Chapter 18: Corporate Governance: Managerial Economics and Organizational Architecture, 5e

Managerial Economics and Organizational Architecture, 5e
Managerial Economics and

Organizational Architecture, 5e
Chapter 18: Corporate

Governance
Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

McGraw-Hill/Irwin
Corporate Governance
• Describes the organizational structure at
the top of the firm
• Includes
– Top-level incentives
– Partitioning of decision rights
– Board of directors
– Top management
– Outside monitors
18-2
Corporate Structure
• Corporations have the legal standing of an
individual
• Shareholders elect a board of directors
with primary decision control rights
• Shareholder-owners have limited liability
• Corporations may establish governance
procedures within legal boundaries
18-3
Corporate Ownership
• Stock in closely-held corporations is not
freely traded
• Stock of publicly-traded corporations may
be freely bought and sold
– Widely held corporation
• No one owner controls more than 10 percent of the
shares
18-4
Corporate Governance Objectives

• Maximizing value
• Protecting assets
• Production of proper financial
statements that meet legal
requirements
18-5
Separation of Ownership
and Control
• Incentive issues
• Are executive interests aligned with those of
stockholders?
• Survival of corporations
• Despite governance concerns, the corporate
form seems both productive and resilient
• Benefit of publicly-traded corporations
• Ability to raise large amounts of capital
18-6
Top-level Architecture
US corporations
• Decision rights divided among selected
stakeholders
• Shareholders
• Governing board
• Top management
• External monitors
18-7
Government Impacts
on Decision Rights
• State regulations affect firms incorporated
within those states
• Federal laws and regulations further
stipulate decision rights
• Courts have impact through interpretations
of laws
18-8
Shareholders
• Ultimate owners
• Limited participation in management
– Elect board
– Board oversees management
– Some ratification rights
18-9
Shareholder Incentives
• Small shareholders (individuals) have
incentive to free ride rather than be
actively involved
• Institutional investors (e.g. pension funds)
differ in incentives to challenge
management
• Blockholders internalize more of the
benefits of active involvement
18-10
Board of Directors
• Delegates legal authority to professional
managers
• Primary function is top-level decision
control
• Other responsibilities
– Hire, monitor, fire CEO
– Authorize strategic directions
– Approve large capital outlays
18-11
Board of Directors
• Fiduciary responsibilities
– Represent the interests of the corporation and
shareholders
– Good faith efforts
– Loyalty
• Legal protection through business
judgment rule
18-12
Board Composition and Work

• Size can vary from 4 to 33+
• Over half are outside directors
• CEO usually sits on board
– Frequently chairs the board
• Much work done in committees
– Audit
– Compensation
– Nominating
18-13
Board Member Incentives

• Some stock ownership aligns financial
interests with other shareholders
• High-profile board members have
reputational concerns
• Are members independent of top
management?
– Incentives to back management for self-
interested reasons
18-14
Top Management
• CEO’s decision authority flows from the
board
• More decision rights are delegated as
firm size and complexity increase
• Senior management retains important
decision rights
– Shape strategic direction
– Establish overall architecture
– Recruiting and retaining key personnel
18-15
Top Management
• CEO often deals with investor relations,
media, and customers
• COO manages internal operations
• CFO supervises senior financial managers
18-16
Top Management Incentives

• Straight salary
• Performance-based compensation
– Bonuses
– Stock options
– Stock ownership
18-17
External Monitors
• Public accounting firms
– Annual independent audits increase
shareholder confidence
• Stock market analysts
– May have incentives to promote stocks that
use their firm’s banking services
• Commercial banks
• Credit-rating agencies
• Regulatory authorities
18-18
International Corporate
Governance
• Historical emphasis on broader set of
stakeholders
– Employees
– Lenders
– Affiliated companies
– Broader public
• Gradual shift toward US architecture
18-19
Monitoring Effect of Market

Forces
• Management failure opens door to hostile
takeover
• Management failure closes door to further
professional opportunities
• Inefficiency places firm’s products at
competitive disadvantage
18-20
Sarbanes-Oxley Act of 2002

• Establishes Public Companies Accounting
Oversight Board
• Prohibits certain transactions between
companies and managers
• Holds CEOs and CFOs accountable for
financial statements
• Establishes civil and criminal penalties for
violations
18-21
Chapter 18 Appendix
Legal Forms of Organization

Organizational Form
• For profit
• Residual claimants
• Nonprofit
• Nondistribution constraint
18-23
For-profit Organizations
• Individual proprietorships
• General partnerships
• Limited liability partnerships
• Limited partnerships
• S corporations
• C corporations
18-24
Individual Proprietorships
• Resolve owner-top management conflict

• Limited ability to raise capital
• Income passes through to owner’s tax
return
18-25
General Partnership
• Income passes through to partners’
individual tax returns
• Partners exposed individually and jointly to
unlimited liability
• fosters mutual monitoring
• Take advantage of teamwork opportunities
18-26
S Corporation
• Attractive choice for some small
companies
• Same tax treatment as proprietorships
and partnerships
• Limited liability
• Entails incorporation fees
• Lenders still require personal
guarantees
18-27
C Corporations
• Attractive for large companies
• Easier to raise capital
• Shareholders subject to “double taxation”
• Limited liability for shareholders
• Small risk-bearing costs
• shareholders have diversified portfolios
18-28

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Chapter 18: Corporate Governance: Managerial Economics and Organizational Architecture, 5e

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Managerial Economics and Organizational Architecture, 5e

Managerial Economics and

Chapter 18: Corporate

Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Corporate Governance Objectives

Board Composition and Work

Board Member Incentives

Top Management Incentives

Monitoring Effect of Market

Sarbanes-Oxley Act of 2002

Legal Forms of Organization

• Resolve owner-top management conflict

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