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Chapter 10: Corporate Governance

Chapter 10 Corporate Governance KNOWLEDGE OBJECTIVES 1. 2. 3. 4. 5. 6. 7. 8.

Define corporate governance and explain why it is used to monitor and control managers’ strategic decisions. Explain why ownership has been largely separated from managerial control in the modern corporation. Define an agency relationship and managerial opportunism and describe their strategic implications. Explain how three internal governance mechanisms—ownership concentration, the board of directors, and executive compensation—are used to monitor and control managerial decisions. Discuss the types of compensation executives receive and their effects on strategic decisions. Describe how the external corporate governance mechanism—the market for corporate control—acts as a restraint on top-level managers’ strategic decisions. Discuss the use of corporate governance in international settings, especially in and Japan. Describe how corporate governance fosters ethical strategic decisions and the importance of such behaviors on the part of top-level executives. CHAPTER OUTLINE

Opening Case How Has Increasingly Intensive Corporate Governance Affected the Lives of CEOs? SEPARATION OF OWNERSHIP AND MANAGERIAL CONTROL Agency Relationships Product Diversification as an Example of an Agency Problem Agency Costs and Governance Mechanisms OWNERSHIP CONCENTRATION The Growing Influence of Institutional Owners BOARD OF DIRECTORS Enhancing the Effectiveness of the Board of Directors EXECUTIVE COMPENSATION Strategic Focus Executive Compensation Is Increasingly Becoming a Target for Media, Activist Shareholders, and Government Regulators The Effectiveness of Executive Compensation MARKET FOR CORPORATE CONTROL Managerial Defense Tactics INTERNATIONAL CORPORATE GOVERNANCE Corporate Governance in Corporate Governance in Japan Strategic Focus Shareholder Activists Invade Japan’s Large Firms Traditionally Focused on “Shareholder” Capitalism Global Corporate Governance GOVERNANCE MECHANISMS AND ETHICAL BEHAVIOR SUMMARY REVIEW QUESTIONS EXPERIENTIAL EXERCISES NOTES

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Chapter 10: Corporate Governance LECTURE NOTES Chapter Introduction: The purpose of this chapter is to present and discuss how shareholders (owners) can ensure that managers develop and implement strategic decisions in the best interests of the shareholders (owners) and not be primarily self-serving (working for the best interests of managers only, to the detriment of shareholders). In the absence of effective internal governance mechanisms, the market for corporate control—an external governance mechanism—may be activated. While it is a subject most frequently associated with firms in the U.S. and the U.K., the effectiveness of governance is gaining attention throughout the world. The chapter begins by describing the relationship that provides the foundation on which the modern corporation is built—i.e., the relationship between owners and managers. However, the majority of this chapter is devoted to an explanation of various mechanisms owners use to govern managers and ensure maximization of shareholder value.

OPENING FOCUS How Has Increasingly Intensive Corporate Governance Affected the Lives of CEOs? Although corporate governance is a necessity, it is also important to make sure it's executed properly to avoid the problems and pitfalls associated with expectations of CEO behavior and performance that have evolved as a result of greater scrutiny. In 2006, a record number of CEOs left their jobs. This exodus is due in part to increasing scrutiny by boards, governance activists, and increased pressure from the market for corporate control as board are pressured to challenge the views of the CEO if they appear to be headed in a direction that will not benefit all stakeholders. The Sarbanes-Oxley legislation (ed in 2002) caused U.S. corporate governance policies to be more intense. This scrutiny translates into a zero tolerance for any form of corruption, conflict of interest, or other forms of wrongdoing or inappropriate behavior. But this scrutiny may have a price. The average tenure for CEOs is now down to 18-24 months because so many new CEO are in place. If this trend continues, Harvard Business Review reports that nearly half of the largest U.S. firms will have a new CEO in the next four years. Because of the high turnover and shorter tenures, CEOs are focusing more and more on short-term turnaround corporate strategies and contractually looking to their inevitable departure. Ironically, the increases in governance controls have led to an increase in CEO pay and severance perks, including golden parachutes that often pay three years of annual salary if a CEO exits before his/her contract expires because the firm is taken over. If the SEC sets a limit on exit pay, CEOs will likely arrange more pay upfront to compensate for the risks they are taking, given the shorter CEO tenures in most firms. Author Jim Collins found that inside CEOs have been able to provide leadership that allows firms to realize longer-term profitability and above average returns, but it takes about seven years in place to affect profitability. But the abbreviating of average CEO tenure will not accommodate this window since they are leaving their jobs before that are reaching their maximum effectiveness. Thus, corporate governance is a double-edged sword. On the one hand, it is necessary to put an end to scandals such as the Enron disaster, which led to a significant loss for all stakeholders involved, including employees. Also, CEO compensation is quite excessive relative to other managers and employees. On the other hand, governance that is overly restrictive can reduce managerial risk taking and increase governance costs excessively, as well as constrain the CEO’s decision-making authority. Ironically, it inadvertently leads to increased pay for CEOs, which many governance activists rail against. Although corporate governance is a necessity, it is also important to make sure that it is executed properly to avoid the problems noted here. Give your students a chance to do their “thing” with this opening case. This case can best be described as a paradox. Is it a case of “be careful what you ask for?” Or maybe it’s an example of “ready, fire, aim!” Allow students to voice their opinions; allow others to rebut. You may end up with a “food fight.”

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1

Define corporate governance and explain why it is used to monitor and control managers’ strategic decisions.

Corporate governance is a relationship among stakeholders that is used to determine and control the direction and performance of organizations. At its core, corporate governance is concerned with identifying ways to ensure that strategic decisions are made effectively. Corporate governance has been emphasized in recent years because, as the Opening Case illustrates, corporate governance mechanisms increasingly affect all stakeholders and the firm's future. Effective corporate governance is also of interest to nations. Governments want firms operating within their countries to grow and provide employment, wealth, and satisfaction. This raises standards of living and enhances social cohesion. Three internal governance mechanisms examined here are (1) ownership concentration, as represented by types of shareholders and their different incentives to monitor managers, (2) the board of directors, and (3) executive compensation. The external governance mechanism is the market for corporate control. Teaching Note: In the chapter, corporate governance is discussed from two perspectives: • The primary purpose of governance mechanisms is to prevent severe problems that may occur because of the separation of ownership and control in large firms by positively influencing managerial behavior. • The ability of governance mechanisms to direct top mangers’ actions toward shareholder objectives is dependent on the correct combination of mechanisms being used.

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Explain why ownership has been largely separated from managerial control in the modern corporation.

SEPARATION OF OWNERSHIP AND MANAGERIAL CONTROL The growth of the large, modern public corporation is based primarily on the efficient separation of ownership and managerial control. Shareholders make investments by purchasing stock (representing ownership), which entitles them to a share of the firm’s residual income (or profits) that remain after all expenses have been paid. • The right to share in residual income also means that shareholders also must accept the risk that no residual profits will remain if the firm’s expenses exceed its income. • Shareholders can manage investment risk by investing in a diversified portfolio of firms. • In small firms, managers and owners are often one in the same—less separation of ownership and control. • As family-controlled firms grow, the owners generally do not have sufficient capital or managerial skills to grow the business and seek other sources of capital and skills to this expansion. Teaching Note: It is helpful to provide a story that would illustrate what the separation of ownership and managerial control is all about, and how it came to be. For example, it is easy for students to see that Henry Ford was involved in both the ownership and the operation of Ford Motor Company in the early days. They can see in their minds the old footage of Model T’s coming off a very crude assembly line, by today’s standards, and understand how much simpler operations were at the time. That has all changed with the advent of the modern, complex corporation. Today there is almost no way to bring ownership and managerial control back together again in a workable model.

