Corporate Governance

Chapter 5

© 2006 by Nelson, a division of Thomson Canada Limited. 11-1

 Chapter 3
External The Strategic
Strategic
.

Inputs
Environment
The Strategic Management
Strat. Intent
Management
Process

.
Chapter 4 Strat. Mission
Internal Process
Environment

Strategy Formulation Strategy Implementation

Strategic Actions

Chapter 5 Chapter 6 Chapter 7 Chapter 11 Chapter 12

Bus. - Level Competitive Corp. - Level Corporate Structure
Strategy Dynamics Strategy Governance & Control

Chapter 8 Chapter 9 Chapter 10 Chapter 13 Chapter 14

Acquisitions & International Cooperative Strategic Entrepreneurship
Restructuring Strategy Strategies Leadership & Innovation
Outcomes
Strategic

Chapter 2 Chapter 1 Feedback

Above Average Strategic
Returns Competitiveness

© 2006 by Nelson, a division of Thomson Canada Limited. 11-2

 Corporate Governance

Knowledge objectives:
1. Define corporate governance & explain why it is used
to monitor & control managers’ strategic decisions.
2. Explain how ownership came to be separated from
managerial control in the modern corporation.
3. Define an agency relationship & managerial
opportunism & describe their strategic implications.
4. Explain how three internal governance mechanisms –
ownership concentration, the board of directors and
executive compensation – are used to monitor &
control managerial decisions.

© 2006 by Nelson, a division of Thomson Canada Limited. 11-3

 Corporate Governance
Knowledge objectives cont’d…
5. Discuss trends among the three types of compensation
executives receive and their effects on strategic
decisions.
6. Describe how the external corporate governance
mechanism – the market for corporate control - acts as
a restraint on top level managers strategic decisions.
7. Discuss the use of corporate governance in
international settings, in particular in Germany &
Japan.
8. Describe how corporate governance fosters ethical
strategic decisions & the importance of such
behaviours on the part of top-level executives.
© 2006 by Nelson, a division of Thomson Canada Limited. 11-4
 Corporate Governance

Corporate Governance is a relationship among stakeholders

that is used to determine and control the strategic direction &
performance of organizations.

Concerned with identifying ways to ensure that strategic

decisions are made effectively.

Used in corporations to establish order between the firm’s

owners and its top-level managers.

© 2006 by Nelson, a division of Thomson Canada Limited. 11-5

Ten most admired & respected corporations in Canada

© 2006 by Nelson, a division of Thomson Canada Limited. 11-6

Internal Governance Mechanisms

© 2006 by Nelson, a division of Thomson Canada Limited. 11-7

Separation of Ownership & Managerial Control
Basis of the modern corporation
Shareholders purchase stock, becoming
Residual Claimants
Shareholders reduce risk efficiently
by holding diversified portfolios.
Professional managers contract to provide
decision-making.
Modern public corporation form leads to efficient
specialization of tasks.
Risk bearing by shareholders.
Strategy development and decision-making
by managers.
© 2006 by Nelson, a division of Thomson Canada Limited. 11-8
 Agency Theory
An agency relationship exists when:
Agency
Shareholders Relationship
(Principals) Risk Bearing Specialist
(Principal)
Firm Owners Hire Managerial Decision-
Making Specialist
(Agent)
Managers
(Agents)
Decision which creates
Makers

© 2006 by Nelson, a division of Thomson Canada Limited. 11-9

 Agency Theory
The Agency problem occurs when:
The desires or goals of the principal & agent conflict
and it is difficult or expensive for the principal to verify
that the agent has behaved appropriately.
Example: Over - diversification: Greater product
diversification leads to lower management
employment risk & greater compensation.

Solution: Principals engage in incentive-based

performance contracts, monitoring mechanisms
like the board of directors & enforcement
mechanisms like managerial labour market to
mitigate agency problems.
© 2006 by Nelson, a division of Thomson Canada Limited. 11-10
Product Diversification as an example of an
Agency Problem
• Diversification usually increases the size of the
firm – therefore complexity and an opportunity
for top executives to increase their
compensation.
• Diversification usually reduces top executives’
employment risk.
• Top executives have control over free cash flow
and may invest in in products not associated
with the firm’s current lines of business.

