Corporate Governance In The Twenty-first Century

Chapter 13 Corporate Governance in the Twenty-First Century

OBJECTIVES

1

Explain what is meant by corporate governance

2

Describe how corporate governance relates to competitive advantage and understand its basic principles and practices

3

Identify the roles of owners and different types of ownership profiles in corporate governance

4

Describe how boards of directors are structured and the roles they play in corporate governance

5

Explain and design executive incentives as a corporate governance device

6

Describe how the market for corporate control is related to corporate governance

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Compare and contrast corporate governance practices around the world 1

SUNBEAM Al Dunlap’s mgmt. philosophy 1. Shareholders are most important corporate constituents 2. Most corporations have bloated bureaucracies

Results

Early success

Signs of problems

5. CEOs should be rewarded like stars when they perform well and fired when they do not 6. Board members should have significant personal investments in the company

billion to $5 billion

• With R&D budgets cut, new

3. Drastic layoffs are usually needed to save failing companies 4. Layoffs should be quick, one-time events

• Costs slashed • Stock doubled in first month • Market cap rises from $1.1

Failure

• •

product development hampered Growth fails to meet targets Company accused of “channel stuffing”

• Board fines Dunlap • He loses his stock options • Sunbeam stock is delisted

2

CHAINSAW AL

“The last dirty secret in the corporate world is how directors live off the fat of a business that is not their employer. I started a revolution by insisting that Scott directors be paid only in stock.” - Al Dunlap

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CORPORATE GOVERNANCE In a broader perspective, governance determines how all stakeholders influence the corporation:

Shareholders

Corporate governance The system by which organizations, particularly business corporations, are directed and controlled by their owners

Board

Management

Corporation

Employees

Society

Environment

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CORPORATE GOVERNANCE IMPACTS PERFORMANCE

The Italian stock exchange started a new exchange called STAR for small and midsized companies that followed strict governance prescriptions

Companies of the STAR exchange consistently out perform their counterparts on the regular exchange (e.g., during 2004 STAR firms achieved returns 24.5% greater than their counter parts)

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AGENTS AND PRINCIPALS

• When interests are virtually Principals Shareholders of a firm

Agents Act on behalf of principals in managing the firm

identical, the agency problem is small: executives do what is in principals’ best interests

• However interests often do not overlap. Then agents may act to detriment of principals and visa-versa (e.g., executives raise salaries and reduce returns)

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EXAMPLES OF CODES OF GOVERNANCE What is the recommendation on director independence?

Can the same executive be both CEO & chairperson?

Is auditor rotation required?

Brazil CVM Code (2002)

As many as possible

Split recommended

Not addressed

No

Russia CG Code (2002)

At least one-quarter

Split required by law

Not addressed

No

Singapore CG Committee (2001)

At least one-third

Split recommended

Not addressed

Yes

United Kingdom Cadbury Code1

Majority

Split recommended

Periodic rotation of lead auditor

Yes

United States Conference Board and CalPers (2003)2

Substantial majority

Separation is one of three acceptable alternatives

Recommended3

No

Country

Is disclosure required if the company does not comply with the recommendations?

1. In 2003, a Combined Code made further additions to the code, but these basic principles remain 2. Just one of several codes in existence in the United States 3. The Sarbanes-Oxley Act requires that the lead audit partner be rotated every 5 years; changing audit firm after 10 years of continual relationship or if former audit partner is employed by the company

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INSTITUTIONAL ACTIVISM ON THE RISE

CalPERS known for their institutional activism

TIAA-CREF Corporate Governance Team

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ROLES AND ACTIONS OF BOARD OF DIRECTORS

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STAGGERED BOARDS A turn over the entire

are

at once

Board does not

staggered so Board

elections

Nearly 2/3 of boards today are

considered staggered.

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BOARD INVOLVEMENT

Phantom

Phantom boards have no involvement in the strategic management process of the firm.

Active

The public (and major stakeholders) have higher expectations for board involvement today.

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INCENTIVE ALIGNMENT Conflicts of interest can arise

Principals

Incentive alignment can solve such problems

Agents

Example:

• A company receives a buy-out offer

• Shareholders (principals) would benefit because price assures a good return on investment

• Management (agents) resists because they may lose their jobs

Boards can include “golden parachute” provisions in manager’s compensation packages

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HOW WOULD YOU DO THAT? – DENDRITE INTERNATIONAL

Dendrite’s challenge:

Dendrite’s solution:

How can Dendrite better align management incentives with shareholders?

 20 senior-most executives must own 15,000 to 100,000 shares of stock

 Must be common shares not options

 Must be achieved within 5 years  Executives may elect to receive incentive compensation in stock instead of cash

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EXECUTIVE STOCK OWNERSHIP IN 2004

Largest 250 companies with stock ownership guidelines Number of companies

Percent of companies

Percent increase from 2001 to 2004

Executives

142

57

58

Directors

123

49

127

Source: Adapted from Fredrick W. Cook & Co., Inc., “Stock Ownership Policies: Prevalence and design of Executive and Director Ownership Policies Among the Top 250 Companies,” www.fecook.com/surveys.html (accessed Nov 29, 2005), Sep 2004

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INCENTIVE COMPENSATION

Annual bonus plans

Oldest form of incentive pay. Board can evaluate executives’ performance along multiple dimensions and allocate a yearend cash award

Stock options

An employee receives the right to buy a set number of shares of company stock at a later date for a predetermined price

Other longterm incentives

More recent forms of incentive compensation. Long-term bonuses linked to performance over several years. May help executives avoid short-term myopia and focus on long-term

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HIGHEST PAID CEOs

Source: Company annual reports and ExecComp Service of Thomson Financial, www.aflcio.org/Corporate-Watch/CEO-Pay-and-the-99

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EXECUTIVE PAY TRENDS

Source: U.S. Bureau of Labor Statistics, www.aflcio.org/Corporate-Watch/CEO-Pay-and-the-99

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THE MARKET FOR CORPORATE CONTROL

Share holders Elect Example:

Corporate control: The right to choose the members of the board of directors of a company and to control all major decisions made by a company

Board

Hires/fires Top management

• Corporate raiders such as T. Boone Pickens, CarI Icahn, Ted Turner and Michael Milken

• Oracle engaged in 18month battle to gain control of PeopleSoft

Directs Corporation

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POOR CORPORATE GOVERNANCE, A WORLD-WIDE PROBLEM Recent examples of scandal-ridden non-U.S. multinationals

• Netherlands Ahold Group (grocery stores)

• Italy’s Parmalat (dairy and food products)

• France’s Vivendi (entertainment)

• French-Belgian Firm ELF (petroleum)

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CORPORATE GOVERNANCE: U.S VS. JAPAN

U.S

Japan

Owner-manager relationship

Adversarial

Co-operative

Manager and shareholder relationship

Through one company

Through a Keiretsu (group of interlocking companies)

Ownership concentration

Control function

Monitoring function

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