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3

Define an agency relationship and managerial opportunism and describe their strategic implications.

Agency Relationships While the efficient separation of ownership and control enables specialization both by owners and managers, it also results in some potential costs (and risks) for owners by creating an agency relationship. An agency relationship exists when one party (the principal[s]) delegates decision making to another party (the agent[s]) in return for compensation as a decision-making specialist who performs a service. This relationship can be broader than just owners and managers—e.g., consultants and clients or insured and insurer. Figure Note: Figure 10.1 illustrates how separation of ownership from control results in an agency relationship and is very helpful in getting students to understand the issues involved. FIGURE 10.1 An Agency Relationship Note the following in the figure (Figure 10.1): • Shareholders (principals) hire managers (agents) as decision makers. • The hiring act creates an agency relationship wherein a risk-bearing specialist (principal) compensates a managerial decision-making specialist (agent).

The potential for conflicts of interests between owners and managers is created by the delegation of the responsibilities of decision making to managers. Therefore, managers may take actions that are not in the best interests of owners by selecting strategic alternatives that serve managerial interests rather than shareholder or owner interests. An agency relationship enables the possibility of managerial opportunism, the seeking of self-interest with guile (i.e., with cunning or deceit), where opportunism is represented by an attitude or inclination and a set of behaviors. Before observing the results of decisions, it is impossible to know which agents will behave opportunistically and which ones will not because a manager’s reputation is an imperfect guide to future behavior. As a result, principals establish governance and control mechanisms because the opportunity for opportunistic behavior and conflicts of interest exists. Product Diversification As an Example of an Agency Problem Product diversification—discussed in Chapter 6—can be beneficial to both shareholders and managers, but it also is a potential source of agency problems. Managers may pursue higher levels of product diversification than are desired by shareholders to capture the value of opportunities that are available to managers, but not to owners. • Increased diversification generally drives the growth of the firm and firm growth is positively related to managerial compensation. Thus, by diversifying to a greater extent than may be desired by shareholders, managers may enjoy the higher levels of compensation that accompany managing larger firms. • Increased diversification also can reduce managerial employment risk (the risk of job loss, loss of compensation, or loss of managerial reputation). Increased diversification reduces managerial employment

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Chapter 10: Corporate Governance risk because the firm (and the manager) is less affected by a reduction in demand for (or failure of) a single product line when the firm produces and sells multiple products. • Increased diversification also may provide managers with access to increased levels of slack resources or free cash flows, resources that are generated after investment in all internal projects that have positive net present values within the firm’s current product lines. Managers may choose to invest excess funds in products or activities that are not related to the firm’s existing core businesses and products if they perceive attractive (positive net present value) investment opportunities. Figure Note: Figure 10.2 illustrates the variance between the risk profiles of shareholders and managers based on the level or type of firm diversification. It shows that owners may benefit from managers’ decisions to diversify the firm’s products, but only to the point where investment returns at the margin are no longer positive. That is, diversification is valuable to (and preferred by) owners as long as it has a positive effect on firm value. However, some firms may be overdiversified, despite the lack of profitability in their dominant business. Owners also may prefer that excess funds be returned to them in the form of dividends so they can control reinvestment decisions. FIGURE 10.2 Manager and Shareholder Risk and Diversification Curve S represents the business or investment risk profile for shareholders (owners). It spans a diversification scope from dominant business (which would be to the left of related-constrained) to a point between relatedconstrained and related-linked diversification. The optimum risk level is at point A, between dominant business and related-constrained diversification. Curve M represents the managerial employment risk profile. It spans a diversification profile from relatedconstrained to unrelated diversification. The optimum diversification level for managers is point B, between related-linked and unrelated businesses.

As illustrated by the S-curve (owner business risk preference) and M-curve (managerial employment risk preference), there is a conflict between owners and managers regarding the desired levels of firm diversification and risk. • Owners prefer that the scope be greater than a dominant business but less than related-linked diversification. • Owners’ optimum level of diversification is where the S curve turns up, a point between dominant business and related-constrained diversification. • Managers prefer a greater scope of diversification than owners. As can be seen from the M curve in Figure 10.2, managers prefer that the firm’s diversification be between related-linked and unrelated diversification. • However, as the curve indicates, there is a point at which managerial employment risk increases as the firm overdiversifies (as discussed in Chapter 6). • The optimum level of firm diversification from a managerial risk perspective is at point B on the M curve, somewhere between related-linked and unrelated businesses. Agency Costs and Governance Mechanisms The potential conflict illustrated by Figure 10.2, coupled with the fact that principals do not know which managers might act opportunistically, demonstrates why principals establish governance mechanisms. For firm diversification to approach the shareholder optimum (point A on curve S in Figure 10.2), managerial autonomy must be controlled by the firm’s board of directors or by other governance mechanisms that encourage managers to make strategic decisions that are in the best interests of shareholders.

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Chapter 10: Corporate Governance Agency costs are 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 percent compliance through monitoring arrangements. Research suggests that more intensive application of governance mechanisms may produce significant changes in strategies. Corporate America needs more intense governance in order for continued investment in the stock market to facilitate growth. However, others argue that the indirect costs are even more telling in regard to the impact on strategy formulation and implementation. That is, because of more intense governance, firms may make decisions that are much less risky and thus decrease potential shareholder wealth significantly due to the implementation of SOX.

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Explain how three internal governance mechanisms—ownership concentration, the board of directors, and executive compensation— are used to monitor and control managerial decisions.

OWNERSHIP CONCENTRATION Ownership concentration is defined both by the number of large-block owners and by the total percentage of the firm’s shares that they own. Large-block shareholders are investors who typically own at least five percent (5 percent) of the firm’s shares. Diffuse ownership (a large number of shareholders with small holdings and few/no large-block shareholders) • produces weak monitoring of managerial decisions • 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) The Growing Influence of Institutional Owners In recent years, large block ownership by individuals has declined, but they have been replaced by significant positions held by institutional owners. Institutional owners are large block shareholder positions controlled by financial institutions, such as stock mutual funds and pension funds. The importance of institutional owners is indicated by the fact that these shareholders now controls over 50 percent of the stock in large U.S. corporations and approximately 56 percent of the stock of the 1,000 largest U.S. corporations. These ownership percentages suggest that as investors, institutional owners have both the size and the incentive to discipline ineffective top-level managers and can significantly influence a firm’s choice of strategies and overall strategic decisions. Initially, these shareholder activists and institutional investors concentrated on the performance and ability of CEOs and contributed to the ouster of a number of them. They are now targeting what they believe are ineffective boards of directors. The rising tide of shareholder pressure also is evidenced by actions taken by CalPERS. • CalPERS provides retirement and health coverage to over 1.3 million current and retired public employees. • CalPERS is generally thought to act aggressively to promote decisions and actions that it believes will enhance shareholder value in companies in which it invests. • Institutions’ activism may not have a direct effect on firm performance, but its influence may be indirect through its effects on important strategic decisions.

