (pension funds, mutual funds) in corporate governance processes.

4) Greater oversight of corporate boards and managers by regulators, shareholders, and non-shareholder stakeholders.