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Stakeholders, Board of Directors
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ASPECTS OF CONTROL : STAKEHOLDERS AND
CORPORATE GOVERNANCE
Stephen Ong, BSc(Hons) Econs (LSE), MBA International Business(Bradford)
Visiting Fellow, Birmingham City UniversityVisiting Professor, Shenzhen University
MBA1034 GOVERNANCE, LAW & ETHICS
• Discussion: Corporate Governance & Culture
1
• Stakeholders and the role of Boards of Directors2
• Case Discussion: Google• Video : Google and
China3
Today’s Overview
1. Open Discussion
• Mayer, Colin (2002) “Corporate Cultures and Governance: Ownership, Control and Governance of European and US Corporations”, TRANSATLANTIC PERSPECTIVES ON US-EU ECONOMIC RELATIONS:CONVERGENCE, COOPERATION AND CONFLICT ,Conference paper, JFK School of Government, Harvard University, April 11-12
2.1 STAKEHOLDERS
Learning outcomes
• Consider appropriate ways to express the strategic purpose ofan organisation in terms of statements of purpose, values,vision, mission or objectives.
• Identify the components of the governance chain of anorganisation.
• Understand differences in governance structures and theadvantages and disadvantages of these.
• Identify differences in the corporate responsibility stances takenby organisations and how ethical issues relate to strategicpurpose.
• Undertake stakeholder analysis as a means of identifying theinfluence of different stakeholder groups in terms of theirpower and interest.
Influences on strategic purpose
Figure 4.1 Influences on strategic purpose
Who are the stakeholders?Stakeholders are those individuals or groups who depend on an organisation to fulfil their own goals and on whom, in turn, the organisation depends.
Mission statements• A mission statement aims to provide employees
and stakeholders with clarity about the overriding purpose of the organisation
• A mission statement should answer the questions: ‘What business are we in?’
‘How do we make a difference?’‘Why do we do this?’
Vision statements• A vision statement is concerned with the
desired future state of the organisation; an aspiration that will enthuse, gain commitment and stretch performance.
• A vision statement should answer the question : ‘What do we want to achieve?’
Statement of corporate values• A statement of corporate values should
communicate the underlying and enduring core ‘principles’ that guide an organisation’s strategy and define the way that the organisation should operate.
• Such core values should remain intact whatever the circumstances and constraints faced by the organisation.
Objectives• Objectives are statements of specific outcomes
that are to be achieved.• Objectives are frequently expressed in: financial terms (e.g. desired profit levels)
market terms (e.g. desired market share)and increasinglysocial terms (e.g. corporate social responsibility targets)
Issues in setting objectives
• Do objectives need to be specific and quantified targets?
• The need to identify core objectives that are crucial for survival.
• The need for a hierarchy of objectives that cascade down the organisation and define specific objectives at each level.
Corporate governanceCorporate governance is concerned with the structures and systems of control by which managers are held accountable to those who have a legitimate stake in an organisation.
The growing importance of governance
• The separation of ownership and management control – defining different roles in governance.
• Corporate failures and scandals (e.g. Enron) – focussing attention on governance issues.
• Increased accountability to wider stakeholder interests and the need for corporate social responsibility (e.g. green issues).
The governance chain
Figure 4.2 The chain of corporate governance: typical reporting structuresSource: Adapted from David Pitt-Watson, Hermes Fund Management
The principal-agent model• Governance can be seen in terms of the
principal agent model• Principals pay agents to act on their
behalf (e.g. beneficiaries/trustees pay investment managers to manage funds, Boards of Directors pay executives to run a company).
• Agents may act in their own self interest.
Issues in governance (1)• The key challenge is to align the interests
of agents with those of the principals.• Misalignment of incentives and control –
e.g. beneficiaries may require long term growth but executives may be seeking short term profit.
• Responsibility to whom – should executives pursue solely shareholder aims or serve a wider constituency of stakeholders?
Issues in governance (2)• Who are the shareholders – should boards respond
to the demands of institutional investment managers or the needs of the ultimate beneficiaries?
• The role of institutional investors – should they actively intervene in strategy?
• Establishing the specific role of the board – in particular the role of non-executive directors.
• Scrutiny and control – statutory requirements and voluntary codes to regulate boards.
Different governance systems
Table 4.1 Benefits and disadvantages of governance systems
The role of boards
• Operate ‘independently’ of themanagement – the role of non-executives is crucial.
• Be competent to scrutinise the activities of managers.
• Have time to do their job properly.• Behave appropriately given expectations
for trust, role fluidity, collective responsibility, and performance.
Corporate social responsibilityCorporate social responsibility (CSR) is the commitment by organisations to ‘behave ethically and contribute to economic development while improving the quality of life of the workforce and their families as well as the local community and society at large’.1
1 World Business Council for Sustainable Development.
Corporate social responsibility stances
Table 4.2 Corporate social responsibility stances
Questions of corporate social responsibility – internal aspects (1)
Table 4.3 Some questions of corporate social responsibility
Questions of corporate social responsibility – external aspects (2)
Table 4.3 Some questions of corporate social responsibility (Continued)
The ethics of individuals and managersEthical issues have to be faced at the individual level :• The responsibility of an individual who believes
that the strategy of the organisation is unethical – resign, ignore it or take action.• ‘Whistle-blowing’ - divulging information to the authorities or media about an organisation if
wrong doing is suspected.
26
External Influences are importantPrivate sector“Many of the failures in the last 18 months can be traced back to
poor strategies & business models, which investors had approved or not challenged”
Hector Sants ,CEO, FSA, Feb09
Public Sector“One of the worst NHS hospital care scandals – in which up to 1,200 patients died – could happen again, campaigners warned yesterday. As a full public inquiry opened into the appalling standards of care at the Mid-Staffordshire NHS Foundation Trust”, Julie Bailey said “little had changed at the hospital and complaints were still being routinely ignored.”