© 2006 by Nelson, a division of Thomson Canada Limited. 11-11

 Manager & Shareholder Risk & Diversification

Shareholder Managerial
(Business) (Employment)
Risk Profile Risk Profile
Risk

S M

A
Dominant Related Related B Unrelated
Business Constrained Linked Businesses

Level of Diversification
© 2006 by Nelson, a division of Thomson Canada Limited. 11-12
 Agency Costs & Governance Mechanisms

• Managerial interests may prevail when governance

mechanisms are weak.
• If the board of directors control managerial
autonomy, the firm’s strategies should better reflect
the interests of the shareholders.

© 2006 by Nelson, a division of Thomson Canada Limited. 11-13

 Governance Mechanisms
Ownership Concentration
- Large block shareholders have a strong incentive to
monitor management closely.
In Canada such shareholders account for 65% to 70% of
publicly traded stocks (59% in the U.S.)

- Their large stakes make it worth their while to spend time,

effort & expense to monitor closely.

- Institutional owners are financial institutions such as

stock mutual funds and pension funds that control large-
block shareholder positions.

© 2006 by Nelson, a division of Thomson Canada Limited. 11-14

 Governance Mechanisms
Boards of Directors
- Formally monitor & control the firm’s top-
level executives.
- Set compensation of CEO & decide when to
replace the CEO.
- May lack contact with day to day operations.
Insiders A firm’s CEO & other top-level managers
Individuals not involved with a firm’s day-to-
Related day operations, but who have a relationship
Outsiders with the company

Outsiders Individuals independent of a firm’s day-to-

day operations and other relationships
© 2006 by Nelson, a division of Thomson Canada Limited. 11-15
 Accountability of Board Members

• Increased diversity amongst board members.

• The strengthening of internal management &
accounting control systems.
• The establishment & consistent use of formal
processes to evaluate board’s performance.
• Directors are being required to own significant
equity stakes as a prerequisite to holding a
board seat.

© 2006 by Nelson, a division of Thomson Canada Limited. 11-16

 Executive Compensation

Executive compensation: A governance

mechanism aligning the interests of managers
& owners through salaries, bonuses and long
term incentives such as stock options.

Stock options: A mechanism which links the

executive’s performance to the performance of
the company.
© 2006 by Nelson, a division of Thomson Canada Limited. 11-17
 Table 11.4

© 2006 by Nelson, a division of Thomson Canada Limited. 11-18

 Table 11.5

© 2006 by Nelson, a division of Thomson Canada Limited. 11-19

 Market for Corporate Control

An external governance mechanism that becomes

active when a firms internal controls fail which is
triggered by a firm’s poor performance, relative
to industry competition.

© 2006 by Nelson, a division of Thomson Canada Limited. 11-20

 A Basic List of Management Defence Tactics
Increase the costs of mounting a takeover and can
entrench current management.

Golden Parachute
Raises the cost of making changes at a take-over target due
to the need to pay fired executives large severance packages.
Greenmail
Where company money is used to repurchase stock from
a corporate raider to avoid takeover.
Poison Pill
When the takeover target does something to make itself
unpalatable to the suitor (e.g. assume a large amount of
debt and then issue dividends with the money).
© 2006 by Nelson, a division of Thomson Canada Limited. 11-21
 Governance Mechanism & Ethical Behaviour
• Shareholders are recognized as a company’s most
significant stakeholders.
• The minimum interests or needs of all stakeholders must
be recognized through the firms actions.
• A firm’s strategic competitiveness is enhanced when its
governance mechanisms take into consideration the
interests of all stakeholders.
• Only when the proper corporate governance is
exercised can strategies be formulated & implemented
that will help the firm achieve strategic competitiveness
& earn above average returns.
© 2006 by Nelson, a division of Thomson Canada Limited. 11-22