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Outline Separation of ownership & managerial control Ownership concentration Boards of directors Executive compensation Multi-divisional structure International corporate governance Governance mechanisms and ethical behaviour
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Corporate Governance
The relationship among stakeholders that is used to determine and control the strategic direction and performance of the organisation
Concerned with identifying ways to ensure that strategic decisions are made effectively
Used in corporations to establish order between the firm’s owners and its top-level managers
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Shareholders The right to share in residual income means that
shareholders must accept the risk that no residual profits will remain if the firm’s expenses exceed its income.
Reduce risk efficiently by holding diversified portfolios In small firms, managers and owners are often one in the
same, so there is no separation of ownership and control.
As firms grow larger, individual owners generally do not have access to sufficient capital to fund the growth of the business and seek other investors with which to share residual profits (and risk).
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Separation of Ownership & Managerial Control
Shareholders Purchase stock, becoming Residual Claimants Reduce risk efficiently by holding diversified portfolios
Professional managers contract to provide decision-making
Leads to efficient specialisation of tasks, such as: Risk bearing by shareholders Strategy development and decision-making by
managers
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An agency relationship exists when:An agency relationship exists when:
Shareholders (Principals)
Firm Owners
Agency Relationship
Risk Bearing Specialist(Principal)
Managerial Decision-Making Specialist
(Agent)
Managers (Agents)
DecisionMakers
which creates
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Agency TheoryAgency TheoryAgency TheoryAgency Theory
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Agency Theory
An agency problem occurs when the desires or goals of the principal and agent conflict, and it is difficult or expensive for the principal to verify that the agent has behaved appropriately
Example: Over-diversification that occurs because increased product diversification leads to lower employment risk for managers and greater compensation
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Risk
Risk
Level of Diversification
Manager & Shareholder Risk & DiversificationManager & Shareholder Risk & Diversification
DominantBusiness
UnrelatedBusinesses
RelatedConstrained
RelatedLinked
Shareholder (Business) Risk Profile
Managerial(Employment)
Risk Profile
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Agency Theory
The Solution: Incentive-based performance contracts Monitoring mechanisms such as the board of
directors Enforcement mechanisms such as the
managerial labour market
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Agency Theory Principals may engage in monitoring behaviour
to assess the activities and decisions of managers
However, dispersed shareholding makes it difficult and inefficient to monitor management’s behaviour
Boards of directors have a fiduciary duty to their shareholders to monitor management
However, boards of directors are often accused of being lax in performing this function
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Agency Costs The sum of incentive, monitoring, and
enforcement costs as well as any residual losses incurred by principals because it is not possible for principals to guarantee 100% compliance through monitoring arrangements.
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Corporate Governance Mechanisms
Prevent problems emanating from the separation of ownership and control by positively influencing managerial behaviour
Direct top level managers actions towards preferred shareholder aims is dependent on correct mechanisms
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Governance Mechanisms
Internal Ownership Concentration Boards of Directors Executive Compensation Multidivisional Organisational Structure
External Market for Corporate Control
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Internal Governance Mechanisms
Ownership concentration Relative amounts of stock owned by individual
shareholders & institutional investors Defined by the number of large block
shareholders and the total % they own Large block typically have at least 5% Large block shareholders have a strong
incentive to monitor management closely
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Internal Governance Mechanisms
Ownership concentration Their large stakes make it worthwhile for them to
spend time, effort and expense to monitor closely
They can obtain board seats. This enhances their ability to monitor effectively (although financial institutions are legally forbidden to hold board seats directly)
Diffuse Ownership Produces weak monitoring of managerial
decisions
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Internal Governance Mechanisms
Diffuse Ownership (cont.) Makes it difficult for owners to coordinate their
actions effectively May result in levels of diversification that are
beyond the optimum level desired by shareholders (especially when this condition is combined with weak monitoring)
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Internal Governance Mechanisms
Board of Directors Responsible for representing the firms owners
by monitoring strategic decisions of top level managers
Consists of insiders, related outsiders and outsiders
Review and ratify important decisions Set compensation for the CEO and decide when
to replace the CEO Usually lack contact with day-to-day operations
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Internal Governance Mechanisms
Board of Directors Must deal with Managerial Opportunism Seeking of self-interest with guile where
opportunism is represented by an attitude or inclination and a set of behaviors (self-interest seeking with guile).
