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Chapter 13 Corporate Governance in the Twenty-First Century

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Page 1: Chapter 13 Corporate Governance in the Twenty-First Century

Chapter 13Corporate Governance in the Twenty-First Century

Page 2: Chapter 13 Corporate Governance in the Twenty-First Century

2

OBJECTIVES

Explain what is meant by corporate governance1

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

2

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

3

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

4

Explain and design executive incentives as a corporate governance device

5

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

6

Compare and contrast corporate governance practices around the world

7

Page 3: Chapter 13 Corporate Governance in the Twenty-First Century

3

SUNBEAM

Al Dunlap’s mgmt. philosophy

1. Shareholders are most important corporate constituents

2. Most corporations have bloated bureaucracies

3. Drastic layoffs are usually neededto save failing companies

4. Layoffs should be quick,one-time events

5. CEOs should be rewarded likestars when they perform welland fired when they do not

6. Board members should have significant personal investmentsin the company

Results

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

• With R&D budgets cut, newproduct development hampered

• Growth fails to meet targets• Company accused of “channel

stuffing”

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

billion to $5 billion

Earlysuccess

Failure

Signsof problems

Page 4: Chapter 13 Corporate Governance in the Twenty-First Century

4

CORPORATE GOVERNANCE

Corporate governance

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

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

Board

Employees

Share holders

Corporation

Environment

Management

Society

Page 5: Chapter 13 Corporate Governance in the Twenty-First Century

5

CORPORATE GOVERNANCE IMPACTS PERFORMANCE

The Italian stock exchange started a new exchange called STAR for small and mid-sized 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)

Page 6: Chapter 13 Corporate Governance in the Twenty-First Century

6

EARLY WARNING SIGNS OF PROBLEMS WITH KRISPY KREME

Source: M. Maremont and R. Brooks, “Fresh Woes Batter Krispy Kreme; Doughnut Firm to Restate Results, Delay SEC Filing; Shares Take a 15% Tumble,” Wall Street Journal (Eastern edition), January 5,2005.p.A3

Page 7: Chapter 13 Corporate Governance in the Twenty-First Century

7

AGENTS AND PRINCIPALS

• When interests are virtually 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)

Agents Principals

Shareholders of a firm

Act on behalfof principalsin managingthe firm

Page 8: Chapter 13 Corporate Governance in the Twenty-First Century

8

EXAMPLES OF CODES OF GOVERNANCE

Country

United Kingdom Cadbury Code1

Singapore CG Committee (2001)

Russia CG Code (2002)

Brazil CVM Code (2002)

United States Conference Board and CalPers (2003)2

Can the same executive be both CEO & chairperson?

Split recommended

Split recommended

Split required by law

Split recommended

Separation is one of three acceptable alternatives

Is auditor rotation required?

Periodic rotation of lead auditor

Not addressed

Not addressed

Not addressed

Recommended3

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

Yes

Yes

No

No

No

What is the recommendation on director independence?

Majority

At least one-third

At least one-quarter

As many as possible

Substantial majority

1. In 2003, a Combined Code made further additions to the code, but these basic principles remain2. Just one of several codes in existence in the United States3. 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

Page 9: Chapter 13 Corporate Governance in the Twenty-First Century

9

SOME NEW COMPLIANCE RULES FROM SARBANES-OXLEY

• Auditors must list the non-audit services they are unable to perform during an audit

• A one-year waiting period for audit-firm employees who leave an accounting firm to become an executive for a former client

• Transactions and relationships that are off the balance sheet but that may affect financial status must now be disclosed

• Personal loans from a corporation to its executives are now largely prohibited

• Research analysts for securities firms must now file conflict of interest disclosures. For instance, analysts must report whether they hold any securities in a company or have received corporate compensation

• Brokers and dealers must disclose if the public company is a client

• Altering, destroying, concealing, or falsifying records or documents with the intent to influence a federal investigation or bankruptcy case is subject to fines and up to 20 years of imprisonment

