Corporate Governance

Corporate governance is a relationship among stakeholders that is used to determine a firm’s

direction and control its performance. How firms monitor and control top-level managers
‘decisions and actions affect the implementation of strategies. Effective governance that aligns
managers ‘decisions with shareholders ‘interests can help produce a competitive advantage.
The 21st-century competitive landscape is fostering the creation of a relatively uniform
governance structure that will be used by firms throughout the world.154 For example, as
markets become more global and customer demands more similar, shareholders are becoming
the focus of managers’ efforts in an increasing number of companies. The firm’s strategic
competitiveness is enhanced when its governance mechanisms take into consideration the
interests of all stakeholders.

Anglo-American Corporate Governance:

• The United States and Britain had adopted a shareholder-centric model of corporate
governance (often referred to as the Anglo-Saxon model)
• This model emphasized the increase in shareholder value, in compliance with national
laws and regulations, as the primary objective of the corporation.
• has a one-tier board structure, is smaller in size, with an average of 12 members, and
gives shareholders the right to change the size and composition of the supervisory
board.
• The board of directors provided oversight of the actions of professional management to
protect the financial interests of shareholders.
• The board had four primary responsibilities:
• the selection of the chief executive officer;
• the selection of candidates for the board of directors;
• evaluation and review of the company’s strategy, operational execution, capital
structure, and published financial statements;
• and ensuring that the company was in compliance with all applicable laws and
regulations.
• Anglo-American model boards served both an advisory role and a compliance role.
• includes both executive directors (“insiders”) and non-executive or independent
directors (“outsiders”).
Separation of ownership and Managerial control (Basis of the Modern Corporation)
The separation of ownership and managerial control allows shareholders to purchase stock,
which entitles them to income (residual returns) from the firm’s operations after paying
expenses. This right, however, requires that they also take a risk that the firm’s expenses may
exceed its revenues. To manage this investment risk, shareholders maintain a diversified
portfolio by investing in several companies to reduce their overall risk. As shareholders diversify
their investments over a number of corporations, their risk declines. The poor performance or
failure of any one firm in which they invest has less overall effect. Thus, shareholders specialize
in managing their investment risk. In small firms, managers often are high percentage owners,
so there is less separation between ownership and managerial control. Without owner
(shareholder) specialization in risk bearing and management specialization in decision making, a
firm may be limited by the abilities of its owners to manage and make effective strategic
decisions. Thus, the separation and specialization of ownership (risk bearing) and managerial
control (decision making) should produce the highest returns for the firm’s owners.

Problems of separation of ownership and managerial control

The separation between ownership and managerial control can be problematic. Research
evidence documents a variety of agency problems in the modern corporation.31 Problems can
surface because the principal and the agent have different interests and goals, or because
shareholders lack direct control of large publicly traded corporations. Problems also arise when
an agent makes decisions that result in the pursuit of goals that conflict with those of the
principals. Thus, the separation of ownership and control potentially allows divergent interests
(between principals and agents) to surface, which can lead to managerial opportunism

Drawbacks of not having the separation of ownership and managerial control

There are at least two critical issues for family-controlled firms. First, as they grow, they may
not have access to all of the skills needed to effectively manage the firm and maximize its
returns for the family. Thus, they may need outsiders. Also, as they grow, they may need to
seek outside capital and thus give up some of the ownership.

Agency Relationship
An agency relationship exists when one or more persons (the principal or principals) hire
another person or persons (the agent or agents) as decision-making specialists to perform a
service. Thus, an agency relationship exists when one party delegates decision-making
responsibility to a second party for compensation 28 In addition to shareholders and top
executives, other examples of agency relationships are consultants and clients and insured and
insurer. Moreover, within organizations, an agency relationship exists between managers and
their employees, as well as between top executives and the firm’s owners. In the modern
corporation, managers must understand the links between these relationships and the firm’s
effectiveness.
Example of Agency Problem: a corporate-level strategy to diversify the firm’s product lines can
enhance a firm’s strategic competitiveness and increase its returns, both of which serve the
interests of shareholders and the top executives. However, product diversification can result in
two benefits to managers that shareholders do not enjoy, so top executives may prefer product
diversification more than shareholders do. First, diversification usually increases the size of a
firm, and size is positively related to executive compensation. Second, product diversification
and the resulting diversification of the firm’s portfolio of businesses can reduce top executives’
employment risk