Source: http://www.dailymail.co.uk/news/article-1327766/Mid-Staffordshire-NHS-hospital-scandal-left-1-200-dead-happen-again.html#ixzz1bDNTl0QJ
Stakeholders (a reminder)
OrganizationSuppliers Customers
Public Authorities
Staff Directors
Stakeholders are – groups of people who are affected by what the company does, therefore they should be able to influence what the company does.
Investors
Stakeholders of a large organisation
Figure 4.3 Stakeholders of a large organisationSource: Adapted from R.E. Freeman, Strategic Management: A Stakeholder Approach, Pitman, 1984. Copyright 1984 by R. Edward Freeman.
StakeholdersTypical stakeholders• Primary stakeholder - for companies = shareholders? - Public sector and charities = customers, patients, students etc• Secondary stakeholders?
– Management and staff– Suppliers– Customers– Community groups – Interest groups – direct action (WWF, Greenpeace, Friends of Earth)
These secondary stakeholders usually have – - no financial stake, - no rights at corporate AGMs, - no fiduciary rights over management ,or - no reporting rights over EA.
Their influence is therefore often indirect
Stakeholder governance matters therefore reflect
• CG guidance shows that decisions should also include the interests of these groups? - King III especially
• Companies Act 2006 (Business Review), OECD CG guide (2004) take into account these issues
• Most companies place profit above stakeholder needs (Mallin: p56) – foreign investment ,– international outsourcing
• Stakeholder mapping – balance of interest versus power?
• Stakeholder satisfaction
Companies Act 2006Effective from Oct 1 2007Aligns UK Law with EU Accounts Modernization Directive (2005)
The Business Review (S417):• A statement of business in previous financial year• A fair review of performance in previous financial year & the year end
financial position• Includes environmental, employment, social & community issues• Includes discussion of methods & measure of financial & non-financial
performance• A fair projection of the business’s prospects , including an analysis of key
events (risks) that are likely to affect the company.
• Not a prescriptive checklist – just broad guidelines for content/process which can be modified to suit company
• But, the EAs should check to see if the review accords with evidence from the accounts.
Companies Act 2006 (Business Review)The business review must contain—(a) a fair review of the company’s business, and (b) a description of the principal risks and uncertainties facing the company.The review required is a balanced and comprehensive analysis of—(a) the development and performance of the company’s business during the financial year, and(b) the position of the company’s business at the end of that year, consistent with the size and
complexity of the business.In the case of a quoted company the business review must, to the extent necessary for an understanding of the development, performance or position of the company’s business, include—(a) the main trends and factors likely to affect the future development, performance and position of
the company’s business; and (b) information about— (i) environmental matters (including the impact of the company’s business
on the environment), (ii) the company’s employees, and (iii) social and community issues, including information about any policies of the company in relation to those matters and the effectiveness of those policies; and
(c) subject to subsection (11), information about persons with whom the company has contractual or other arrangements which are essential to the business of the company.
If the review does not contain information of each kind mentioned in paragraphs (b)(i), (ii) and (iii) and (c), it must state which of those kinds of information it does not contain.
The review must, to the extent necessary for an understanding of the development, performance or position of the company’s business, include—(a) analysis using financial key performance indicators, and (b) where appropriate, analysis using
other key performance indicators, including information relating to environmental matters and employee matters
Business Review -2010 Survey
Stakeholder conflicts of expectations
Table 4.4 Some common conflicts of expectations
Stakeholder mappingStakeholder mapping identifies stakeholder expectations and power and helps in understanding political priorities.
Stakeholder mapping: the power/interest matrix
Figure 4.4 Stakeholder mapping: the power/interest matrixSource: Adapted from A. Mendelow, Proceedings of the Second International Conference on Information Systems, Cambridge, MA, 1986
Stakeholder mapping issues• Determining purpose and strategy – whose
expectations need to be prioritised?• Do the actual levels of interest and power reflect
the corporate governance framework?• Who are the key blockers and facilitators of
strategy?• Is it desirable to try to reposition certain
stakeholders?• Can the level of interest or power of key
stakeholders be maintained?• Will stakeholder positions shift according to the
issue/strategy being considered.
PowerPower is the ability of individuals or groups to persuade, induce or coerce others into following certain courses of action.
Sources of power
Table 4.5 Sources and indicators of power
Indicators of power
Table 4.5 Sources and indicators of power (Continued)
Summary (1)• An important managerial task is to decide how the
organisation should express its strategic purpose through statements of mission, vision, values or objectives.
• The purpose of an organisation will be influenced by the expectations of its stakeholders.
• The influence of some key stakeholders is represented formally within the governance structure of an organisation. This can be represented in terms of a governance chain, showing the links between ultimate beneficiaries and the managers of an organisation.
Summary (2)• There are two generic governance structures systems:
the shareholder model and the stakeholder model though there are variations of these internationally.
• Organisations adopt different stances on corporate social responsibility depending on how they perceive their role in society. Individual managers may face ethical dilemmas relating to the purpose of their organisation or actions it takes.
• Different stakeholders exercise different influence on organisational purpose and strategy, dependent on the extent of their power and interest. Managers can assess the influence of different stakeholder groups through stakeholder analysis.
