Chapter 13 Corporate Governance in the Twenty First Century OBJECTIVES 1 Explain what is meant by corporate governance 2 Describe how corporate governance relates to competitive advantage and understand its basic principles and practices 3 Identify the roles of owners and different types of ownership profiles in corporate governance 4 Describe how boards of directors are structured and the roles they play in corporate governance 5 Explain and design executive incentives as a corporate governance device 6 Describe how the market for corporate control is related to corporate governance 7 Compare and contrast corporate governance practices around the world 2 SUNBEAM Al Dunlap s mgmt philosophy Results 1 Shareholders are most important corporate constituents 2 Most corporations have bloated Early success Costs slashed Stock doubled in first month Market cap rises from 1 1 billion to 5 billion bureaucracies 3 Drastic layoffs are usually needed to save failing companies 4 Layoffs should be quick one time events With R D budgets cut new Signs of problems 5 CEOs should be rewarded like stars when they perform well and fired when they do not 6 Board members should have significant personal investments in the company Failure product development hampered Growth fails to meet targets Company accused of channel stuffing Board fines Dunlap He loses his stock options Sunbeam stock is delisted 3 CORPORATE GOVERNANCE In a broader perspective governance determines how all stakeholders influence the corporation Share holders Corporate governance The system by which organizations particularly business corporations are directed and controlled by their owners Board Management Corporation Employees Society Environment 4 CORPORATE GOVERNANCE IMPACTS PERFORMANCE The Italian stock exchange started a new exchange called STAR for small and midsized 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 5 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 6 AGENTS AND PRINCIPALS When interests are virtually Principal s Shareholders of a firm Agents Act on behalf of principals in managing the firm 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 7 EXAMPLES OF CODES OF GOVERNANCE What is the recommendation on director independence Can the same executive be both CEO chairperson Is auditor rotation required Brazil CVM Code 2002 As many as possible Split recommended Not addressed No Russia CG Code 2002 At least one quarter Split required by law Not addressed No Singapore CG Committee 2001 At least one third Split recommended Not addressed Yes United Kingdom Cadbury Code1 Majority Split recommended Periodic rotation of lead auditor Yes United States Conference Board and CalPers 2003 2 Substantial majority Separation is one of three acceptable alternatives Recommended3 No Country Is disclosure required if the company does not comply with the recommendations 1 In 2003 a Combined Code made further additions to the code but these basic principles remain 2 Just one of several codes in existence in the United States 3 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 8 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 9 OWNERSHIP STRUCTURE VARIES Source Company annual reports 10 ROLES AND ACTIONS OF BOARD OF DIRECTORS 11 EFFECTS OF CEO FIRINGS Firing and outside new blood Organized internal succession Source M wiersema Holes at the Top Why CEO Firings Backfire Harvard Business Review 80 12 2002 70 77 12 INCENTIVE ALIGNMENT Conflicts of interest can arise Principal s Incentive alignment can solve such problems Agents Example 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 Boards can include golden parachute provisions in manager s compensation packages 13 HOW WOULD YOU DO THAT DENDRITE INTERNATIONAL Dendrite s challenge Dendrite s solution How can Dendrite better align management incentives with shareholders 20 senior most executives must own 15 000 to 100 000 shares of stock Must be common shares not options Must be achieved within 5 years Executives may elect to receive incentive compensation in stock instead of cash 14 EXECUTIVE STOCK OWNERSHIP IN 2004 Largest 250 companies with stock ownership guidelines Number of companies Percent of companies Percent increase from 2001 to 2004 Executives 142 57 58 Directors 123 49 127 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 15 INCENTIVE COMPENSATION Annual bonus plans Oldest form of incentive pay Board can evaluate executives performance along multiple dimensions and allocate a yearend cash award Stock options An employee receives the right to buy a set number of shares of company stock at a later date for a