HT8 - Corporate Governance

Question 1

Hart (1995)

Answer 1

Corporate governance is needed because of agency problems
Writing a comprehensive contracts for bonuses, incentive systems and consequences of actions has high transaction costs - needs to be replaced
CG allocates the control over the firm’s nonhuman assets to replace contracts
If owners make decisions on these assets: too many shareholders result in no monitoring of management
Incentives need to strike a balance between risk and motivation – if incentives are too tied to results, managers won’t take risks
Mechanisms for controlling management:
1. Board of directors – represent the shareholders, decisional roles, but principal-agent problem when choosing them
2. Proxy fights – shareholders can replace board members, but it is hard to execute
3. Large shareholders – could leverage their privileged position
4. Hostile takeovers – raiders buy the shares, rearrange the company and earn profits once the company starts growing
5. Financial structure – large debt could force management to be efficient
Chicago view: the company’s founders have an incentive to choose efficient corporate governance structure, so there is no need for rules
externality argument: view is not true as, e.g. in case of a negative demand shock, it is not always wise to lay off workers – need worker representatives on board
‘unforeseen events’ arguments: view is not true as, e.g. under uncertainty, it could be good to separate the chairman and the chief executive (Cadbury recommendation) – board does not like that

Question 2

Jensen & Murphy (1990)

Answer 2

It is more important how CEOs are paid than how much they are paid
Annual changes in executive compensation do not reflect changes in corporate performance
Higher CEO compensation based on performance could drive shareholder profits up
The board can incentivise management by:
- requiring that they become substantial owners of company stock
- Bonuses and options that provide big reward for superior performance / punishment
- threat of dismissal
Disclosing CEO salaries could cause more harm than good – trying to control the salaries and imposing ceilings on them just demotivates management
If CEO positions are not paid well enough, the most talented people will migrate away
Investment bankers and lawyers earn much more than corporate CEOs
Money is not everything, but nonmonetary rewards often create the wrong incentives for CEOs

Question 3

Pfeffer (1998)

Answer 3

Labor costs and labor rates are not the same – cost can be lower per unit of output while the rate is higher
Low labor costs are not an effective competitive strategy- productivity matters
Labor costs are often not a significant proportion of total costs, individual incentive compensation motivates people
People primarily do not work for money (e.g. SAS Institute of Cary, really low turnover rate by exceptional benefits and working conditions)
It is simpler for managers and consulting firms to change the company’s compensation system than to change the culture, structure, etc.
Performance-contingent pay plans do not increase productivity, but they undermine teamwork, and lead to a focus on short-term
It is hard to measure individual efforts in a team
Individual performance compensation can demotivate the workers who did not do that well
Pay cannot substitute for a working environment high on trust, fun and meaningful work
Pay practices send messages to the external world

Question 4

Kerr (1995)

Answer 4

People only do things that they are rewarded for – incentive systems are important
Mistake of incentive systems:
- hoping for performance, but rewarding attendance
- hope for teamwork, but reward individual effort
- hope for long-term growth, but reward quarterly earnings
Simple, objective criterion for compensation could cause goal displacement
Overemphasising highly visible behaviours shifts the focus from less visible qualities
The emphasis on morality or equity rather than performance could backfire

Question 5

Kolev & Wiseman (2016)

Answer 5

CEOs can take advantage of a weaker board of directors and capture a larger share of firm residuals than shareholders
Along with increasing their compensation, CEOs can also insulate their firm-specific wealth from fluctuations in firm performance
If the board consists mostly of outsiders, CEOs can negotiate more effectively for higher compensation

Question 6

Eisenhardt (1989)

Answer 6

Agency theory examines the problems that arise when the employer and employee have different goals and interest, and when the principal has a hard time verifying what the employee is actually doing