CASE DISCUSSION : GOOGLE
Case - Nonmarket Environment of Google• EU law required data holders to store an
individual’s data only as long as necessary• Google launched a nonmarket campaign to
influence the FCC’s design of the auction• Google did not use material from a media
source that requested that it not do so, but in the absence of such a request it used the material
1-44
Case - Nonmarket Environment of Google• Google began to supplement its News service
by inviting, individuals and organizations that had been mentioned in an article to offer comments attached as a link on the story page
• The government asked for data on search queries that it could use to develop filtering technology to which Google refused and found itself on the other side of the law
1-45
Case - Nonmarket Environment of Google• Google assigned a team to develop
Google Health, which proclaimed on a prototype Web page
• Google also announced an open source mobile phone platform called Android that could be used to develop new wireless services
1-46
Case - Nonmarket Environment of Google• Google advocated “net neutrality” and
sought laws to require ISPs to treat all Internet traffic alike
• The company pledged to become carbon neutral and announced a project backed by hundreds of millions of dollars to reduce the cost of renewable energy by 25–50 percent
1-47
2.2 MANAGEMENT &
CONTROL
Management & Control• The main devices or mechanisms that are
believed to ensure that managers run the firm in the interests of the shareholders and punish badly performing managers
• The effectiveness and importance of these mechanisms across various corporate governance systems. – The market for corporate control and hostile takeovers, – dividend policy, – the board of directors, – institutional shareholders, – shareholder activism, – managerial compensation, – managerial ownership, – monitoring by large shareholders and creditors/banks.
Learning OutcomesBy the end of this lecture, you should be able to:
1. Assess the importance of various corporate governance devices across the main systems of corporate governance
2. Judge the efficiency of the various devices in terms of preventing bad performance by the management and/or disciplining bad managers
3. Critically evaluate the empirical research on the importance and effectiveness of corporate governance devices
4. Identify the gaps in the existing literature.
• Corporate governance devices or mechanisms are arrangements that mitigate conflicts of interests corporations may face.
• These conflicts of interests are those that may arise between– the providers of finance and managers,– the shareholders and the stakeholders, and– different types of shareholders (mainly the large
shareholder and the minority shareholders).
Introduction
• Particular corporate governance mechanisms are more likely to prevail in one corporate governance system than in others.
• The reason is that the prevalence of the above conflicts of interests is also likely to vary across systems.
• Hence, in order to study the effectiveness of the various corporate governance devices, one needs to adopt one of the taxonomies of corporate governance systems.
Introduction (Continued)
• We adopt the taxonomy by Julian Franks and Colin Mayer which distinguishes between insider and outsider systems.
• We adopt this taxonomy for two reasons1. It does not advocate the superiority of
one system2. It provides a broad, yet convenient
framework to analyse the various corporate governance devices.
Introduction (Continued)
Product Market Competition
• Competition in product and service markets may reduce managerial slack across all corporate governance systems.
• For example, a French manufacturer of household appliances operates in the same global market as manufacturers from other countries.
• If the French manufacturer suffers from weak corporate governance, it may ultimately be driven out of the market.
Product Market Competition (Continued)• Benjamin Hermalin has developed a
theoretical model about the effects of competition on managerial (agent) performance.
• He argues that competition has four distinct effects on managerial performance– the income effect,– the risk-adjustment effect, – the change-in-information effect, and– the effect on the value of managerial actions.
• The income consists of the following– expected income decreases with increased
competition,– but it also puts pressure on managers to
perform better by e.g. reducing their perks as well as other costs.
• The risk-adjustment effect concerns the fact that competition changes the riskiness of the various actions managers can take.
Product Market Competition (Continued)
• The change-in-information effect consists of the following– Competition makes it easier for the principal to
judge the agent’s actions as there is now a (larger) peer group of other companies
– Competition also has an effect on managerial actions by reducing the riskiness of both easy and hard actions
– However, the decrease in riskiness may not necessarily be uniform across both easy and hard actions
– Hence, it is not clear whether managers will switch from easy to hard actions or the converse.
Product Market Competition (Continued)
• Increased competition also changes the relative value of managerial actions– By reducing the price cap, competition reduces the agent’s
expected income and hence his incentives to work hard– However, it also increases the value attached to cost saving
actions by the agent, making the latter work harder.• A priori, all of the above four effects have ambiguous
signs.• Hermalin shows that under certain conditions the
positive income effect will dominate and
competition will increase managerial performance.
Product Market Competition (Continued)
• However, generally it is still not clear whether increased competition increases or decreases managerial performance.
• While empirical evidence on the effect of competition is still sparse, the studies that exist suggest that – competition forces managers to work harder,
and
– it may even be a substitute for good corporate governance.
Product Market Competition (Continued)
Incentivising and Disciplining Managers in the Insider and Outsider Systems
• The main mechanisms that are thought to keep managers in check in the outsider system are– the market for corporate control,– dividend policy,– the board of directors,– institutional shareholders,– shareholder activism,– managerial remuneration, and– managerial ownership.
Incentivising and Disciplining Managers in the Insider and Outsider Systems (Continued)• In the insider system, they are
– monitoring by large shareholders, and– monitoring by banks and other large creditors.
The Market for Corporate Control• The disciplinary role of the market for
takeovers was first proposed by Henry Manne.
• Badly performing firms see their share price drop.
• They then become easy targets for hostile raiders intend on changing the management, thereby creating firm value.
• However, the empirical evidence does not support Manne’s argument.
The Market for Corporate Control (Continued)
• A US study by William Schwert and a UK study by Julian Franks and Colin Mayer investigate the pre-acquisition performance of targets of hostile takeovers and targets of friendly takeovers.
• Hostility is defined as the target management’s attitude toward the proposed takeover bid.
• Neither the US nor the UK study finds any difference in the pre-acquisition performance of both types of targets.