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Chapter 10: Corporate Governance Teaching Note: The students should know about a few of the more common anti-takeover provisions. For example, a golden parachute is a type of managerial protection that pays a guaranteed salary for a specified period of time in the event of a takeover and the loss of one’s job. A golden goodbye provides automatic payments to top executives if their contracts are not renewed, regardless of the reason for nonrenewal. In the case of acquisitions, managers may receive this compensation even if they voluntarily decide to quit. Still other defense strategies are described in greater detail in Table 10.2. BOARD OF DIRECTORS Even though institutional ownership has increased, the majority of firms still “enjoy” the benefits or advantages of diffuse ownership (i.e., limited monitoring of managers by individual shareholders). Furthermore, large financial institution shareholders—such as banks—are effectively prevented from having direct ownership of firms and are prohibited from placing a representative on the boards of directors. These conditions highlight the importance of boards of directors to corporate governance. Teaching Note: Legally, the board of directors has broad powers, including: • directing the affairs of the organization • punishing (disciplining) and rewarding (compensating) managers • protecting the rights and interests of shareholders (owners) Boards are experiencing increasing pressure from shareholders, lawmakers, and regulators to become more forceful in their oversight role and thereby forestall inappropriate actions by top executives. The board of directors is a group of elected individuals whose primary responsibility is to act in the owners’ interests by formally monitoring and controlling the corporation’s top-level executives. If the board of directors is appropriately structured and operates effectively, it can protect owners from managerial opportunism. Table Note: Table 10.1 provides characteristics of three classifications of of the board of directors: insiders, related outsiders, and outsiders. These will be useful for students as you discuss board effectiveness. TABLE 10.1 Classifications of Board of Director Insiders are represented by the firm’s CEO and other top-level managers. Related outsiders are individuals who are not involved in the firm’s day-to-day operations, but may have a relationship with the company. Examples might include the firm’s legal counsel, a large customer or supplier, or a close relative of one of the firm’s top-level managers. Outsiders are individuals who are independent of the firm. They are neither involved in the firm’s day-to-day operations, nor do they have other relationships with the firm. An example of an outsider might be the president of a university or a community volunteer.

Because the primary role of the board of directors is to monitor and ratify major managerial actions to protect the interests of owners, there is a call by advocates of board reform that outsiders should represent a significant majority of a board’s hip.

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Chapter 10: Corporate Governance Teaching Note: Outside directors (and boards) are perceived as ineffective because: • insiders dominate the board by limiting the flow of information to outside directors. • outside directors are nominated for board hip by insiders (primarily by the CEO) and thus are indebted to insiders. The drawbacks of outside boards: • Because outside directors do not have day-to-day with the ongoing operations of the firm, they must obtain detailed, in-depth information about the quality of management decisions. Generally this information is obtained through frequent interactions, often developed over time, with inside directors (generally, at board meetings). • In the absence of rich information, boards may be forced to emphasize financial rather than strategic controls. Potentially, this means that outsider-dominated boards—because they lack sufficient information— will evaluate managers, not on the basis of the appropriateness of their actions (which the board ratified) but based on the financial outcomes of those actions. Enhancing the Effectiveness of the Board of Directors Because of the board’s importance, the performance of individual board as well as that of entire boards is being evaluated more formally and intensely. Many boards have voluntarily initiated changes, including: • increasing the diversity of board ’ backgrounds • strengthening internal management and ing control systems • establishing and consistently using formal processes to evaluate the board’s performance • the creation of a “lead director” role that has strong powers with regard to the board agenda and oversight of nonmanagement board member activities • changes in the director compensation, especially reducing or eliminating stock options as part of the package Teaching Note: The following comments can be used to expand the class discussion of whether a more active board is a more effective board. The findings from research regarding the effectiveness of board involvement in the strategic decision-making process are mixed, indicating the following: • Board involvement in the strategic decision-making process may improve firm performance because it provides the firm’s managers with access to outside opinions, and outside directors should be more objective and interested in protecting owner interests. • Boards are more likely to be involved in strategic decisions when the firm is smaller and less diversified, since information regarding strategic actions is more readily available and both the scope and size of the firm are manageable. • Boards are less active in large, diversified firms. • The board’s access to sufficiently rich information on appropriateness of strategic actions in large diversified firms is limited. • Board may be limited to evaluating financial outcomes (instead of action appropriateness). Teaching Note: McKinsey & Co. research found that institutional shareholders were willing to pay an 11 percent for the shares of companies when outsiders constitute a majority of the board, own significant amounts of stock, are not personally tied to top management, and when management is subjected to formal evaluation. Research shows that boards working collaboratively with management:

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Chapter 10: Corporate Governance • make higher quality strategic decisions • make decisions faster • become more involved in the strategic decision-making process Because of the increased pressure from owners and the potential conflict among board , procedures are necessary to help boards function effectively in facilitating the strategic decision-making process. Increasingly, outside directors are being required to own significant equity stakes as a prerequisite to holding a board seat. In fact, some research suggests that firms perform better if outside directors have such a stake. One activist concludes that boards need three foundational characteristics to be effective: director stock ownership, executive meetings to discuss important strategic issues, and a serious nominating committee that truly controls the nomination process to strongly influence the selection of new .

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Discuss the types of compensation executives receive and their effects on strategic decisions.

EXECUTIVE COMPENSATION As illustrated in the Opening Case and Strategic Focus, the compensation of top-level managers generates great interest and strongly held opinions. One reason for this widespread interest can be traced to a natural curiosity about extremes and excesses. But furthermore, CEO pay is an indirect but tangible way to assess governance processes in large corporations. Executive compensation is a governance mechanism that seeks to align managers’ and owners’ interests through salary, bonus, and long-term incentive compensation such as stock options. Sometimes the use of a long-term incentive plan prevents major stockholders (e.g., institutional investors) from pressing for changes in the composition of the board of directors, because they assume that long-term incentives ensure that top executives will act in shareholders’ best interests. Alternatively, stockholders largely assume that top-executive pay and the performance of a firm are more closely aligned when firms have boards that are dominated by outside . Using executive compensation as a governance mechanism is more challenging in international firms. Evidence suggests that the interests of owners of multinational corporations may be served best when the firm’s foreign subsidiary compensation plans are customized to local conditions. Though unique compensation plans require additional monitoring and increase the firm’s agency costs, it is important to adjust pay levels to match those of the region of the world (e.g., higher in the U.S. and lower in Asia). Teaching Note: When DaimlerBenz acquired Chrysler, it highlighted the fact that top executives at Chrysler made much more than the executives at DaimlerBenz—but higherpaid Chrysler executives report to lower-paid Daimler bosses. This example is one that students seem to be able to grasp. Developing and implementing an effective incentive compensation program is quite challenging because: • Strategic decisions made by top managers are complex and non-routine. Due to difficulties in judging decision quality, compensation is often linked to more measurable outcomes such as financial performance. • Decisions made by top-level managers are likely to affect firm performance over an extended period of time. As a result, it is difficult to assess the effect of current decisions using current period performance. • Many variables (or outside factors) intervene between management behavior and firm performance (e.g., uncontrollable shifts in the environment).

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Chapter 10: Corporate Governance Although incentive compensation plans may increase the value of a firm in line with shareholder expectations, such plans are subject to managerial manipulation. Although long-term performance-based incentives may reduce temptations to under-invest in the short run, they increase executive exposure to risks associated with uncontrollable events—e.g., market shifts, industry decline.