Agency Costs and Governance Mechanism:

Agency costs are the sum of incentive costs, monitoring costs, enforcement costs, and
individual financial losses incurred by principals because governance mechanisms cannot
guarantee total compliance by the agent. If a firm is diversified, governance costs increase
because it is more difficult to monitor what is going on inside the firm. In general, managerial
interests may prevail when governance mechanisms are weak, as is exemplified by allowing
managers a significant amount of autonomy to make strategic decisions. If, however, the board
of directors controls managerial autonomy, or if other strong governance mechanisms are used,
the firm’s strategies should better reflect the interests of the shareholders.

Managerial Opportunism
seeking of self-interest with guile (i.e., cunning or deceit).32 Opportunism is both an attitude
(e.g., an inclination) and a set of behaviors (i.e., specific acts of self-interest).33 It is not possible
for principals to know beforehand which agents will or will not act opportunistically. The
reputations of top executives are an imperfect predictor, and opportunistic behavior cannot be
observed until it has occurred. Thus, principals establish governance and control mechanisms to
prevent agents from acting opportunistically, even though only a few are likely to do so.34 Any
time that principals delegate decision-making responsibilities to agents, the opportunity for
conflicts of interest exists. Top executives, for example, may make strategic decisions that
maximize their personal welfare and minimize their personal risk.
Governance Mechanism: -
Ownership Concentration
Both the number of large-block shareholders and the total percentage of shares they own
define ownership concentration. Large-block shareholders typically own at least 5 percent of a
corporation’s issued shares. Ownership concentration as a governance mechanism has received
considerable interest because large-block shareholders are increasingly active in their demands
that corporations adopt effective governance mechanisms to control managerial decisions. In
general, diffuse ownership (a large number of shareholders with small holdings and few, if any,
large-block shareholders) produces weak monitoring of managers’ decisions. Among other
problems, diffuse ownership makes it difficult for owners to effectively coordinate their actions.
ownership concentration is associated with lower levels of firm product diversification.53 Thus,
with high degrees of ownership concentration, the probability is greater that managers’
strategic decisions will be intended to maximize shareholder value.
Institutional owners are financial institutions such as stock mutual funds and pension funds that
control large-block shareholder positions.

Board of Directors
The board of directors is a group of elected individuals whose primary responsibility is to act in
the owners’ interests by formally monitoring and controlling the corporation’s top-level
executives.
• The board of directors provided oversight of the actions of professional management to
protect the financial interests of shareholders.
• The board had four primary responsibilities:
– the selection of the chief executive officer;
– the selection of candidates for the board of directors;
– evaluation and review of the company’s strategy, operational execution, capital
structure, and published financial statements;
– and ensuring that the company was following all applicable laws and regulations.
Basic Duties of Board of directors:
• Approving the company’s philosophy and mission
• Selecting, monitoring, advising, evaluating, compensating and, if necessary,
 • replacing the CEO and other senior executives
• Ensuring orderly management succession
• Reviewing and approving management’s strategic and business plan; financial plans and
objectives, including significant capital allocations; and material transactions not in the
ordinary course of business
• Monitoring company performance against strategic goals and objectives
• Ensuring compliance with applicable standards of ethics, law and regulation, auditing
and accounting principles, and the company’s own governing documents
• Assessing its own effectiveness in carrying out its responsibilities
• Performing such other functions as are prescribed by law or assigned to the board in the
company’s governing documents
• Duty of care: diligence in making decisions, acting, exercising oversight for the benefit of
the corporation and its shareholders
• • Duty of loyalty: forbearance from pursuing personal interests at the expense of the
corporation or its shareholders
• • Duty of candor: accurate and timely disclosure of material information relevant to the
affairs of the corporation and its shareholders

