Chapter 10

Corporate governance

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Knowledge objectives
1 define corporate governance and explain why it is used to monitor and control managers strategic decisions 2 explain why ownership has been largely 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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Knowledge objectives
4 explain how three internal governance mechanisms ownership concentration, the board of directors and executive compensation are used to monitor and control managerial decisions 5 discuss types of compensation executives receive and their effects on strategic decisions 6 describe how the external corporate governance mechanism the market for corporate control acts as a restraint on toplevel managers strategic decisions
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Knowledge objectives
7 discuss the use of corporate governance in international settings, in particular in Australia, Germany and Japan 8 describe how corporate governance fosters ethical strategic decisions and the importance of such behaviours on the part of top-level executives.

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Corporate governance
Definition
corporate governance represents the set of mechanisms used to manage the relationship among stakeholders that determines 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 reflects and enforces the company values.
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Corporate governance mechanisms

Internal governance mechanisms
ownership concentration board of directors executive compensation.

External governance mechanism

market for corporate control.

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Internal governance mechanisms

Ownership concentration
high relative amounts of shares owned by individual shareholders and institutional investors.

Board of directors
individuals responsible for representing the firms owners by monitoring top-level managers strategic decisions.

Executive compensation
the use of salary, bonuses and long-term incentives to align managers interests with shareholders interests.

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External governance mechanism

Market for corporate control
the purchase of a firm that is underperforming relative to industry rivals in order to improve its strategic competitiveness.

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Separation of ownership and managerial control

Historically, firms were managed by the founder-owners and their descendants. In the modern corporation:
control of the firm shifted from owners to professional managers ownership has been dispersed to among many unorganised shareholders shareholders purchase shares, which entitles them to income residual returns from the operations of the firm after expenses have been paid.

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Agency relationships
An agency relationship exists when one or more persons (principal or principals) hire another person or persons (agent or agents) as decision-making specialists to perform a service.
the principals delegate decision-making responsibility to an agent the agency relationship is related to how the firms strategies are implemented.

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An agency relationship

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Problems of agency relationships

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 also arise when the agent makes decisions resulting in the pursuit of goals that conflict with those of the principal. The agent sometimes exercises managerial opportunism.
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Problems of agency relationships (cont.)

The principal establishes governance and control mechanisms. It remains difficult or expensive for the principal to verify that the agent has behaved appropriately. Managerial opportunism prevents the maximisation of shareholder wealth. Top executives make strategic decisions to maximise their personal welfare, increasing the company risks
example: Global Financial Crisis (GFC).
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Manager and shareholder risk and diversification

Shareholders prefer to reduce risk by holding a diversified portfolio of equity investments. Top executives may prefer a level of diversification that maximises firm size and their compensation and reduces their employment risk.

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Manager and shareholder risk and diversification (cont.)

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Agency costs and governance mechanisms

Definition
agency costs are the sum of incentive costs, monitoring costs, enforcement costs and individual financial losses incurred by principals boards of directors have a fiduciary duty to shareholders to monitor management boards of directors are often accused of being lax in performing this function.

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Ownership concentration
Ownership concentration
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 enhance their ability to monitor effectively.
Financial institutions are legally forbidden from directly holding board seats.

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Ownership concentration (cont.)

The growing influence of institutional owners
Institutional owners (financial institutions such as stock mutual funds and pension funds) have increasing influence.

they have the size (proxy voting power) and incentive (demand for returns to funds) to discipline ineffective top-level managers
they can influence the firms choice of strategies.

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Ownership concentration (cont.)

Shareholder activism
Shareholders can convene to discuss the corporations direction. 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.

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Board of directors
Ownership concentration
Board of directors: a group of elected individuals whose primary responsibility is to act in the owners interests by formally monitoring and controlling the corporations top-level executives. The board has the power to: direct the affairs of the organisation punish and reward managers protect the rights and interests of shareholders.

Board of directors (a)

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Board of directors (cont.)