STRATEGIC FOCUS Executive Compensation Is Increasingly Becoming a Target for Media, Activist Shareholders, and Government Regulators Amid growing outrage over excessive executive compensation, a number of outside entities, including the media, shareholder activists, and government regulators, are seeking to reduce the increases in CEO executive compensation pay packages. The reason for this outrage can be illustrated by the compensation package for former Home Depot CEO Robert Nardelli. Home Depot awarded Mr. Nardelli $245 million over his five-year stint. Shareholders felt betrayed that Home Depot’s stock prices dropped 12 percent during Nardelli’s tenure while, during the same period, Home Depot’s most important competitor, Lowes, increased 173 percent. Nardelli negotiated his compensation package relative to what his compensation would have been had he stayed with his previous employer (General Electric). As such, he was awarded $25 million in vested shares on his start date. Additionally, he received a new car every three years (similar price to a MercedesBenz S series), the opportunity to use the company jet for personal trips, as well as a $10 million loan at an annual interest of 5.8 percent that would be forgiven over five years. The board of directors that approved the hiring of Nardelli was pleased that it could attract and hire such a high-profile candidate. Were there other factors that played into the board’s decision to approve such a “pricey” package? A New York Times article suggested that the six-member compensation board was composed of other CEOs, one of whom had an even higher salary than Nardelli. Others were suggested to have had associations with Nardelli, directly or indirectly, through his previous employer GE. As such, it would be hard for his associates to lower Nardelli’s pay, especially when one board member was making more than he was. Increased information disclosure as well as the number of scandals associated with backdating options have made board executive compensation committees (and boards in general) a focus of activist investors and increased government scrutiny. Certainly Home Depot was a target for much of this scrutiny, which forced the board to oust Nardelli from his position when he refused to accept a lower pay package. The new Home Depot CEO, Frank Blake, has a pay package that is significantly less than his predecessor (around one-third of Nardelli’s annual compensation). Interestingly, Blake rejected the retailer’s first offer because it included too much pay. He refused compensation in the form of restricted stock that retains value even if the share price declines. In other words, he wanted to make sure that his pay package was in line with the desires of Home Depot shareholders. At least in the case of Home Depot, it appears that increased scrutiny, activist shareholder monitoring, and executive pay disclosure rules had a significant effect in bringing CEO pay in line. Who really “owns” this problem? How much is too much? Why are shareholders not reacting by replacing the board who approve executive compensation packages deemed excessive? Students should be made aware that directors are being held able for their actions through an increasing frequency of civil law-suits. Many companies are furnishing malpractice” insurance to directors in order to obtain their services on their boards.

The Effectiveness of Executive Compensation

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The compensation received by top-level managers, especially by CEOs, is often a subject of controversy. Large CEO compensation packages result mostly from the inclusion of stock options and stock in the total pay packages. This is intended to entice executives to keep the stock price high, thus aligning manager and owner interests. Research has shown that managers owning more than one percent of the firm’s stock are less likely to be forced out of their jobs, even when the firm is performing poorly Furthermore, a review of the research suggests that over time, firm size has ed for more than 50 percent of the variance in total CEO pay, while firm performance has ed for less than 5 percent of the variance. Teaching Note: One way that boards have found to compensate executives is through giving them loans with favorable, or no, interest for the purpose of buying company stock. If done correctly, this can be a governance tool, since it aligns executives’ priorities with those of the shareholders because the executives hold stock, not just options on the stock. They gain or lose money along with the shareholders. It is important to consider that annual bonuses may provide incentives to pursue short-run objectives at the expense of the firm’s long-term interests. While some stock option–based compensation plans are well designed with option strike prices substantially higher than current stock prices, too many have been designed simply to give executives more wealth that will not immediately show up on the balance sheet. Research of stock option repricing where the strike price value of the option has been lowered from its original position suggests that action is taken more frequently in highrisk situations. However, it also happens when firm performance was poor to restore the incentive effect for the option. Often, organizational politics play a role in this. Repricing stock options does not appear to be a function of management entrenchment or ineffective governance. These firms often have had sudden and negative changes to their growth and profitability. They also frequently lose their top managers. Interestingly, institutional investors prefer compensation schemes that link pay with performance, including the use of stock options. Again, this evidence shows that no internal governance mechanism is perfect. Option awards became a means of providing large compensation packages, and the options awarded did not relate to the firm’s performance, particularly when boards showed a propensity to reprice options at a lower strike price when stock prices fell precipitously. Option awards are becoming increasingly controversial. Teaching Note: Board directors also receive compensation. Some recent figures follow: • Median base compensation for directors in telecommunications was almost $90,000. • Directors at Microsystem Inc. received average compensation of about $410,000 a year, while directors at Compaq earned over $360,000 and directors at Pfizer received almost $260,000. • On average, directors at the largest 200 firms received about $134,000. • Similar to executives in the firm, there is a move by large institutional investors such as CalPERS to pay directors at least partially in stock (some estimating that some 50 percent of director pay will be in company stock).

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Describe how the external corporate governance mechanism —the market for corporate control—acts as a restraint on top-

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level managers’ strategic decisions. MARKET FOR CORPORATE CONTROL The market for corporate control generally comes into use as an external governance mechanism only after internal governance mechanisms have failed.

A Brief History of the Market for Corporate Control The market for corporate control has been active for some time. The 1980s were known as a time of merger mania, with around 55,000 acquisitions valued at approximately $1.3 trillion. However, there were many more acquisitions in the 1990s, and the value of mergers and acquisitions in that decade was more than $10 trillion. The major reduction in the stock market resulted in a significant drop in acquisition activity in the first part of the twenty-first century. However, the number of merger and acquisitions began to increase in 2003, and the market for corporate control has become increasingly international with over 40 percent of the merger and acquisition activity involving two firms from different countries. While some acquisition attempts are intended to obtain resources important to the acquiring firm, most of the hostile takeover attempts are due to the target firm’s poor performance. Therefore, target firm managers and of the boards of directors are highly sensitive about hostile takeover bids. It often means that they have not done an effective job in managing the company because of the performance level inviting the bid. If they accept the offer, they are likely to lose their jobs; the acquiring firm will insert its own management. If they reject the offer and fend off the takeover attempt, they must improve the performance of the firm or risk losing their jobs as well.

The market for corporate control is composed of individuals and firms who buy ownership positions in (or take over) potentially undervalued firms. They do this in order to form a new division in an established diversified firm, merge two previously separate firms, and usually replace the target firm’s management team to revamp the strategy that caused low firm performance. The market for corporate control governance mechanism should be triggered by a firm’s poor performance relative to industry competitors. A firm’s poor performance, often demonstrated by the firm’s earning belowaverage returns, is an indicator that internal governance mechanisms have failed; that is, their use did not result in managerial decisions that maximized shareholder value. Managerial Defense Tactics Because of the threat of dismissal, managers have devised a number of defensive tactics designed to both ward off takeovers and buffer or protect managers from external governance mechanisms. These tactics include: • managerial pay interventions, such as golden parachutes • asset restructuring, such as divesting a business unit or division • financial restructuring—e.g., stock repurchases, paying out a firm’s free cash flows as a dividend • changing the state of incorporation • making targeted shareholder repurchases (known as greenmail)

TABLE 10.2 Hostile Takeover Defense Strategies

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This table presents a number of defense strategies and identifies them according to category (preventive, reactive), popularity (high, medium, low, very low), effectiveness (high, medium, low, very low), and stockholder wealth effects (positive, negative, inconclusive). The defense strategies mentioned are poison pill, corporate charter amendment, golden parachute, litigation, greenmail, standstill agreement, and capital structure change.