Classification of Board of directors

Insiders: The firm’s CEO and other top-level managers
Related outsiders: Individuals not involved with the firm’s day-to-day operations, but who have
a relationship with the company
Outsiders: Individuals who are independent of the firm in terms of day-to-day operations and
other relationships
Healthy Board members Practice:
Board Qualifications
• Target number of directors is 10; all non-executive directors must be independent
• Term limit of 10 years; one new board member per year
Board Effectiveness
• Role of chairman and CEO should be split
• At least 8 meetings per year with executive sessions at each
• Chairman responsible for agenda, committee coordination, and annual review of board
effectiveness
• Chairman’s performance reviewed each year by the board... term limit of 6 years
• Mandatory purchases of common stock equal to 25% cash compensation; directors
required to hold all mandatory
• holdings of stock until at least 6 months after leaving the board
• All stock sales by directors must be disclosed to the market at least 2 days in advance
Board Committees
• • Audit: at least 3 independent directors, all with financial expertise; at least 8 meetings
per year; meet with General Counsel 2 times per year; rotate chairmanship every 3
years; review performance of CFO annually;
• • Governance: 3 members with expertise in governance issues or substantial leadership
experience; at least 4 meetings per year; responsible for board nominations, board
compensation, amendments to by-laws or committee charters; establish shareholder
“town meeting;” establish Disclosure Committee
• Compensation: 3 members with expertise in compensation and HR; at least 4 meetings
per year; review performance of HR director
• Risk Mgt: 3 members with experience in risk and telecom issues; at least 6 meetings per
year; review risk disclosures

• • Imbed governance constitution in Articles of Incorporation – can only be changed by

shareholder vote
• • Shareholders have opportunity to add nominees to the proxy ballot (ad hoc group of
five largest shareholders, or 15% of shares)
• • Electronic “town meeting” for shareholders owning more than 1% of voting power
entitled to place resolutions on the website for consideration of all shareholders. If
proposal received a majority vote of shareholders, it would go on the following year’s
proxy card
• • Audit Committee meet with shareholders at least once per year and invite comment
on quality of the company’s disclosure program
• • Executive compensation over $15million for CEO requires shareholder approval;
severance over $10 million for CEO requires shareholder approval
 • • Devices that create an ability for directors to prevent shareholders from ever acting on
a change of control / purchase proposal are not acceptable

