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On the Efficiency of Internal and On the Efficiency of Internal and External Corporate External Corporate

Control MechanismsControl Mechanisms

Walsh, James P. and Seward, James K. (1990), Walsh, James P. and Seward, James K. (1990), Academy of Management ReviewAcademy of Management Review, 15 (3): 421-458, 15 (3): 421-458

Prepared by: Prepared by: Enrique, Lihong, John, Enrique, Lihong, John, JongkukJongkuk

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Introduction

In modern firms, owners usually diversify their holdings:

Owners usually do not monitor managers themselvesBoards of Directors are hired to monitor the managers for the owners

As the amount of influence of individual shareholders decrease, the influence of top management increases

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Owner’s Interests

To earn the maximum economic profit with a compatible degree of risk

To distribute the profits generously and equitably among the owners

To maintain market conditions favorable to the owner

(Berle & Means, 1932)

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Manager’s Interests

Unfortunately the management may be motivated by:

PrestigePowerGratification of professional zeal

This is the “agency problem”

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Internal Control Options

These are measures designed to bring the economic interests of managers and shareholders into alignment

Managerial vs. Environmental Assessments must be made:

Bad decisionsUnfavorable business environment

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Assessment

How does the board assess the situation?

From inside directorsBy comparing with other similar firms

Managers can become the scapegoats for poor performance

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Misplaced Misguided

Incompetent Shirking

High

Low

Low High

Effort

Ability

Figure 1: Inferences about top Management Performance

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Internal Control Options

Alter the incentives of top management

Are the incentives structured correctly?Increasing the magnitude of compensationTying compensation to firm results• Accounting rates of return• Use market measures like stock price

Dismiss top management

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Internal Entrenchment Practices

Alter personal assessments of the board

Withholding informationUsing outside consulting reports Set norms where they cannot be questioned

Alter Situation Assessments

Pointing out the environmental difficulties

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Internal Entrenchment PracticesAlter Performance Assessments

Set low expectationsRedefine performance metrics

Avoid Internal Control Mechanisms

Avoid pay-for-performance plansAim for high management salariesUse accounting measures for bonusesBecome non-substitutable (Lee Iacocca)

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Addressing Internal Control Inefficiencies

Include outside directors on the board

Increase the ownership of managers

May increase manager entrenchmentMay also align managers and owners

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External Control Options

The Market for Corporate Control

Assumptions:

• Underperformance will be represented in company stock

• Other management teams will compete for the company’s resources

• The firm will be acquired

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Reasons to Acquire a Firm

Reasons to Acquire

SynergiesTax SavingsWealth transfersHubrisElimination of inefficient management

Target firms usually increase in value

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Dual Class Re-capitalization

Acquisitions and divestitures

Greenmail

Poison Pills

New Securities

Spin offs, Sell offs etc.

Supermajority amendments

Fair Price amendments

State of incorporation

Voting Rights amendments

Litigation by target

Standstill Agreements

Anti-takeover amendments

Golden Parachutes

Shareholder Approval Required

No Shareholder Approval Required

Operating Non-Operating

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Effective GovernanceInternal: Incentives are designed appropriately and management responds appropriatelyExternal: None needed

Board ObstructionInternal: Incentives are designed inappropriately and management is scapegoated

External: Going private

Managerial DeadwoodInternal: Incentives are designed appropriately and management responds inappropriatelyExternal: Tender Offers

Governance FailureInternal: Incentives are designed inappropriately and management exhibits low ability and effortExternal: hostile takeovers

Good

Bad

Board of Directors

Good BadManagement

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International Perspectives

Different countries use different mechanisms

I.E., Japan generally does not use turnover as a control mechanism

Monitoring often comes from banks and capital sources

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Conclusions

Both internal and external controls are used by firms to control managers

Management can use various methods to entrench themselves against these controls

Work by financial economists and organizational theorists can be synthesized