Chapter 12

Corporate Governance

What Is Corporate Governance?

What do you think it is?

“the institutions that design and monitor the rules used to make decisions in a firm, especially those involving compliance”

alternative:“relationship among stakeholders that is used to determine and control the strategic direction and performance of organizations”

Agency Theory can explain

Focuses on the relationship between the principal and the agent

the principal is the shareholder

the agent is the firm’s management

Principal tries to ensure that the agent acts in the principal’s interest through incentives and monitoring

concern over separation of ownership and control

control of the modern corporation passed from owners to managers because owners had become too dispersed for effective control (Berle and Means, 1932)

how are these disparate interests aligned?

Incentives

Compensation

Monitoring

Board of directors (internal)

Market for corporate control (external)

The Board of Directors

Shareholders exercise influence over managerial decision-making primarily through their election of the board of directors

The board has primary responsibility for corporate governance

Project details received by the board depend on the firm’s size, complexity, and the scale of the project

Legal responsibilities of the board include duty of care, duty of loyalty, and the business judgment rule

The Board of Directors (cont’d)

Board composition

Inside directors: upper management, family members

Outside (independent) directors: persons not employed by the firm or related to the firm by blood or commercial transactions

Committees (composed of independent directors)

Audit, compensation, and nominating

Other committees that deal with various governance issues

Finance, Executive, Risk, Strategy, Technology, others

Lead director

The chief independent director

Chairs executive sessions of independent directors at board meetings

Duty of Care

Defined as “the care that an ordinarily prudent person would reasonably be expected to exercise in a like position and under similar circumstances”

Carries with it a requirement to develop knowledge related to the firm’s business

May require the support of in-house and external experts and consultants

Implies the duty to inquire into and remain informed about the firm’s ongoing activities

Reduces the potential for management misbehavior

Duty of Loyalty

Defined as a “duty in good faith to act in the best interests of the corporation”

The firm’s interests must dominate conflicts between the interests of a director and the firm

The firm’s interest is congruent with but not identical with shareholders

Other constituencies – called stakeholders, e.g., local communities, labor, and suppliers - may be considered

Business Judgment Rule

Underlies the “duty of care” obligation

Acts as a “safe harbor” or protection when the duty of care is being questioned

Shields directors from liability for taking reasonable actions on behalf of the firm that subsequently turn out badly

Preserves directors’ willingness to take risks in investments in new products or markets

Did Sarbanes-Oxley make a difference?

Rule 404

Requires a stringent and costly internal audit of the firm’s processes

Problems in processes that had a material effect on the firm’s financial data had to be reported

Most problems (in 2005) were in tax accounting, documentation, and personnel expertise

Smaller firms were hurt more by this rule given the high fixed costs of adhering to it

But in general, research has shown that after SOX:

shareholders receive better information about firms

listing shares on U.S. exchanges sends a stronger signal of financial strength

Are Better Governed Firms Higher Performers?

Gompers, Ishii and Metrick (2003) showed that

Investing in better governed firms and selling worse governed firms short resulted in an 8% return

Better governed firms had fewer policies that impeded a takeover

Worse governed firms had more of these policies

Anti-takeover Defenses

Tactics for delaying hostile bidders

Blank check

Staggered board

Special meeting

Written consent

Board and management protection

Compensation plan

Golden parachutes

Liability and indemnification

Voting rules

Supermajority voting

Other

Fair price

Poison pill

CEO Compensation

Are CEOs paid too much?

Possible determinants of CEO compensation: Firm size (revenues), Higher returns to shareholders, CEO influence on the board

Research indicates that each is valid to some degree:

Firm size is primary

Controlling for size, compensation is weakly related to shareholder returns

Controlling for size and performance, ingratiation behavior affects compensation

Table 12.3

What Predicts CEO Compensation in the Health Insurance Industry?

Quotes from “What’s Wrong with Executive Compensation,” (Elson, 2003)

Roiter: Need to restore a greater liquidity in the market for corporate control

Bachelder: Weren’t we saying in the 80’s to tie CEO compensation to the market in order to identify them with shareholders? We got what we asked for

Bachelder: In trying to create independence between the CEO and board, you do not want to create an adversarial relationship

Woolard: Compensation committees are really not independent

Meyer: We need to tie the elements of executive compensation more closely to the organization’s mission and annual business performance and to long-term results

England: Unfortunately options became just another form of currency, rather than an incentive to own shares

Quotes from “What’s Wrong with Executive Compensation,” (Elson, 2003)

Roiter: If we turn to Congress or the courts to solve the problem with executive compensation, the cure may prove worse than the disease

Roiter: I do think the answers lie in process changes

Woolard: We need strong independent directors to hold CEOs’ feet to the fire, but they are hard to find; some of the few are stepping down to avoid the hassle

Roiter: At least some executives are greedy, we have to assume that at least a fair segment of the CEO population will not exercise self-restraint

Bachelder: We must be careful not to diminish the motivation for risk taking and entrepreneurship that drives so many leaders