Most institutional investors oppose the use of defense tactics. For example, TIAA-CREF and CalPERS have taken actions to have several firms’ poison pills eliminated. The market for corporate control also can be plagued by inefficiency. In the 1980s, roughly 50 percent of all takeovers targeted firms that were high performers. As a result, • acquisition prices were excessive • expensive defensive strategies were often implemented to protect the firm Despite its inefficiency, the threat of acquisition by corporate raiders can serve as an effective constraint on the managerial growth motive and result in strategies that are in the best interests of the firm’s owners. Teaching Note: As mentioned throughout the chapter, internal and external governance mechanisms, while they may restrain managerial actions, are imperfect means of controlling managerial opportunism. This means that some combination of both internal and external mechanisms is necessary.

7

Discuss the use of corporate governance in international settings, in particular in and Japan.

INTERNATIONAL CORPORATE GOVERNANCE Our discussion of internal and external governance mechanisms—and their effectiveness in controlling managerial behavior—has been centered on the U.S. and the U.K. But this does not necessarily apply to the systems of corporate governance used elsewhere in the world – e.g., German and Japanese firms. While the stability that has been associated with the German and Japanese systems has been perceived as a strength, it is possible, given the dynamic and uncertain nature of the new competitive landscape, that stability may be a potential source of weakness. Corporate Governance in The owner-manager relationship in differs from that described for the U.S. For example: • In many private German firms, the owner and manager are the same person. • In publicly traded firms there often is a dominant shareholder. Banks historically have occupied a central position in German governance structure. • Banks became major shareholders when companies that they financed either sought new capital in the stock market or defaulted on loans. • Banks generally hold less than 10 percent of a firm’s stock. • Bank ownership of a single firm’s stock is limited to 15 percent of the bank’s capital. • Three large banks—Deutsche, Dresdner, and Commerzbank—hold majority positions in large German firms through their own holdings and proxy votes for shareholders who retain shares with the banks.

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Chapter 10: Corporate Governance • German firms with more than 2,000 employees must have a two-tiered board structure, with supervision of management being separated from other board duties and all of the functions of direction and management being placed in the hands of the Vorstand or management board. • Appointment to the management board is the responsibility of the Aufsichtsrat or supervisory board. Despite the ability of major owners and banks to monitor and control the managers of large German firms, maximizing shareholder value has not been an historical focus. However, this is changing. Teaching Note: A shift is taking place in German firms’ historic lack of focus on maximizing shareholder value. For example, SGL Carbon AG lost more than $71 million in the early 1990s and was later restructured to turn the corporation around. In particular the firm’s governance structure was changed, transparent ing practices were adopted, and the firm set a goal of enhancing shareholder value. The firm’s performance has since improved, and many attribute this to the new governance structure. Corporate Governance in Japan Corporate governance in Japan is affected by the concepts of obligation, family, and consensus. In Japan, obligation goes beyond principles but is more a product of specific causes, events, and relationships. It can mean returning a service for one that has been rendered. The concept of family goes beyond the American concept to include the firm—individuals see themselves as of a company family. And the family concept is extended to include of the firm’s keiretsu, a group of firms that are tied together by cross-shareholdings, interrelationships, and interdependencies. Consensus represents one of the most important influences on governance structure in Japan. This requires that managers—among others—expend significant amounts of energy to win the hearts and minds of people rather than proceed by the edicts of top-level managers. As in , banks also play an important role in financing and monitoring large public firms in Japan. • The bank owning the largest share of stocks and the largest amount of debt—the main bank—has the closest relationship with the company’s top executives. • Banks occupy an important position in the governance system, both financing and monitoring firms. • The main bank—the bank holding the largest share of a firm’s debt—provides financial advice and assumes primary responsibility for monitoring the firm’s management. • Japanese banks can hold up to five percent of a firm’s stock. • Groups of banks can hold up to 40 percent of a firm’s stock. • In many cases, bank relations are an integral part of the Japanese firm’s keiretsu (an industrial group of firms that interact with the same bank). Teaching Note: Keiretsus are both diversified and vertically integrated to the extent that they generally include one or more firms in almost all important industrial sectors. As in , Japan’s corporate governance structure is changing. For example, the role of banks in the monitoring and control of managerial behavior and firm outcomes has become less significant.

STRATEGIC FOCUS

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Chapter 10: Corporate Governance Shareholder Activists Invade Japan’s Large Firms Traditionally Focused on “Stakeholder” Capitalism Japan has traditionally applied relationship-capitalism, which is based on the premise that firms help each other when they are weak and facilitate and encourage each other as they become strong. This system has been a very effective method of protection in order to keep Japanese firms Japanese. This relationshipcapitalism created a system for protection against “outside” owners by having a close-knit group of insiders who manage the firm as well as a larger set of interlocking shareholders who are mutually bonded by owning each other’s stock. In the 1980s, these cross-shareholdings ed for 50 percent of the equity in Japanese firms. Recently, relationship-capitalism s for only 20 percent of total equity. Foreign ownership of Japanese firms has increased from approximately 4.7 percent in 1990 to 28 percent in 2007. A parallel trend is the increase in activist foreign shareholders making proposals in governing the firms differently. Japanese managers are facing an increasing level of activism, especially by foreign shareholders. Interestingly, in Japan, shareholders can vote directly on dividends and executive pay. Thus, on the surface it would appear that Japanese stock market policies are more shareholder-friendly than those in the United States or the United Kingdom. Furthermore, shareholders can vote to dismiss the entire board without cause. However, Japanese investors do not take up this power readily and most often defer to executive proposals. Since 28 percent of Japanese shares are now held by foreign institutional investors, these practices have begun to change. Shareholder activity is becoming more common. In June 2007, firms holding their shareholders’ meetings faced 30 shareholder resolutions which were twice as many as there were one year earlier. Japanese managers who are determined to maintain a tightly-knit business culture feel threatened. Some of the issues raised by shareholders included the accumulation of heavy cash reserves that could be used to pay dividends that are inline with those paid by U.S. and U.K. firms and reorganizations that would result in employee layoffs. Japanese managers have fought back through use of the Japanese media to paint non-Japanese shareholders as short-sighted financial criminals. In fact, the long-term health of Japanese firms might be improved given that Japanese firms hold cash and securities equivalent to 16 percent of GDP, whereas American firms’ long-term average of cash and securities is about 5 percent. Although these slack resources in Japan may facilitate a longer-term view, from the eyes of the Japanese firms have recently begun experiencing activist shareholders who seek to increase returns through improved dividend policy. Were not the symptoms of change anticipated in this case? This is a clash of cultures. Japanese business culture has valued relationships and consensus which calls for the expenditure of significant amounts of energy to win the hearts and minds of people whenever possible, as opposed to top executives issuing edicts. Consensus is highly valued, even when it results in a slow and cumbersome decision-making process. Do students feel that “compromise” is a realistic strategy in addressing this apparent conundrum?