• However, the mere threat of a hostile takeover may be enough to ensure that managers do not shirk.
• Still, hostile takeovers are an extreme and expensive mechanism to correct managerial failure.
• They also tend to be very rare outside the UK and the USA.
The Market for Corporate Control (Continued)
Dividends and Dividend Policy• Frank Easterbrook and Michael Rozeff were
the first to formalise the corporate governance role of dividends.
• In Rozeff’s model, dividends reduce agency costs by reducing the free cash flow.
• However, they also increase transaction costs as higher dividends increase the need for costly external financing.
• Hence, there is an optimal dividend payout which minimises the sum of both costs.
Dividends and Dividend Policy (Continued)• Easterbrook also argues that by committing to
high dividends the free cash flow is kept to a minimum and wastage by the managers is reduced.
• In addition, the firm has to raise regularly outside finance.
• Each time it does so it subjects itself to the scrutiny of outsiders.
• If the managers have been performing badly, then outside finance is unlikely to be made available.
• For dividends to be able to fulfil their disciplinary role, they need to be sticky.
• Managers will need to carry on paying dividends even if profits are down temporarily.
• The role of dividends is likely to be more important in the outsider system given the lack of shareholder monitoring.
Dividends and Dividend Policy (Continued)
• Marc Goergen, Luc Renneboog and Luis Correia da Silva study the flexibility of German dividends compared to UK and US dividends.
• They find that, when profits are down temporarily, German firms are much more willing to cut or omit their dividends than UK and US firms.
• German firms controlled by banks are even more willing to cut or omit their dividends.
• They conclude that large shareholder monitoring acts as a substitute for dividends.
Dividends and Dividend Policy (Continued)
Boards of Directors• UK and US firms as well as firms from most
other countries have a single-tier board where both executive and non-executive directors sit.
• A few countries, such as Germany and China, have two separate boards, the so called two-tier board.
• The two-tier board consists of– the supervisory board where the non-executives (as
well as maybe employee representatives) sit, and– the management board where the executives sit.
Boards of Directors (Continued)• There is an ongoing debate about whether a
single- or two-tier board is better.• Some argue that having two boards ensures
the independence of the non-executives from the executives.
• Others argue that having two boards prevents the non-executives from being effective monitors due to a lack of information.
• Is there a link between board structure and financial performance?
• Do boards fire executives in the wake of poor performance?
• What factors determine board changes?• Should the roles of the chairman and the CEO
be separated?
Boards of Directors (Continued)
Is There a Link between Board Structure and Financial Performance?• The proportion of non-executives is normally
used as a measure of board independence.• Boards that are dominated by non-executives are
likely to be more independent from the management.
• However, there is little evidence in support of a positive link between firm performance and board independence.
• However, board composition may not be exogenous, i.e. it may not be randomly determined.
Is There a Link between Board Structure and Financial Performance? (Continued)• For example, board composition may be
determined by past performance.• If poor performance causes an increase in the
number of non-executives, then this would explain why no link has been found between firm performance and board independence.
• In contrast, there is conclusive evidence that large boards are bad for firm performance.
• There is also evidence that interlocked directorships cause collusion.
Do Boards Fire Executive Directors inthe Wake of Poor Performance?
• There is consistent evidence of an increase in CEO and board turnover in the wake of poor performance.
• There is such evidence for both corporate governance systems– the outsider system of the UK and the USA, as well as– the insider system of Germany and Japan.
• However, board dismissals cannot be equated to good corporate governance.
• Managerial dismissals also only occur in cases of extremely poor performance.
What Factors Determine Board Changes?
• Benjamin Hermalin and Michael Weisbach find that– inside directors are more likely to be replaced by
outside directors in poorly performing companies;
– inside directors normally replace retiring CEOs;– when the CEO is replaced by an outsider, some
inside directors – possibly the losers in the contest to the succession – leave the firm; and
– firms leaving their product market replace their inside directors with outside directors.
What Factors Determine Board Changes? (Continued)
• Steven Kaplan and Bernadette Minton find that banks appoint representatives to the boards of poorly performing Japanese firms that are part of keiretsus.
Should the Roles of the Chairman and CEO Be Separated?• There has been an ongoing debate as to whether
the roles of the chairman and the CEO should be separated or whether duality is preferable.
• Proponents of duality base themselves on the following three arguments1. Duality ensures that there is strong leadership2. Splitting the two roles may create tensions
between the CEO and chairman3. Having a separate CEO and chairman makes it difficult
to designate a single spokesperson for the company.
Should the Roles of the Chairman and CEO Be Separated? (Continued)
• Those opposed to duality argue that1. Combining the two roles reduces board
independence and increase CEO entrenchment2. It combines the role of monitoring the
executives and leading the executives in a single person.
• In the USA, minds are still split as to whether duality is good or bad.
• The empirical evidence on US firms is also as yet inconclusive.
• In contrast, in the UK successive codes of best practice in corporate governance have recommended the separation of the two roles.
• In contrast to US evidence which is inconclusive, evidence from UK firms seems to suggest that duality has no effect on performance.
Should the Roles of the Chairman and
CEO Be Separated? (Continued)
Institutional Investors• Institutional investors are the most
important types of shareholders in the UK and the USA as well as a few other countries (e.g. the Netherlands).
• However, the jury is still out as to whether institutional investors monitor the management of their investee firms.
• Some studies find positive effects of institutional investors– They have a positive effect on firm value– They increase the performance sensitivity of
managerial pay– They reduce the levels of managerial pay.
Institutional Investors (Continued)
• Other studies find negative effects of institutional investors – They reduce firm value– They have short-term horizons– They increase the likelihood and severity of
financial misreporting.
