Chapter 12

• Corporate Governance


  Aims to address agency problems and provide mechanisms to direct and control the firm, ensure it pursues its strategic goals successfully and legally, and offer checks and balances
• Definition of corporate governance


  • Principal-agent problem
  • Principals - shareholders of the firm
  • Bear the risks
  • Hire, monitor, and compensate agents
  • Delegate decision making and control over resources to agents
  • Agents - managers of the firm (decision makers)
  • Provides managerial talent, time and effort
  • Makes strategic decisions on behalf of the principals
• Assumptions of Agency Theory


  • Views the firm as a nexus of legal contracts
  • Individuals (both agents and principals) are opportunistic (i.e., likely to seek their own self-interest)
  • When information asymmetry and goal incongruence are present, agency problems arise and generate agency costs
  • Agents' goals may not align with those of principals (a.k.a., goal incongruence) and agents may choose to not cooperate
  • Principals have no way of knowing agents' intentions
  • The firm needs to design work tasks, incentives, and employment contracts to minimize agent opportunism
• Agency Problems


  • Adverse selection - increases the likelihood of selecting inferior alternatives (e.g., some executives may misrepresent their characteristics, skills, etc.)
  • Moral hazard - increases the incentive of one party to take undue risks or this shirk their responsibilities because the costs incur to another party (e.g., executives may try to obtain highest job security/pay/perquisites with minimal effort)
• Agency Costs


  • Costs that arise when the goals of agents and principals are not aligned
  • Monitoring costs are incurred by principals (e.g., expenses associated with having a board of directors to oversee management, expenses associated with financial audits)
  • Bonding costs are incurred by agents to build trust with principals (e.g., tying CEO compensation to firm performance)
  • Residual loss - costs incurred by principals resulting from agents making decisions not in the best interest of principals even with monitoring and bonding
• Corporate Governance Mechanisms


  • Internal: Board of directors, Ownership concentration, Executive compensation
  • External: Market for corporate control, Auditors, Government Regulators, and Industry Analysts
• Board of Directors


  • Elected by the shareholders through votes during the annual shareholder meeting
  • Boards have several committees (e.g., nominating, compensation, audit)
  • Key roles: Monitoring and control of executives, Reviewing, monitoring, evaluating, and approving strategic initiatives, Selecting, evaluating, and compensating the CEO, Making CEO termination decisions and overseeing the CEO succession plan, Providing resources (e.g., expertise, legitimacy) and guidance with strategic-decisions, Offering advice based on knowledge and experience, Risk assessment and mitigation, Building relationships with key stakeholders
• Types of Directors


  • Inside directors: usually consist of CEO, COO, CFO
  • Related (or affiliated) outsiders: have some relationship with the firm, contractual or otherwise, that may create questions about their independence, but not involved in the firm's day-to-day operations
  • Independent outsiders: current or former executives of other firms or other professionals
• Chairman of the Board


  Oversees board discussions, determines board agenda, etc. When the chairman of the board is also the CEO of the firm = CEO Duality
• Board Interlocks


  Relations established among boards of directors of different firms, when a director is a member of multiple boards
• Executive Compensation


  Total executive compensation consists of: Fixed compensation (e.g., salary) - not linked to objectives such as firm performance, Variable (e.g., bonuses, stock ownership, stock options) - received for reaching certain objectives (e.g., stock price, ROA), Benefits and perquisites (e.g., company jet use, housing)
• Challenges of Executive Compensation

  Observability: Strategic decisions are complex, non-routine and affect the firm over an extended period, making it difficult to assess the current decision effectiveness

  Outcome uncertainty: Other intervening factors affect the firm's performance over time (e.g. environmental effects)