Global Corporate Governance As discussed in this section, the changes in governance that are taking place in and Japan are representative of the twenty-first century competitive landscape, where customer demands are becoming more similar and shareholder value is becoming a more significant focus of managerial agents. This will result in more uniform governance structures. Teaching Note: Examples of differences and changes in international governance follow: • In , anger has been growing over the lack of information on top executive compensation. A recent report recommended that the positions of CEO and chairman of

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Chapter 10: Corporate Governance the board be held by two different individuals. It also recommended reducing the tenure of board and to disclose their pay. • In South Korea, principles of corporate governance are being adopted to provide proper board and management incentives to pursue the interests of both the company and the shareholders and to facilitate effective monitoring. • Changes in corporate governance are occurring even in transitional economies, such as China and Russia, though implemented more gradually. The use of stock-based compensation plans has influenced foreign companies to invest (particularly in China).

8

Describe how corporate governance can foster ethical strategic decisions and the importance of such behaviors on the part of top-level executives.

GOVERNANCE MECHANISMS AND ETHICAL BEHAVIOR Governance mechanisms discussed in this chapter are focused on ensuring that managers work effectively toward meeting their obligation to maximize shareholder wealth. However, shareholders are only one group of the firm’s stakeholders (as discussed in Chapter 1). Over the long-term, the demands of other key stakeholders—such as employees, customers, suppliers, and the community—also must be satisfied in order to maximize shareholder wealth. For that reason, and others, governance mechanisms must be carefully designed and implemented so that managers’ attention is not focused on maximizing short-term returns and to ensure that they consider the interests of all stakeholders. Teaching Note: John Smales (outside director of the board at GM) has commented that the most fundamental obligation of management is to perpetuate the organization, taking priority even over stockholder interests. His comments may provide a good opportunity to engage students in a discussion about the purpose of the firm and its obligations to all stakeholders.

— ANSWERS TO REVIEW QUESTIONS 1. What is corporate governance? What factors for the considerable amount of attention corporate governance receives from several parties, including shareholder activists, business press writers, and academic scholars? Why is governance necessary to control managers’ decisions? (pp. 276278) Corporate governance is a relationship among stakeholders that is used to determine and control the direction and performance of organizations. Corporate governance receives a great deal of attention because governance mechanisms sometimes fail to adequately monitor and control top-level managers’ strategic decisions. If the behavior of top-level mangers is not monitored and controlled effectively, this could mean that the firm will not be strategically competitive. Effective corporate governance is also of interest to nations. A country prospers as its firms grow and provide employment, wealth, and satisfaction—thus improving standards of living. These aspirations are met when firms are competitive internationally in a sustained way. Corporate governance reflects the standards of the company, which collectively reflect societal standards. Thus, in many corporations, shareholders attempt to hold top-level managers more able for their decisions and the results they generate. As with individual

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Chapter 10: Corporate Governance firms and their boards, nations that govern their corporations effectively may gain a competitive advantage over rival countries. As owners delegate strategy development and decision making to managers, conflicts of interest emerge— managers may select strategic alternatives that serve their own best interests, not those of the owners. Governance mechanisms help owners (shareholders) to ensure that managers make strategic decision that are in the best interests of the former. If internal governance mechanisms are ineffective, the market for corporate control (an external governance mechanism) may be activated. 2. What does it mean to say that ownership is separated from managerial control in the modern corporation? Why does this separation exist? (p. 278) Historically, U.S. firms were managed by the founders/owners and their descendants. In these cases, corporate ownership and control resided in the same person(s). As firms grew larger, ownership and control were separated in most large corporations so that control of the firm shifted to professional managers while ownership was dispersed among unorganized stockholders who were removed from day-to-day management. These changes created the modern public corporation, which is based on the efficient separation of ownership and managerial control. ing the separation is a basic legal premise suggesting that the primary objective of a firm’s activities is to increase the corporation’s profit and thereby the financial gains of the owners (or shareholders). However, this right also requires that they accept the financial risk of the firm and its operation. As shareholders diversify their investments over a number of corporations, their risk declines (the poor performance or failure of any one firm in which they invest has less overall effect). Shareholders thus specialize in managing their investment risk while managers focus on decision making. Without management specialization in decision making and owner specialization in risk bearing, a firm probably would be limited by the abilities of its owners to manage and make effective strategic decisions. Therefore, in concept, the separation and specialization of ownership (risk bearing) and managerial control (decision making) should produce the highest returns. 3. What is an agency relationship? What is managerial opportunism? What assumptions do owners of modern corporations make about managers as agents? (pp. 279-282) Despite its advantages, the separation of ownership and control may result in some potential costs (and risks) for owners by creating an agency relationship. An agency relationship exists when one or more persons (the principal or principals) hires another person or persons (the agent or agents) as a decision-making specialist to perform a service. In other words, the agency relationship exists when one party delegates decision making to another party in return for compensation. The owner-agent relationship enables the possibility of managerial opportunism, the seeking of self-interest with guile (i.e., cunning or deceit) where opportunism is represented by an inclination toward self-seeking behaviors. However, before observing the results of decisions, it is impossible to know which agents will behave opportunistically and which ones will not. A manager’s reputation is an imperfect guide to future behavior and opportunistic behavior cannot be observed until after it has occurred. 4. How is each of the three internal governance mechanisms—ownership concentration, boards of directors, and executive compensation—used to align the interests of managerial agents with those of the firm’s owners? (pp. 283-290) Ownership concentration is an effective governance mechanism because owners of large blocks of stock (representing a higher percentage of ownership) have a greater financial interest in monitoring managerial decisions than do small shareholders (characterized as diffuse ownership). Increasingly, institutional investors such as stock mutual funds and public-pension funds hold large blocks of stock, and these shareholders aggressively monitor and take action against managers who receive excessive compensation and perks but achieve only poor firm performance.

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Chapter 10: Corporate Governance Monitoring and controlling managerial decisions are supposed to be accomplished through the firm’s board of directors, of which are elected by shareholders to oversee managers and ensure that the firm is operated in the best interests of owners. can be classified into three categories—insiders (the CEO and other top-level managers), related outsiders (member who are not involved in day-to-day operations but have some relationship with the firm), and outsiders ( who are independent from the firm and its operations). Executive compensation can be used to help align the interests of managers and owners by tying managerial pay to firm performance through salaries, bonuses, and long-term incentives based on stock options. However, given the complexity and long-term nature of strategic decisions, it may be difficult to perfectly align compensation with firm performance. First, the strategic decisions made by top-level managers are typically complex and nonroutine, so direct supervision of executives is inappropriate for judging the quality of their decisions. Thus, compensation of top-level managers is usually determined by the firm’s financial performance. Second, the impact of an executive’s decisions is not immediate, making it difficult to assess the effect of decisions on the corporation’s performance. Third, a number of variables (unpredictable economic, social, or legal changes) intervene between top-level managerial behavior and firm performance, making it difficult to discern the effects of strategic decisions. 5. What trends exist regarding executive compensation? What is the effect of the increased use of longterm incentives on executives’ strategic decisions? (pp. 287-290) In recent times, many stakeholders, including shareholders, have been angered by what they consider the excessive compensation received by some top-level managers, especially CEOs. The primary reason for such large compensation packages is the inclusion of stock options and stock in the total pay packages. The primary reasons for compensating executives with stock is that it provides incentives to keep the stock price high, thus aligning manager and owner interests. However, there may be some unintended consequences. Research has shown that managers who own more than one percent of the firm’s stock are less likely to be forced out of their jobs, even when the firm is performing poorly. Increasingly, long-term incentive plans are becoming a critical part of compensation packages in U.S. firms. The use of longer-term pay helps firms cope with or avoid potential agency problems. Because of this, the stock market generally reacts positively to the introduction of a long-range incentive plan for top executives. While some stock option-based compensation plans are well designed with option strike prices substantially higher than current stock prices, too many have been designed simply to give executives more wealth that will not immediately show up on the balance sheet. Research of stock option repricing where the strike price value of the option has been changed to be lower than it was originally set suggests that step is taken more frequently in high-risk situations. However, it also happens when firm performance was poor to restore the incentive effect for the option. But evidence also suggests that organizational politics are often involved. Additionally, research has found that repricing stock options does not appear to be a function of management entrenchment or ineffective governance; these firms often have had sudden and negative changes to their growth and profitability. They also frequently lose their top managers. Interestingly, institutional investors prefer compensation schemes that link pay with performance, including the use of stock options. Again, this evidence shows that no internal governance mechanism is perfect. While stock options became highly popular as a means of compensating top executives and linking pay to performance, they also have become controversial of late. It seems that option awards became a means of providing large compensation packages and the options awarded did not relate to the firm’s performance, particularly when boards showed a propensity to reprice options at a lower strike price when stock prices fell precipitously. Because of the large number of options granted in recent years and the increasingly common practice of repricing them, some have called for expensing the options by the firm at the time they are awarded. This action could be quite costly to many firms’ stated profits. Thus, some firms have begun to move away from granting stock options.