Ownership concentration Board of directors (b)
Composition of boards: insiders: the firms CEO and other toplevel managers

related outsiders: individuals not involved with the firms day-to-day operations, but who have a relationship with the firm
outsiders: individuals who are independent of the firms day-to-day operations and other relationships.

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Board of directors (cont.)

Ownership concentration Board of directors (c)
Criticisms of boards of directors:

they are not fulfilling their primary fiduciary duty to protect shareholders
they too readily approve managers selfserving initiatives they are exploited by insiders with personal ties to board members they are not vigilant enough in monitoring CEO behaviour there is a lack of agreement about the number and appropriate role of outside directors.

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Board of directors (cont.)

Ownership concentration Enhancing the effectiveness of the board of directors
Methods of 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 boards performance more collaborative working and open debate appointing a reasonable number of outsiders ensuring directors have an ownership stake through share holdings.
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Executive compensation
Forms of compensation:

Ownership concentration Board of directors Executive compensation (a)

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 firms performance over time, such as unpredictable economic, social or legal changes.

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Executive compensation (cont.)

Ownership concentration Board of directors Effectiveness of executive compensation
Limits on the effectiveness of executive compensation: unintended consequences of share options

managers who own more than 1% of the firms shares are less likely to be removed
some executives benefit from big increases in the overall value of their shares even though the firms shares underperformed the market.

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Executive compensation (cont.)

Ownership concentration
Board of directors Executive compensation
The corporate office, along with the firms board of directors, closely monitors performance of the business units or divisions. Compensation for corporate executives

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Market for corporate control

Market for corporate control
Individuals and firms buy or take over undervalued corporations.
ineffective managers are usually replaced in such takeovers. The threat of takeover may lead the firm to operate more efficiently. Changes in regulations have made hostile takeovers difficult.

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External governance mechanism

Managerial defense tactics
Managerial defense 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.

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Corporate governance in Australia

Legislation
Trade Practices Act 1974 (TPA) promotes competition and fair trading and provision for consumer protection Prices Surveillance Act 1983 (PSA) serves three functions: to vet proposed price rises in organisation under surveillance to hold inquiries into pricing practices and report findings to a Commonwealth minister to monitor prices, costs and profits of an industry or business and report findings to a minister.
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Corporate governance in Australia (cont.)

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

The Australian Securities and Investments Commission (ASIC)
established in 1991 to administer Corporations Law ASIC is the single national regulator of Australias 1.2 million companies.

The Australian Stock Exchange (ASX) listing rules

the Australian Stock Exchange imposes a series of important regulatory guidelines for all listed companies in Australia.
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Corporate governance in Australia (cont.)

Standards Australia
Standards Australia has published a set of corporate governance standards which complement the ASX Best Practice Recommendations and target small and mediumsized enterprises and the not-for-profit sector.

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 corporations board of directors.

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Corporate governance in Australia (cont.)

The Australian Shareholders Association (ASA) now has policies on:
poor performance executive remuneration accounting policies conflict of interest disclosure share ownership limits.

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Corporate governance in Australia (cont.)

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 televisions Business Sunday, freely report Australian corporate activities.

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Corporate governance in Germany

Owner and manager are often the same individual. Public firms often have a dominant shareholder, frequently a bank. The concentration of ownership is an important means of corporate governance in Germany, as it is in the United States. Power-sharing may have gone too far; it includes representation from the local community as well as unions. Historically, German executives generally have not been dedicated to maximising shareholders value.
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Corporate governance in Japan

Important governance factors:
obligation family consensus.

Banks (especially the main bank) are highly influential with the firms managers. Keiretsu: a system of relationship investments. Japanese stewardship-management is dominated by inside managers and produces greater investment in R&D.
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Governance mechanisms and ethical behaviour

A firms strategic competitiveness is enhanced when its governance mechanisms take into account the interests of all stakeholders. 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 are served by the board of directors.
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Governance mechanisms and ethical behaviour (cont.)

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.
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