Page 10: Chapter 13 Corporate Governance in the Twenty-First Century

10

OWNERSHIP STRUCTURE VARIES

Source: Company annual reports

Page 11: Chapter 13 Corporate Governance in the Twenty-First Century

11

ROLES AND ACTIONS OF BOARD OF DIRECTORS

Page 12: Chapter 13 Corporate Governance in the Twenty-First Century

12

EFFECTS OF CEO FIRINGS

Source: M.wiersema, “Holes at the Top: Why CEO Firings Backfire,” Harvard Business Review 80;12 (2002), 70-77

Page 13: Chapter 13 Corporate Governance in the Twenty-First Century

13

INCENTIVE ALIGNMENT

Conflicts of interest can arise

Agents Principals

Incentivealignment can solve

such problems

• 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

Example:

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

Page 14: Chapter 13 Corporate Governance in the Twenty-First Century

14

HOW WOULD YOU DO THAT? – DENDRITE INTERNATIONAL

Dendrite’s challenge: Dendrite’s solution:

How can Dendrite better align managementincentives with shareholders?

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

Must be common sharesnot options

Must be achieved within 5 years

Executives may elect to receive incentive compensation in stock instead of cash

Page 15: Chapter 13 Corporate Governance in the Twenty-First Century

15

EXECUTIVE STOCK OWNERSHIP IN 2004

Largest 250 companies withstock ownership guidelines

Executives

Directors

Number ofcompanies

142

123

Percent ofcompanies

57

49

Percent increase from 2001 to 2004

58

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

Page 16: Chapter 13 Corporate Governance in the Twenty-First Century

16

INCENTIVE COMPENSATION

Annual bonus plans

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

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

Other long-termincentives

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

Page 17: Chapter 13 Corporate Governance in the Twenty-First Century

17

CEO PAY COMPARISON

Page 18: Chapter 13 Corporate Governance in the Twenty-First Century

18

HIGHEST PAID CEOs

Source: Company annual reports and ExecComp Service of Thomson Financial

Page 19: Chapter 13 Corporate Governance in the Twenty-First Century

19

EXECUTIVE PAY TRENDS

Source: U.S. Bureau of Labor Statistics

Page 20: Chapter 13 Corporate Governance in the Twenty-First Century

20

THE MARKET FOR CORPORATE CONTROL

Share holders

Board

Top management

Corporation

Directs

Hires/fires

Elect

The right to choose the members of the board of directorsof a company andto control all major decisions madeby a company

Corporate control: Example:

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

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

Example:

Page 21: Chapter 13 Corporate Governance in the Twenty-First Century

21

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)

Page 22: Chapter 13 Corporate Governance in the Twenty-First Century

22

CORPORATE GOVERNANCE: U.S VS. JAPAN

Owner-managerrelationship

Manager andshareholderrelationship

Ownershipconcentration

U.S

Adversarial

Through onecompany

Control function

Japan

Co-operative

Through a Keiretsu (group of interlockingcompanies)

Monitoring function

Page 23: Chapter 13 Corporate Governance in the Twenty-First Century

23

CORPORATE GOVERNANCE IN GERMANY AND CHINA

Germany

• Two-tier board system

• Management board manages the enterprise

• Supervisory board appoints, supervises, and advises members of the management board

China

• Only recently started a securities market

• Majority of listed companies started off as state-owned enterprises

• State ownership remains high across all industries

Page 24: Chapter 13 Corporate Governance in the Twenty-First Century

24

HOW WOULD YOU DO THAT? – CHIQUITA

The Chiquita board set objectives as:

1. Delivery of quality products to consumers

2. Quality returns to shareholders

3. Transform Chiquita into a global player

How should Chiquita compensate its new CEO?

Source: Company annual reports

Chiquita Dole Del Monte

Sales 2004($ millions)

2,613 4,773 2,171

Net income ($ millions)

96 84 134

CEO salary($ thousands)

950 810

CEO bonus($ thousands)

What is appropriate?

1,368 870

CEO total Compensation($ thousands)

4,387 7,394

Page 25: Chapter 13 Corporate Governance in the Twenty-First Century

25

SUMMARY

Explain what is meant by corporate governance1

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

2

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

3

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

4

Explain and design executive incentives as a corporate governance device

5

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

6

Compare and contrast corporate governance practices around the world

7


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