Institutional Investors (Continued)
• In the UK, successive codes of best practice in corporate governance have urged institutional investors to become more active.
• The 2001 Myners Report states that – institutional investors “remain unnecessarily
reluctant to take an activist stance in relation to corporate underperformance, even where this would be in their clients’ financial interests”.
• A number of UK studies suggest that institutional investors are mostly passive and prefer exit over voice.
Institutional Investors (Continued)
• Jana Fidrmuc, Marc Goergen and Luc Renneboog study the price reaction to insider trades in UK firms
• They expect that monitoring reduces the information conveyed by insider trades.
• They find that the price reaction – is highest for firms dominated by
institutional investors, and– lowest for firms dominated by families
and other firms.
• They interpret this as evidence that institutional investors are passive.
Institutional Investors (Continued)
• However, evidence from case study research by Marco Becht and others suggests that institutional investors act behind the scenes.
• Still, from an agency perspective it is not clear why institutional investors should be the panacea to all corporate governance issues.
Institutional Investors (Continued)
Shareholder Activism• Shareholders may prefer to act behind the
scenes to address poor managerial performance in their investee firms.
• However, they may use so called proxy contests as a means of last resort if management remains unresponsive.
• Proxy contests consist of soliciting the support of other shareholders, via their votes, to bring about change.
Shareholder Activism (Continued)
• While shareholder-initiated proxy voting is frequent in the USA and on the increase in the UK, it is relatively rare in Continental Europe.
• Whereas proxy contests are relatively successful in the USA, they are less successful in the UK and Continental Europe.
• Nevertheless, managers of US firms are not legally bound to implement shareholder proposals whereas they have to in the UK and most of Continental Europe.
• The stock market reaction to proxy contests is also different between the USA and the UK-Continental Europe– In the USA, the stock price reaction is normally
positive– In the UK and Continental Europe, it is negative
suggesting that the market interprets proxy contests as a signal of shareholder discontent rather than positive change.
Shareholder Activism (Continued)
Managerial Compensation
• One possible way of aligning the interests of the managers with those of the shareholders is managerial compensation.
• By making managerial compensation sensitive to firm performance, managers
should have the right incentives to maximise shareholder value.
Managerial Compensation (Continued)
• Managerial compensation may consist of various components including– the base (or cash) compensation,– long-term incentive plans (LTIPs) such as stock
options and restricted stock grants,– benefits, and– perquisites.
Figure 1 – Level and composition of CEO pay for 2005
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2005 CEO Pay Mix: International Comparison
Salary Bonus Option/LTIPs Other
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
Is Managerial Compensation Sensitive to Firm Performance
• Pay sensitivity to performance has been documented for a range of countries, including the USA, the UK and Germany.
• However, other factors have also been shown to have an effect– firm size, and– ownership and control.
Is Managerial Compensation Sensitive to Firm Performance (Continued)
• An important factor influencing managerial pay is firm size.
• This suggests that executive directors benefit from empire building via increased salaries.
• The empirical evidence suggests that this is a concern– Firms where managerial compensation is sensitive to
firm size are more likely to conduct acquisitions
– Managers experience a net increase in their compensation despite the drop in post-acquisition stock performance and sales
– Managerial compensation increases in line with good post-acquisition performance, but is insensitive to bad performance
– In contrast, changes in compensation after large capital expenditures are much smaller and also more sensitive to poor performance
– Managers seem to use the higher information asymmetry surrounding acquisitions to boost their compensation.
Is Managerial Compensation Sensitive to
Firm Performance (Continued)
• Another factor influencing managerial pay is ownership and control–Widely held firms have been reported to
have higher managerial compensation than firms with large shareholders
–This suggests that large shareholder monitoring is a substitute for managerial incentivising via compensation packages.
Is Managerial Compensation Sensitive to
Firm Performance (Continued)
• Some argue that– managerial compensation is unlikely to address
corporate governance issues, and– it is a corporate governance issue in itself as
directors of firms with poor governance are able to set their own, excessive pay.
• Managerial pay has also been shown to be asymmetric as– it increases with good luck,– but not with bad luck.
Is Managerial Compensation Sensitive to
Firm Performance (Continued)
Lucian Bebchuk and Jesse Fried go one step further.• They argue that managers are entirely self-
serving and they maximise their pay subject to a public outrage constraint.
Is Managerial Compensation Sensitive to
Firm Performance (Continued)
How Should One Design ManagerialCompensation Contracts?• There is an extensive theoretical and empirical
literature on the design of managerial compensation.
• Both stock ownership and stock options have their advantages and drawbacks.
• Stock ownership seems to make managers even more risk averse given its downside.
• Stock options address this issue as they have a limited downside.
• However, they also seem to exacerbate conflicts of interests between managers and shareholders.
Managerial Ownership• The principal–agent problem stems from
the separation of ownership and control.• One way of mitigating this problem is to
give managers shares in their firm.• However, managerial ownership may also
entrench managers.• Hence, there may be two sides to
managerial ownership.
Managerial Ownership (Continued)• Two types of studies analyse the
link between performance and managerial ownership– Those that assume
ownership to be exogenous, i.e. determined outside the system
– Those that assume ownership to be endogenous, i.e. ownership may depend on firm characteristics such as past performance.
Studies Assuming Managerial Ownership to be Exogenous• Morck, Shleifer and Vishny allow for a non-linear
relationship between managerial ownership and firm value for the USA.
• They find evidence of such a non-linear relationship– Firm value rises with ownership in the 0–5% region– It then decreases in the 5–25% region to reach its
minimum value– It then increases again above 25% ownership, but at a
decreasing rate.