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Internal Governance Mechanisms
Executive Compensation Salary, bonuses, long-term incentive
compensation To align interests of managers with those of
shareholders Executive decisions are complex and non-
routine It is difficult to establish how managerial
decisions are directly responsible for outcomes
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Internal Governance Mechanisms
Executive compensation Incentive systems do not guarantee that
managers make the ‘right’ decisions, but do increase the likelihood that managers will perform the activities and achieve the results for which they are rewarded
Stock ownership (long-term incentive compensation) makes managers more susceptible to market changes that are partially beyond their control
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Internal Governance Mechanisms
Multi-divisional structure Designed to control managerial opportunism
Corporate office and board monitor business-unit managers’ strategic decisions
Increased managerial interest in maximising wealth
Broadly diversified product lines make it difficult for top-level managers to evaluate the strategic decisions of divisional managers
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Internal Governance Mechanisms
Multi-divisional structure (cont.) It may not effectively govern actions taken by the
corporate office. Firms using the M-form structure are more likely
to continue diversification. The M-form facilitates further diversification. Continued diversification may create conditions
requiring division mangers to emphasize short-term results.
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External Governance Mechanism
Market for corporate control The market for corporate control acts as an
important source of discipline over managerial incompetence and waste
Operates when firms face the risk of takeover where they are operated inefficiently
Changes in regulations have made hostile takeovers difficult
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Board of Directors
Powers Directing the affairs of the organisation Punishing (disciplining) and rewarding
(compensating) managers Protecting the rights and interests of
shareholders (owners) As a result, if the board of directors is
appropriately structured and operates in an effective manner, it can protect owners from managerial opportunism.
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Board of Directors
Problems Insiders continue to dominate boards (by
controlling the flow of information to outside directors)
Outside directors are nominated for board membership by insiders (primarily by the CEO) and thus are indebted to insiders
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Board of Directors
Boards working collaboratively with management Make higher quality strategic decisions Make decisions faster Become more involved in decisions regarding
succession (rather than blindly supporting the incumbent’s choice)
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Board of Directors
Recommendations for More Effective Board
Governance: Increase diversity of board members’
backgrounds (Australian boards obviously lack diversity)
Strengthen internal management and accounting control systems
Establish formal processes for evaluation of the board’s performance
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Corporate Governance in Australia Importance of institutional shareholders A small market for corporate control compared
to the USA Boards are relatively small: 6-12 people,
very few females, many multiple board memberships, 75% non-executive directors
Australian landscape features an active financial press, an active shareholders’ association and an increasingly important role for government in corporate governance
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Corporate Governance in Australia
Major banks dominate large companies The top three shareholders of Amcor, BHP and
Brambles are the same: Westpac Chase Manhattan (a US bank) National Nominees (NAB)
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Corporate Governance in Australia There must be protection for all shareholders
(including those with a minority holding) Management must be held accountable to
shareholders regularly There must be transparency and full disclosure
by each Australian Stock Exchange-listed company
There must be an active, and independent, board that oversees a corporation’s management.
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Laws and Institutions in Australia Legislation:
Corporations Law Trade Practices Act 1974 Prices Surveillance Act 1983
The Australian Competition and Consumer Commission (ACCC);
Australian Securities and Investments Commission (ASIC);
Australian Stock Exchange (ASX) Shareholder activists Financial media
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Corporate Governance in Germany
Public firms often have a dominant shareholder frequently a bank
Medium-to-large firms have a two-tiered board: Vorstand monitors and controls managerial decisions Aufsichtsrat selects the Vorstand Employees, union members and shareholders appoint
members to the Aufsichtsrat
There is usually less emphasis on shareholder value than for Australian. firms, although this may be changing
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Corporate Governance in Japan Obligation, ‘family’ and consensus are important factors Banks (especially ‘main bank’) are highly influential with
firm’s managers Keiretsus are strongly interrelated groups of firms tied
together by cross-shareholdings Powerful government intervention Close relationships between firms and government
sectors Passive and stable shareholders who exert little control Virtual absence of external market for corporate control
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Ethical Corporate Behaviour It is important to serve the interests of multiple
stakeholder groups Important stakeholder groups
Shareholders are served by the board of directors Product market stakeholders (customers, suppliers
and host communities) and organisational stakeholders (managerial and non-
managerial employees) There is a controversial belief that ethically responsible
firms should introduce governance mechanisms that serve all stakeholders’ interests
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