Executive Compensation:
Executive compensation is a governance mechanism that seeks to align the interests of
managers and owners through salaries, bonuses, and long-term incentive compensation, such
as stock awards and options. long-term incentive plans have become a critical part of
compensation packages in U.S. firms. The use of longer-term pay helps firms cope with or avoid
potential agency problems by linking managerial wealth to the wealth of common
shareholders.92 Because of this, the stock market generally reacts positively to the introduction
of a long-range incentive plan for top executives. Effectively using executive compensation as a
governance mechanism is particularly challenging to firms implementing international
strategies. For example, the interests of owners of multinational corporations may be best
served when there is less uniformity among the firm’s foreign subsidiaries’ compensation
plans.96 Developing an array of unique compensation plans requires additional monitoring and
increases the firm’s potential agency costs.
The primary reason for compensating executives in stock is that the practice affords them an
incentive to keep the stock price high and hence aligns managers’ interests with shareholders’
interests. However, there may be some unintended consequences. Managers who own more
than 1 percent of their firm’s stock may be less likely to be forced out of their jobs, even when
the firm is performing poorly
Following steps can be taken for a healthy executive compensation practice.
• • Increase proportion of cash to 2/3; reduce proportion of equity-based to 1/3
• • All stock options and other forms of equity-based pay shall be expensed
• • At least 75% of all equity awards must be retained until at least 6 months following
termination of employment
• • Annual compensation should not exceed $15 million, without shareholder approval
• • Compensation should be performance-based
• • Prohibition of insider and related party transactions... of “loans”
• • Maximum severance payment to any employee absent a shareholder vote ($10 million
for CEO; $5 million for any other employee)
• • Compensation consultants must be retained directly by Compensation Committee
Market for Corporate Control
The market for corporate control is an external governance mechanism that becomes active
when a firm’s internal controls fail. The market for corporate control is composed of individuals
and firms that buy ownership positions in or take over potentially undervalued corporations so
they can form new divisions in established diversified companies or merge two previously
separate firms. Because the undervalued firm’s executives are assumed to be responsible for
formulating and implementing the strategy that led to poor performance, they are usually
replaced. Thus, when the market for corporate control operates effectively, it ensures that
managers who are ineffective or act opportunistically are disciplined. The market for corporate
control is often viewed as a “court of last resort.”115 This suggests that the takeover market as
a source of external discipline is used only when internal governance mechanisms are relatively
weak and have proven to be ineffective. The market for corporate control governance
mechanism should be triggered by a firm’s poor performance relative to industry competitors.
A firm’s poor performance, often demonstrated by the firm’s earning below-average returns, is
an indicator that internal governance mechanisms have failed; that is, their use did not result in
managerial decisions that maximized shareholder value. While some acquisition attempts are
intended to obtain resources important to the acquiring firm, most of the hostile takeover
attempts are due to the target firm’s poor performance

Defense Strategy:
Poison pill: Preferred stock in the merged firm offered to shareholders at a highly attractive rate
of exchange.
Corporate charter amendment: An amendment to stagger the elections of members to the
board of directors of the attacked firm so that all are not elected during the same year, which
prevents a bidder from installing a completely new board in the same year.
Golden parachute: Lump-sum payments of cash that are distributed to a select group of senior
executives when the firm is acquired in a takeover bid
Litigation: Lawsuits that help a target company stall hostile attacks; areas may include antitrust,
fraud, inadequate disclosure.
Green mail: The repurchase of shares of stock that have been acquired by the aggressor at a
premium in exchange for an agreement that the aggressor will no longer target the company
for takeover.
Standstill agreement: Contract between the parties in which the pursuer agrees not to acquire
any more stock of the target firm for a specified period of time in exchange for the firm paying
the pursuer a fee
Capital structure change: Dilution stock, making it costlier for a bidder to acquire; may include
employee stock option plans (ESOPs), recapitalization, new debt, stock selling, share buybacks.

Preventive Measures for Corporate governance failure:

– Ensuring Board Independence
– Considering the Character Dimension of Leadership
– Setting Challenging but Realistic Targets
– Inclusion of Non-Financial Performance Metrics
• Company reputation or brand preference: This measure helps the
company understand its corporate products/services position in relation to competitors.
• Triple bottom line
• Customer experience: A company will need to consider all of the major
reasons a customer will again interact with the company.
• Internal growth and learning: Some human-resource indicators are
employee engagement, trust, emotional intelligence and ethical orientation.
• Corporate culture:
– Getting Corporate Culture Right
– Installing Effective Corporate Governance Framework in the Context of Social
Responsibility

Character Dimension of Leadership

• Accountability: Be accountable for the organization’s impact on society, the economy
and the environment
• Transparency: Be transparent in decisions and activities that impact society and the
environment
• Ethical behavior: Behave ethically and actively promote ethical behavior
• Respect for stakeholder interests: Respect, consider and respond to the interests of
stakeholders
• Respect for rule of law: Keep informed of all legal obligations and conduct periodic legal-
compliance reviews
• Respect for international norms of behavior: Respect international norms of behavior
and the rule of law: In the absence of a legal framework to provide sufficient
environmental or social safeguards, especially in underdeveloped or developing
countries, an organization should at least strive to respect international norms of
behavior.
• Respect of human rights: Respect the importance and universality of human rights