Studies Assuming Managerial Ownership to be Exogenous (Continued)
• There are three criticisms of this study–It has low explanatory power–Being a US study, there is low cross-
sectional variation of ownership–The study ignores non-managerial
ownership.
Studies Assuming Managerial Ownership to be Exogenous (Continued)
• Karen Wruck looks at 128 US firms with large changes of ownership.
• She includes non-managerial ownership.• She replicates the Morck et al. model
– She finds the same effects for the 0–5% and 5–25% ranges
– However, she only finds a positive effect in the 25–100% range when she considers total ownership.
Studies Assuming Managerial Ownership to be Exogenous (Continued)
• John McConnell and Henri Servaes clearly distinguish between managerial and non-managerial ownership.
• They find a curvilinear link between firm value and managerial ownership.
• Firm value reaches its maximum in the 40–50% ownership range.
• They also find a positive linear link between firm value and institutional ownership.
Studies Assuming Managerial Ownership to be Exogenous (Continued)
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8
MSV
McC&S
Wruck
Managerial ownership
Firm value
Studies Assuming Managerial Ownership to be Endogenous (Continued)
• These studies allow for current managerial ownership to depend on past firm characteristics, including firm performance.
• These studies do not tend to find a link between managerial ownership and firm value.
Studies Assuming Managerial Ownership to be Endogenous (Continued)
• Stacey Kole argues that if ownership influences firm value, there should be corrective transfers.
• She uses the same sample as Morck et al. • She finds the same effects for the 0–5% and 5–25%
ranges, but no effect above 25%.• She then regresses performance for each of the
years 1977–85 on 1980 ownership.• She finds a link for the years 1977–80, but no link
for the years 1981–85.
Studies Assuming Managerial Ownership to be Endogenous (Continued)
• She concludes that there should be a reversal of causality as past performance seems to have an effect on current managerial ownership.
Studies Assuming Managerial Ownership to be Endogenous (Continued)
• In addition to managerial ownership, Anup Agrawal and Charles Knoeber look at the following six governance mechanisms– institutional ownership,– large shareholder monitoring,
– non-executives directors,– the managerial labour market,– the market for corporate control, and– monitoring by debtholders.
• They employ a whole battery of econometric techniques.
Studies Assuming Managerial Ownership to be Endogenous (Continued)
• The only persistent effect they find is a negative effect of non-executives on firm value.
• They explain this negative effect by the fact that non-executives frequently represent interest groups other than the shareholders with objectives other than shareholder value maximisation.
• Charles Himmelberg, Glenn Hubbard and Darius Palia allow for both ownership and firm performance to be endogenous.
• They do not find that current performance depends on past ownership either.
Large Shareholder Monitoring• Do large shareholders enhance firm value?• Some theoretical research suggests that large
shareholders create value via their monitoring which overcomes the free-rider problem.
• Generally, there is little empirical evidence that large shareholders create value.
• Nevertheless, there is some evidence from the USA and Germany that family control creates value.
• However, this only seems to be the case when the founder is the CEO or chairman.
Large Shareholder Monitoring (Continued)
• In contrast, when one of the founder’s descendents acts as the CEO there is normally value destruction.
• Finally, evidence on East Asian countries by Faccio et al. suggests that families expropriate the minority shareholders by paying out dividends that are too low.
• Other theoretical papers argue that large shareholders may overmonitor the management.
Bank and Creditor Monitoring
• Debt on its own may be a powerful disciplinary mechanism.
• As debt commits part of the firm’s cash flows to its servicing, it reduces managerial discretion and wastage.
• Firms with a large creditor may also benefit from the monitoring by the latter.
Bank and Creditor Monitoring (Continued)
• As the German system has been traditionally qualified as being bank based, there is a body studying the effects of German banks on firm performance.
• However, the evidence is as yet inconclusive as to the effect of bank ownership and board representation on firm performance.
Conclusions• The relative importance of
corporate governance mechanisms varies across the insider and outsider system.
• The effectiveness of the various corporate governance mechanisms.
• The likely endogeneity of corporate governance mechanisms.
• The interdependence of corporate governance mechanisms.
2.3 THE ROLE OF BOARDS
The Role of Boards inCorporate Governance• What is the role of Boards of directors in corporate
governance, mainly from a UK perspective, with reference to the academic literature.
Learning Outcomes
By the end of this lecture, you should be able to:• explain the main initiatives introduced in the UK to
improve the effectiveness of boards of directors; • evaluate the impact of these initiatives on board
function; • discuss the findings of academic research relating to
the effectiveness of boards as a corporate governance mechanism.
Corporate Governance: A Practical Guide An 'effective board' should have:
• clear strategy aligned to capabilities• vigorous implementation of strategy• key performance drivers monitored• effective risk management• sharp focus on views of City and other key
stakeholders• regular evaluation of board performance.
The Fish Rots from the Head (Garratt, 1996)• Said boards spent too much
time ‘managing’• Not enough time ‘directing’• Should be 'learning boards'
Unitary and Two-tier Board StructuresUnitary boards (UK, US)• executive and non-executive directors• make decisions as a unified groupTwo-tier boards (Germany, Taiwan)• 2 separate boards• management board• supervisory board
Two-Tier Board
Management board• only executives• focuses on operational issues• headed by chief executiveSupervisory board• only non-executive directors• deals with other strategic decisions• oversees the management board• chairman sits as a non-executive• often a vehicle for stakeholder inclusion
One-Tier modelUK & USA
• We examine 3 mechanisms for improving corporate governance in boards
• Splitting chairman/chief executive position• Improve effectiveness of NEDs• Curb excessive executive remuneration
Splitting the Role of Chairman and Chief Executive: one-tier boardsChairman• pivotal role in helping the board to achieve its
potential• responsible for leading the board• responsible for setting the board agenda• responsible for ensuring board effectiveness• 'conductor of an orchestra'
Chief Executive
• determines corporate strategy
• manages day to day running of business
Cadbury Report emphasised:• No individual could gain ‘unfettered’ control of the
decision-making process• Should be a clear division of responsibility at the top
of the company, ensuring balance of power• 90% UK listed companies split roles after Cadbury
Higgs Report (2003)re-emphasized split roles:• "The roles of chairman and chief executive should
not be exercised by the same individual"• The essence of these recommendations, among
others made by Higgs, was incorporated in the Combined Code in July 2003.