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Chapter 10: Corporate Governance 6. What is the market for corporate control? What conditions generally cause this external governance mechanism to become active? How does the mechanism constrain top executives’ decisions and actions? (pp. 290-292) The market for corporate control is an external governance mechanism that becomes active when a firm’s internal controls fail. The market for corporate control is composed of individuals and firms that buy ownership positions in (or take over) potentially undervalued corporations so they can form new divisions in established diversified companies or merge two previously separate firms. Because they are assumed to be the party responsible for formulating and implementing the strategy that led to poor performance, the top management team of the acquired company is usually replaced. Thus, the market for corporate control disciplines managers that are ineffective or act opportunistically. A firm’s poor performance is an indication that internal governance mechanisms have failed (that is, their use did not result in managerial decisions that maximized shareholder value), opening the door to the involvement of the market for corporate control. Indeed, hostile takeovers are the major activity in the market for corporate control. 7.

What is the nature of corporate governance in and Japan? (pp. 294-295)

In many private German firms, owner and manager may be the same individual and thus no agency problem will exist. Even in publicly traded corporations, there is often a dominant shareholder, so the problem is minimized. Thus, ownership concentration is an important means of corporate governance in , just as it is in the U.S. Historically, banks have been at the center of the German corporate governance structure, which is the case in many continental European countries such as Italy and . As lenders, banks become major shareholders when companies they had financed earlier seek funding on the stock market or default on loans. Although stakes are usually under 10 percent, there is no legal limit on how much of a firm’s stock banks can hold (except that a single ownership position cannot exceed 15 percent of the bank’s capital). Shareholders can tell the banks how to vote their ownership position, but they generally elect not to do so. Banks monitor and control managers both as lenders and as shareholders by electing representatives to supervisory boards. German firms with more than 2,000 employees are required to have a two-tier board structure. Through this structure, the supervision of management is separated from other duties normally assigned to a board of directors, especially the nomination of new board . Thus, ’s two-tiered system places the responsibility to monitor and control managerial (or supervisory) decisions and actions in the hands of a separate group. While all the functions of direction and management are the responsibility of the management board, appointment to this body is the responsibility of the supervisory tier. Employees, union , and shareholders appoint to the latter. Historically, German executives have not been dedicated to the maximization of shareholder value. However, corporate governance in is changing. Due at least partially to the increasing globalization of business, many governance systems are beginning to gravitate toward the U.S. system. Attitudes toward corporate governance in Japan are affected by the concepts of obligation, family, and consensus. As part of a corporate family, individuals are of a unit that envelops their lives—even the keiretsu is a family, and certainly more than an economic concept. Consensus, an important influence in Japanese corporate governance, calls for the expenditure of significant amounts of energy to win the hearts and minds of people whenever possible, as opposed to depending on edicts from top executives. Consensus is highly valued, even when it results in a slow and cumbersome decision-making process. As in , banks play an important role in financing and monitoring large public firms in Japan. The bank owning the largest share of stocks and the largest amount of debt (the main bank) has the closest relationship with the company’s top executives. The main bank provides financial advice to the firm and also closely monitors managers. Thus, Japan has a bank-based financial and corporate governance structure compared to the United States’ market-based financial and governance structure.

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Chapter 10: Corporate Governance Aside from lending money (debt), a Japanese bank can hold up to five percent of a firm’s total stock; a group of related financial institutions can hold up to 40 percent. In many cases, main-bank relationships are part of a horizontal keiretsu (a group of firms tied together by cross-shareholdings). A keiretsu firm usually owns less than 2 percent of any other member firm; however, each company typically has a stake of that size in every firm in the keiretsu. As a result, somewhere between 30 percent and 90 percent of a typical firm is owned by other of the keiretsu. Thus, a keiretsu is a system of relationship investments. As is the case in , Japan’s corporate governance structure is changing. For example, because of their continuing development as economic organizations, the role of banks in the monitoring and control of managerial behavior and firm outcomes is less significant than it has been. The Asian economic crisis in the later part of the 1990s substantially harmed Japanese firms, making transparent the governance problems in the system. 8. How can corporate governance foster ethical strategic decisions and behaviors on the part of managers as agents? (pp. 298-299) In the United States, the focus of governance mechanisms is on the control of managerial decisions to ensure that shareholders’ interests will be served, but product market stakeholders (e.g., customers, suppliers, and host communities) and organizational stakeholders (e.g., managerial and nonmanagerial employees) are important as well. Therefore, at least the minimal interests or needs of all stakeholders must be satisfied by outcomes from the firm’s actions. Otherwise, dissatisfied stakeholders will decide to withdraw their to one firm and provide it to another (e.g., customers will purchase products from a supplier offering an acceptable substitute).

— EXPERIENTIAL EXERCISES Exercise 1: International Governance Codes As described in the chapter, age of the Sarbanes-Oxley Act in 2002 has drawn attention to the importance of corporate governance. Similar legislation is pending in other nations as well. However, interest in improved governance predated SOX by a decade in the form of governance codes or guidelines. These codes established sets of “best practices” for both board composition and processes. The first such code was developed by the Cadbury Committee for the London Stock Exchange in 1992. The Australian Stock Exchange developed its guidelines in the Hilmer Report, released in 1993. The Toronto Stock Exchange developed its guidelines the following year in the Dey Report. Today, most major stock exchanges have governance codes. Working in small groups, find the governance codes of two stock exchanges. Prepare a short (two to three pages, single-spaced) bullet point comparison of the similarities and differences between the two codes. Be sure to include the following topics in your analysis: How are the guidelines structured? Do they consist of rules (i.e., required) or recommendations (i.e., suggestions)? What mechanism is included to monitor or enforce the guidelines? What board roles are addressed in the guidelines? For example, some codes may place most or all of their emphasis on functions derived from the importance of the agency relationship illustrated in Figure 10.1, such as monitoring, oversight, and reporting. Codes might also mention the board’s role in ing strategy, or their contribution to firm performance and shareholder wealth. What aspects of board composition and structure are covered in the guidelines? For instance, items included in different codes include the balance of insiders and outsiders, committees, whether the CEO also serves as board chair, director education and/or evaluation, compensation of officers and directors, and ownership by board . Exercise 2: Governance and Personal Investments

