ECON 308

Week 15

Corporate Governance Chapter 18

1

Learning Objectives

• Describe the nature of publicly-traded organizations

• Identify and assess issues related to separation of ownership and control

• Describe the top-level architecture of US corporations

• Assess the role of Sarbanes-Oxley in correcting architecture failures

• Appendix: Identify advantages and disadvantages of alternative organizational forms

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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

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Corporate ownershippublicly-traded versus closely-held

• Stock in closely-held corporations is not freely traded

• Stock of publicly-traded corporations may be freely bought and sold

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Corporate governance objectives

• Maximizing value

• Protecting assets

• Meeting legal requirements

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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

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Top-level architectureUS corporations

• Decision rights divided among selected stakeholders– Shareholders– Governing board– Top management– External monitors

• Distinction between decision rights and decision control

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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

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Shareholders

• Ultimate owners

• Limited participation in management– Elect board– Board oversees management– Some ratification rights

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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

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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

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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

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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?

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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

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Top management incentives

• Straight salary

• Performance-based compensation– Bonuses– Stock options– Stock ownership

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External monitors

• Public accounting firms

• Stock market analysts

• Commercial banks

• Credit-rating agencies

• Regulatory authorities

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International corporate governance

• Historical emphasis on broader set of stakeholders– Employees– Lenders– Affiliated companies– Broader public

• Gradual shift toward US architecture

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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

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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

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