Research into Split Roles • Donaldson and Davies (1994)• Splitting roles can reduce agency problems and
result in improved corporate performance because of more independent decision making
• Peel and O'Donnell (1995)• Found that splitting roles led to significantly higher
financial performance
Split Roles in the US• US has been slower to take up split roles• But things are changing• CEO wields excessive power• US boards are excessively large• "American companies should adopt the common
European practice of separating the jobs of chairman and chief executive, entrenching a check at the heart of their corporate governance systems. " (The Economist, 28 November 2002)
The Role of Non-executive Directors (NEDs)• Collapse of Enron focused attention on NEDs• Tyson Report specified NED role:• provide advice and direction to company management
in developing and evaluating strategy• Monitor company management in strategy
implementation and performance• monitor company's legal and ethical performance• Monitor veracity and adequacy of financial/ other
company information provided to investors and other stakeholders
• assume responsibility for appointing, evaluating and, where necessary, removing senior management
• planning succession for top management positions.
Byrd and Hickman (1992, p.196)
• "The inside directors provide valuable information about the firm’s activities, while outside directors may contribute both expertise and objectivity in evaluating the managers’ decisions. The corporate board, with its mix of expertise, independence, and legal power, is a potentially powerful governance mechanism“
Higgs Report emphasized NEDs must have:
• integrity• high ethical standards• sound judgement• ability and willingness to
challenge issues• strong interpersonal skills
• "no crooks, no cronies, no cowards"!
Non Executive Directors
Spira and Bender (2004)• discussed tension between the strategic and
monitoring roles of NEDs
Cadbury Report recommended:• minimum of 3 NEDs• majority NEDs should be independent
Higgs Report 20 January 2003 based on 3 pieces of research:• data on the size, composition and membership of
boards and committees in the 2,200 UK listed companies, as well as the age and gender of their directors
• survey of 605 executive directors, non-executive directors and chairmen of UK listed companies conducted by MORI
• interviews of 40 directors in top UK listed companies carried out by academics in the field
Recommendations: NED
• NEDs should comprise at least half board• One NED should take direct responsibility for
shareholder concerns (SID)
• Strong reaction from business community:• "This could lead to multiple splits in the board which
every man and wife could come along and exploit. And that would be a madhouse"
The Tyson Report: Widening the 'Gene Pool'
• NEDs criticized as "Pale, stale and male"• Higgs also suggested NEDs should come from more
diverse backgroundsTyson Report explored greater diversity:• background• skills• experience of members• race• gender• nationality• age
Milliken and Martins (1996)• Emphasized the importance of board diversity to
effectiveness and financial performance• Widening boardroom diversity also helps companies
engender trust among their stakeholders
Some organisations providing broader source of NEDs• Association of Executive Search Consultants• Charity and Fundraising Appointments• High Tech Women• City Women's Network.
NEDs and the Credit Crunch
• Deficiencies in NEDs role within financial institutions contributed to current global financial crisis
• FT article during financial crisis said companies need to:
• improve the qualifications and on-going training for NEDs
• pay more attention to the relevant experience and competence when recruiting NEDs
• Increase the time commitment given by NEDs
Executive Remuneration
• ‘Fat cats’• Higgs Report• Company chairmen in FTSE 100 companies were
earning £426,000 per annum on average• This was in 2003!
ACCA, 2008, Principles 6
• "Remuneration arrangements should be aligned with individual performance in such a way as to promote organizational performance. Inappropriate
arrangements, however, can promote perverse incentives that do not properly serve the organisation's shareholders or other principal stakeholders"
Greenbury Report 1995Recommended remuneration committees to:• "determine pay packages needed to attract, retain
and motivate directors of the quality required but should avoid paying more than is necessary for this purpose“
Core, Holthausen and Larcker (1999) • Found links between excessive executive
remuneration, ‘bad’ corporate governance and poor corporate performance
Pay and PerformanceThompson (2005)• found various initiatives
to make executive remuneration more transparent had not had much impact on the relationship between executive pay and performance
Voting on Directors’ Remuneration • October 2001 the UK Government
announced proposals to produce an annual directors’ remuneration report that would be approved by shareholders
• No need to legislate as investors have acted in this area
Bonuses and the Financial Crisis
January 2009• French President, Nicolas Sarkozy, insisted on
bonuses and dividends being reduced for executives in French banks
• BNP Paribas, France's largest bank, chairman and chief executive forwent their 2008 bonuses voluntarily, in response to public dissatisfaction
UK Shareholders, Remuneration and the Global Financial Crisis • Grave concerns about excessive remuneration
packages• Institutional investor representative bodies• (ABI) (NAPF) caution companies against paying out
large bonuses to senior executives • UK institutional shareholders voted against
remuneration policies• Currently discussion on taxing bank directors’
bonuses when peoples’ taxes are paying off the banks’ debts!
