Download Top Management The Board of Directors Project Initiation

Modern Competitive Strategy
3rd Edition
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved
Chapter 12
Corporate Governance
12-2
What Is Corporate Governance?

The institutions that design and monitor the rules used to
make decisions in a firm, especially those involving
compliance
12-3
Agency Theory

Focuses on the relationship between the principal and the
agent

In the case of corporate governance:
The principal is the shareholder
 The agent is the firm’s management


The principal tries to ensure that the agent acts in the
principal’s interest through


Incentives
Monitoring
12-4
Berle and Means (1932)


Argued that control of the modern corporation passed
from owners to managers because owners had become
too dispersed for effective control
Managers were positioned to take more for themselves
than they were due (i.e., pay themselves more)
12-5
Berle and Means (cont’d)

But:




Widespread ownership also meant that owners could reduce
their risk by investing in more companies
Owners could also sell their shares in poorly performing firms
without the problems caused by poor liquidity
Managers might know more than owners about decisions that
were best for the firm
So: Giving managers greater discretion might actually
improve a firm’s performance
12-6
The Separation of Ownership and Control
Top Management
The Board of Directors
Project Initiation:
Generates proposals for
allocating resources and
structuring contracts
Project Ratification:
Chooses among the
proposals to be
implemented
Project Implementation:
Executes the proposals
chosen by the board
Project Monitoring:
Measures and rewards
project and firm
performance
Figure 12.1
12-7
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
12-8
The Board of Directors (cont’d)

Board composition



Committees (composed of independent directors)


Audit, compensation, and nominating
Other committees that deal with various governance issues


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
Finance, Executive, Risk, Strategy, Technology, others
Lead director

The chief independent director
 Chairs executive sessions of independent directors at board meetings
12-9
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
12-10
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
12-11
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
12-12
What Happened at Enron?

Overly aggressive growth goals:



The firm diversified into risky ventures with low earnings
growth
Profits in many cases depended on uncertain volumes realized
far into the future
Questionable use of standard accounting practices:


Removal of high risk projects from the balance sheet using
special purpose entities (SPEs)
Booking future revenues as current using mark-to-market
accounting
12-13
What Happened at Enron? (cont’d)

As Enron’s share price began to track the NASDAQ
rather than the NYSE in the late 1990’s (due the startup
of Enron online), red flags appeared


Valuation of many SPEs was in part dependent on Enron’s
stock price
Mark-to-market accounting created confusion about the
relationship between profits and cash flow
12-14
Percentage of Change in the Enron Share Price Compared to the NASDAQ
and Dow Jones Indices from 1990 until the Enron Bankruptcy in late 2001
Figure 12.2
12-15
What Happened at Enron? (cont’d)

Cascading problems






Managerial conflict of interest in the SPEs
High risk taking in the new ventures
Outsized transactions or financial results due to accounting
sleight-of-hand
Unexpected business failures
Management incompetence, especially regarding cost control
Enron’s share price fell sharply starting in September,
2000 and the firm went bankrupt in June, 2001
12-16
The Response to the Enron Fiasco
(and problems in other firms)


Public outcry
Sarbanes-Oxley Act in January, 2002





Established the Public Company Accounting Oversight Board
Required the CEO and CFO to attest to the effectiveness of the
firm’s financial controls
Made CEOs and CFOs accountable for financial reports by
requiring that they sign off on them
Required the firm’s auditors to attest to the firm’s internal audit
Imposed strict rules for a firm’s audit committee (e.g., all
independent directors, the presence of a financial expert)
12-17
The Response to the Enron Fiasco
(cont’d)


Redesign of rules by the major stock exchanges of U.S.
for corporate governance of listed companies
Notable among these were the new prescriptions of the
New York Stock Exchange (NYSE) and NASDAQ
12-18
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
12-19
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
12-20
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
12-21
Anti-takeover Defense (cont’d)

Voting rules


Supermajority voting
Other


Fair price
Poison pill
12-22
Board of Directors Effectiveness

Empirical studies show that:

More independent directors do not necessarily lead to higher
firm performance

Shareholders benefit when independent directors have power
(e.g., on the finance committee)

A board with more outsiders is more likely to avoid policies
that are not in the shareholders’ interests

Independent directors act as conduits of innovation to the firm
12-23
Effects of Board Independence and Size on
Firm Independence
Table 12.1a
12-24
Effects of Board Independence and Size on
Firm Independence (cont’d)
Table 12.1b
12-25
CEO Compensation

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
12-26
Trends in Executive Compensation
1999-2001 (Health Insurance Industry)
Table 12.2
12-27
What Predicts CEO Compensation in the
Health Insurance Industry?
Table 12.3
12-28
How Many Health Insurance Firms Were
Consistently Above or Below the Norm?
Table 12.4
12-29
Governance in Different Countries

Governance rules, practices and legal aspects vary across
countries

Countries differ in the strength of:
Boards
 Owners
 Networks of directors, owners and sources of capital
 Government intervention


The key is the combined effects of these institutional
components on management behavior
12-30
Institutional Environments of Large Firms By
Country
Table 12.5
12-31