FIN 4424 Topics in Financial Management Final Exam Study Guide Governance Governance the action of controlling or directing Governance entails a system of overseeing and delegation of decisions that reaches from the owners of the firm to the board of directors and from there to senior middle and front line managers It is the job of the board to seek the highest value for shareholders they should always accept the highest bid Shareholders can file lawsuits if the board does not extract the highest value Challenges Surrounding Governance 1 Information and Expertise determining what is good governance is a matter of detailed research analysis and judgement Information is expensive and time consuming to obtain 2 Silent Investors for many corporations the majority of investors are institutional investors insurance companies pension funds and mutual funds these stockholders remain silent and passive and sometimes the management and board may feel little threat of discipline from shareholders 3 Agency Costs arise when agents pursue their own interests to the detriment of owners Good governance seeks to minimize these costs to shareholders through schemes of monitoring control and executive compensation that align the interests of managers with those shareholders Agency Costs arise because of a Information asymmetries that grant insiders a better picture of the firms that outsiders shareholders b Less than full ownership of the firm by managers providing an incentive to consume benefits and perquisites beyond what a sole proprietor would consume 4 Board of Composition and Culture for many board the CEO is also chairman of the board so other board members won t confront them 5 Incentive Problems many directors hold small financial interests in the company so they would rather minimize risks and not incur lawsuits or adverse media publicity that maximize value How to Solve Agency Problems 1 Monitoring Board of Directors is supposed to supervise the management to ensure that they are doing a good job Often run into conflict because the CEO will usually be on the Board 2 Bonding when management put up collateral to prove their success Would not put up their own money or forfeit their pay if they were not confident Helps ensure that management will do a good job 3 Incentives incentives paid to executives and directors can be both good and bad If they have financial interest in the company they want to increase their own wealth which means shareholder wealth would also increase but due to this they might want to minimize risk which would limit shareholder wealth Incentives include Long Term Incentive Plans Stocks Options with Restrictions and Clawbacks trying to get money back that you paid the board The Board of Directors must observe four obligations 1 Directors must be loyal to shareholder interests 2 Directors must give careful analysis and deliberation 3 Directors must disclose personal interest and news Shareholders must know all material information and be cognizant of any potential conflicts of interest when they are asked to approve a transaction 4 Under some circumstances the board must conduct an auction when there are bidders competing to acquire the target Cumulative Voting Cumulative voting is where your number of votes is equal to the number of shares multiplied by the number of directors to be elective this is a more equal way of voting Straight voting where you have as many votes as you do shares Staggered Boards voting for all of the board members do not occur at once instead it is spread out with a few directors being voted in each year Allows for smaller shareholders to get more of a say Good Governance Reduces Agency Costs Through 1 Compensation in the form of equity or equity like securities this aligns interests of management with interest of shareholders 2 Monitoring systems of financial reporting and performance review can help identify the economic results of individual business units and their managers 3 Financial Contracting in the absence of significant ownership stakes manager will undertake wealth destroying strategies to pursue their own goals to the detriment of the firm s oweners 4 Jawboning Good Governance Pays 1 Worldwide firms with stronger governance practices tend to trade at higher market values 2 Activism by institutional investors is valuable institutional investors are large in size have strong performance orientation have close proximity to markets are well informed and are able to withstand transaction costs They can be better activists which is associated with the creation of shareholder wealth 3 Governance intervening by shareholders is associated with increased shareholder value investors can influence directors and managers through proxy fights shareholder resolutions lawsuits and jawboning These are usually associated with positive changes in firm value 4 Restructuring to align the interest of managers and shareholders is associated with higher firm valuation alignment occurs through equity like compensation systems and performance measurement based on economic value Business Judgement Rule states that if the board was free of bias and can prove that a decision was good at the time it was made then they are free from the liability of a lawsuit from shareholders court doctrine that discourages intervention in board decisions if directors and officers fulfill their duties in good faith if they are not conflicted are informed and act in rational belief that the transaction serves shareholders interest One Share One Vote Usual procedure is one vote per each share with the new Groupon and Zynga IPOs executives are getting many votes per each share while everyone else receives a 1 1 ratio Supermajority votes are not new but most companies have 5 or 10 votes per share Groupon has 150 and Zynga 70 Dual Class when there are discrepancies in the votes shares ratio Can rule a company several ways Straight good for execs v Cumulative Voting good for small shareholders Staggered Board voting for all board members does not occur at once Two Tier System have two boards one is composed of management and the other of outsiders One Vote per Share is good for shareholders to help ensure that larger shareholders and management will not be able to make major changes But supermajority votes can be good for executives when they hold a minority of the shares happens in start ups where Venture Capital firms take a majority of the shares as payment for their initial