RECIPE FOR A GOOD BOARD• The board should meet frequently• The board should maintain a good balance of power• An individual should not be allowed to dominate board
meetings and decision making• Members of the board should be open to other members’
suggestions• There should be a high level of trust between board
members• Board members should be ethical and have a high level of
integrity• There must be a high level of effective communication
between members of the board• The board should be responsible for the financial statements• Non-executive directors should (generally) provide an
independent viewpoint
Good Board …• The board should be open to new ideas and strategies• Board members should not be opposed to change• The board must possess an in-depth understanding of the
company’s business• The board must be dynamic in nature• The board must understand the inherent risks of the business• The board must be prepared to take calculated risks: no risk
no return• The board must communicate with shareholders, be aware
of shareholder needs and translate them into management strategy
• The board must be aware of stakeholder issues and be prepared to engage actively with their stakeholders
• As education becomes increasingly important, board members should not be averse to attending training courses
Ethical Health of BoardsACCA, 2008, Principle 2
• "Boards should set the right tone and behave accordingly, paying particular attention to ensuring the continuing ethical health of their organizations. Directors should regard one of their responsibilities as being guardians of the corporate conscience … Boards should ensure they have appropriate procedures for monitoring their organisation's 'ethical health‘”
Core Readings• Solomon, Jill (2010) Corporate Governance and
Accountability 3rd Edition, Wiley, UK. Ch.4-5• Goergen, Marc (2012) International Corporate
Governance, Pearson. Ch.5, 9-10• Larker & Tayan (2011) Ch.3-5,12• Monks & Minow (2011) Ch.2 & 3• Johnson, Scholes & Whittington(2008) Ch.4• CIMA - Performance Strategy: Study Text (2011) BPP
Learning Media Ltd. Part B : 5-6• Baron, David P.(2013) Business and its environment, 7th
Edition, Pearson
Additional Readings (1)• Byrd, J. W. and Hickman, K. A. (1992) ‘Do outside directors monitor
managers?’, Journal of Financial Economics, 32, 195–221.• Donaldson, L. and Davies, J. H. (1994) ‘Boards and company
performance—Research challenges the conventional wisdom’, Corporate Governance: An International Review, 2(3), July, 151–160.
• Peel, M. and O’Donnell, E. (1995) ‘Board structure, corporate performance and auditor independence’, Corporate Governance: An International Review, 3(4), October, 207–217.
• Milliken, F. J. and L. L. Martins (1996) "Searching for Common Threads: Understanding the Multiple Effects of Diversity in Organisational Groups", Academy of Management Review, 21, pp.402-433.
• Core, J. E., Holthausen, R. W. and Larcker, D. F. (1999) ‘Corporate governance, chief executive officer compensation, and firm performance’, Journal of Financial Economics, 51, 371–406.
• Thompson, S. (2005) "The Impact of Corporate Governance Reforms on the Remuneration of Executives in the UK", Corporate Governance: An International Review, Vol.13, No.1, January, pp.19-25.
Additional Readings (2)• Berle, A. and Means, G. (1932) The Modern Corporation and Private Property, New York.• Monks, R. A. G. (1994) ‘Tomorrow’s corporation’, Corporate Governance: An International Review, 2(3), July, 125–
130.• Nesbitt, S. L. (1994) ‘Long-term rewards from shareholder activism: A study of the “CalPERS effect”’, Journal of
Applied Corporate Finance, 6, 75–80.• Stapledon, G. P. (1995) ‘Exercise of voting rights by institutional shareholders in the UK’, Corporate Governance: An
International Review, 3(3), 144–155.• Stapledon, G. P. (1996) Institutional Shareholders and Corporate Governance, Clarendon Press, Oxford.• Smith, M. P. (1996) ‘Shareholder activism by institutional investors: Evidence from CalPERS’, Journal of Finance,
51(1), March, 227–252.• Agrawal, A. and Knoeber, C. R. (1996) ‘Firm performance and mechanisms to control agency problems between
managers and shareholders’, Journal of Financial and Quantitative Analysis, 31(3), September, 377–397.• Mallin, C. A. (1996) ‘The Voting Framework: A Comparative Study of Voting Behaviour of Institutional Investors in
the US and the UK’, Corporate Governance: An International Review, 4(2), April, 107–122.• Solomon, A. and Solomon, J. F. (1999) ‘Empirical evidence of long-termism and shareholder activism in UK unit
trusts’, Corporate Governance: An International Review, 7(3), July, 288–300.• Faccio, M. and Lasfer, M. A. (2000) ‘Do occupational pension funds monitor companies in which they hold large
stakes?’, Journal of Corporate Finance, 6, 71–110.• Solomon, J. F., Solomon, A., Joseph, N. L. and Norton, S. D. (2000) ‘Institutional investors’ views on corporate
governance reform: Policy recommendations for the 21st century’, Corporate Governance: An International Review, 8(3), July, 217–226.
• Mallin, C. A. (2001) ‘Institutional investors and voting practices: An international comparison’, Corporate Governance: An International Review, 9(2), April, 118–126.
• Myners (2001) Institutional Investment in the United Kingdom: A Review (The Myners Report), London.• MacKenzie, C. (2004) "Don't Stop Rattling Those Boardroom Chains: Corporate Activists Are Key to Maintaining
Shareholder Returns", Financial Times, 10th May, p.6.• National Association of Pension Funds (NAPF) (2005) Pension Scheme Governance - Fit for the 21st Century, NAPF
Discussion Paper, July.
Next Week’s Ideas for Discussion
• Morck, Randall and Yeung, Bernard (2003) Agency problems in large Family Business Groups, Entrepreneurship: Theory and Practice, Summer 2003. Vol. 27, No. 4: pp. 367 – 382
QUESTIONS?
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