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Governance mechanisms are considered to be effective if they meet the needs of all stakeholders, including shareholders. As an investor, how much weight, if at all, do you place on a firm’s corporate governance? If you currently own any stocks, select a firm that you have invested in. If you do not own any stocks, select a publicly traded company that you consider an attractive potential investment. Working individually, complete the following research on your target firm: Find a copy of the company’s most recent proxy statement. Proxy statements are mailed to shareholders prior to each year’s annual meeting and contain detailed information about the company’s governance and presents issues on which a shareholder vote might be held. Proxy statements are typically available from a firm’s Web site (look for an “Investors” submenu). You can also access proxy statements and other government filings such as the 10-K from the SEC’s EDGAR database (http://www.sec.gov/edgar.shtml). Conduct a search for news articles that address the governance of your target company. Using different keywords (e.g., governance, directors, or board of directors) in combination with the company name may be helpful. Some of the topics that you should examine include: Compensation plans (for both the CEO and board ) Board composition (e.g., board size, insiders and outsiders) Committees Stock ownership by officers and directors Whether the CEO holds both CEO and board chairperson positions Is there a lead director who is not an officer of the company? Board seats held by blockholders or institutional investors Activities by activist shareholders regarding corporate governance issues of concern Prepare a one page, single-spaced memo summarizing the results of your findings. Your memo should include the following topics: Summarize what you consider to be the key aspects of the firm’s governance mechanisms. Based on your review of the firm’s governance, did you change your opinion of the firm’s desirability as an investment? Why or why not?

—

INSTRUCTOR'S NOTES FOR EXPERIENTIAL EXERCISES

Exercise 1: International Governance Codes The goals of this exercise are two-fold: first, the exercise helps to illustrate the stock exchanges use codes of best practice as an alternative to regulation (e.g., SOX). If the exercise is discussed in class, it can be helpful to ask students their opinions of the relative merits of self-policing via exchange requirements versus government intervention. A second goal of the exercise is to highlight the global aspect of corporate governance.

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The European Corporate Governance Institute maintains a list of governance codes for a number of countries, including nations outside the EU. Their database includes historical listings, so that both the most recent and older codes are often available for a given region. For example, the Australia section includes both the current Australian Stock Exchange (ASX) guidelines, as well as the Bosch Report from 1995. If the instructor is looking for a more advanced project on this topic, students could be required to compare the evolution of governance codes over time for a particular region. The ECGI website is: http://www.ecgi.org Additionally, the Corporate Governance Network is a useful resource for other materials relating to governance issues: http://www.corpgov.net The following practitioner articles may also be helpful for framing a discussion of ‘good governance’ guidelines: Finkelstein, S., & Mooney, A.C. 2003. Not the usual suspects: How to use board process to make boards better. The Academy of Management Executive. May 2003. Vol. 17, Iss. 2; p. 101 Norburn, D., Boyd, B.K., Fox, M., & Muth, M. 2000. International corporate governance reform. European Business Journal. Vol. 12, Issue 3, p. 116-133. Exercise 2: Governance and Personal Investments For this exercise, students are asked to evaluate the governance of a firm they currently invest in, or a firm they might consider investing in. The main purpose of the exercise is to help make a connection between different governance elements (e.g., board composition, equity holdings by directors, executive compensation) and a firm’s financial performance. Students are asked to prepare a single page memo that answers the following questions: Summarize what you consider to be the key aspects of the firm’s governance mechanisms. Based on your review of the firm’s governance, did you change your opinion of the firm’s desirability as an investment? Why, or why not? A secondary goal of the exercise is to familiarize students with proxy statements as a resource for analyzing corporate governance. A related benefit is the use of the Securities and Exchange Commission EDGAR database (http://www.sec.gov/edgar.shtml). Because this exercise is completed individually, it can be helpful to spend some time in class debriefing the assignment. An easy way to do this is to restate the question “Based on your review of the firm’s governance, did you change your opinion of the firm’s desirability as an investment?” Ask for a show of hands for those that did change their opinion, and those that did not. Starting with the former group, ask: What prompted the change in opinion? Were there both positive and negative opinion changes? How strong was the change – relatively minor, moderate, or substantial? Next, follow up with the “no change” group, and ask several students for the basis for their assessment.

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Chapter 10: Corporate Governance Finally, ask students how much weight they will play on corporate governance when considering future investments.

— ADDITIONAL QUESTIONS AND EXERCISES The following questions and exercises can be presented for in-class discussion or assigned as homework. Application Discussion Questions 1.

2. 3. 4. 5.

The roles and responsibilities of top executives and of a corporation’s board of directors are different. Traditionally, executives have been responsible for determining the firm’s strategic direction and implementing strategies to achieve it, whereas the board of directors has been responsible for monitoring and controlling managerial decisions and actions. Some argue that boards should become more involved with the formulation of a firm’s strategies. How would the board’s increased involvement in the selection of strategies affect a firm’s strategic competitiveness? What evidence can the students offer to their position? Ask the students if they believe that large U.S. firms have been overgoverned by some corporate governance mechanisms and undergoverned by others; provide an example of each. How can corporate governance mechanisms create conditions that allow top executives to develop a competitive advantage and focus on long-term performance? Have the students use the Internet to search the business press and give an example of a firm in which this occurred. Some believe that the market for corporate control is not an effective governance mechanism. What factors might for the ineffectiveness of this method of monitoring and controlling managerial decisions? Present the following comment to the class: “As a top executive, the only agency relationship I am concerned about is the one between myself and the firm’s owners. I think that it would be a waste of my time and energy to worry about any other agency relationships.” What are these other agency relationships? How would the students respond to this person? Do they accept or reject this view? Have them their position.

Ethics Questions 1.

2. 3. 4. 5. 6. 7.

As explained in this chapter, using corporate governance mechanisms should establish order between parties whose interests may be in conflict. Do owners of a firm have any ethical responsibilities to managers in a firm that uses governance mechanisms to establish order? If so, what are those responsibilities? Is it ethical for a firm’s owner to assume that agents (managers hired to make decisions in the owner’s best interests) are averse to risk? Why or why not? What are the responsibilities of the board of directors to stakeholders other than shareholders? What ethical issues surround executive compensation? How can we determine whether top executives are paid too much? Is it ethical for firms involved in the market for corporate control to target companies performing at levels exceeding the industry average? Why or why not? What ethical issues, if any, do top executives face when asking their firm to provide them with a golden parachute? How can governance mechanisms be designed to ensure against managerial opportunism, ineffectiveness, and unethical behaviors?

Internet Exercise The use of the Internet for buying and selling stocks has opened up markets to an unprecedented number of people. With the click of a mouse, one can buy shares of the hottest stocks. Not always so, though, warns the chairman of the SEC. Orders are not necessarily processed at the moment they are sent, and by the time the

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Chapter 10: Corporate Governance stock is purchased, the price may have risen ten-fold. Read more about investing through the Internet and the SEC’s efforts to combat growing Internet-based investment fraud at http://www.sec.gov. *e-project: Visit two on-line trading venues: the more traditional Merrill Lynch at www.merrill-lynch.com and the newer E*Trade at www.etrade.com. How well do these companies communicate the risks of a volatile market to their customers? Looking at the SEC’s recommendations, how does each company rate?

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