Week 10 - Corporate governance Flashcards
4 reasons why we need to make sure (top-level) management does the right thing
- Top-level managers play with others’ money/resources
ie. they should act in the interest of share-/stakeholders {b/c they’re not personally affected if anything goes wrong} - Top-level managers are “simply” EMPLOYEES
ie. they do not own the firm - Top-level managers are no different from lower-level employees
ie. typical principal-agent problems apply - Top-level managers have their OWN INCENTIVES
eg. relating to insider trading, fraud,… such as Wirecard
Corporate governance
- An umbrella term for management control
- the set of COMPLEMENTARY mechanisms that help align the actions and choices of managers with the interests of SHAREHOLDERS
Board of directors
- typically, (prior) executives of other firms
- diverse set of people who sit on DIFFERENT COMMITTEES
eg. audit, compensation, governance, regulatory, finance, talent committees (not just a single overall committee)
7 examples of what companies do under Corporate governance
- Board structure
- Shareholder rights
eg. staggered boards, dual shares, poison pills, shareholder proposals, say-on-pay - Executive incentive-compensation
eg. bonus plans, equity-based incentives, pay levels, OWNERSHIP GUIDELINES, golden parachutes - Corporate compliance policies
eg. insider trading, clawback provisions, WHISTLEBLOWING - Management practices
eg. executive turnovers, succession planning, corporate culture - EXTERNAL MONITORING
e.g blockholders, institutional investors, bank oversight, analysts - Financial transparency
eg. financial accounting, voluntary disclosure, internal controls
8 complex complementary decisions that must be made considering a complex regulatory environment
- DISCLOSURE of executive compensation, board structure, etc.
- Board independence (50%)
- Shareholder voting
- say-on-pay - Financial reporting/enforcement
eg. SOX, Dodd Frank, Reg FD: fair disclosure, insider trading, whistleblowing - Rise of activist investors & passive investors
eg, the Big Three: BlackRock, Vanguard, State Street - Rise of proxy advisory firms that provide “best practices”
eg. ISS, Glass Lewis sell recommendations from the proxy statements. most companies, eg. the Big 3 investors, just follow these - Rise of ESG RATING AGENCIES
» however, there is a divergence in ESG ratings, ie. one rating might mean very different from other rater - AUDITOR constraints
The power of Proxy advisors~
(Malenko and Shen, 2016)
Their research found that a NEGATIVE RECOMMENDATION by ISS (a proxy advisory firm) resulted in a huge reduction of 25 percentage points regarding the satisfaction of COMPENSATION PACKAGES
» usually about 90% vast majority of investors are satisfied
» if below 70% satisfaction, it is a very bad situation
3 takeaways about Corporate governance + The determinants of board structure (Linck et al., 2008)
- Firms make choices that optimise their governance GIVEN THE FIRM’S CONTEXT
» many ATTRIBUTES COMPLEMENTing each other, moving with each other
» if change 1 attribute, might need to change another. so firms rarely make a lot of changes to corporate governance at a single time -> COSTS are extremely high and nobody wants to bear that cost
-> hence, must make decisions that consider all aspects - The observed mechanisms are HIGHLY PATH DEPENDENT
ie. what happened in the past brought the company to where it is today
- what works for one firm now might not work for another firm/same firm in the future
The determinants of board structure (Linck et al., 2008)
- there is always a TRADE-OFF between costs and benefits for the board structure, so a board’s decisions are highly DEPENDENT on the org’s characteristics
- takeaway: what firms are doing are probably OPTIMAL to their current situation
- the paper argues that in some org.s a larger board may be more useful (in contrary to the popular idea that smaller, more independent boards are better)
- Sometimes, regulations whack firms “out of equilibrium”
» but firms will optimise again over time
“Bad governance” and what we expect firms to do in general
(Adams et al., 2010)
In general, expect firms to make “OPTIMAL” DECISIONS (over time)
1. although it is possible that the governance structure was chosen by mistake, it may represent the right, albeit poor, solution to the constrained OPTIMISATION PROBLEM that the org. faces
eg. it might be “impossible” to change the governance attribute like board size
2. competition should lead to the SURVIVAL OF THE FITTEST
Nowadays (after the 2007 financial crisis), share- AND stakeholders have quite a lot of power.
What are 2 ways shareholders can step in if they really think their firm is “poorly managed”?
*rarely happens in practice, however. which suggests that boards/firms do make appropriate decisions ex ante
-
Shareholder proposals
- shareholders can influence the board by buying shares and voting/proposing during AGMs to make change in the org.
- the board provides a recommendation (for/against) -
Say-on-pay
- a NON-BINDING VOTE on EXECUTIVE COMPENSATION (mainly annual, also triannual or biannual)
- RARELY “FAILS” {<70% in favour is extremely low; negative signal}
-
however, is say on pay really about pay, or is it about performance?
» shareholders use it as a way to complain about mgmt’s performance, to vote on mgmt’s decisions, to express their frustration/concerns. can have consequences for management
“New” corporate governance
*we expect a lot of changes in the future. If companies don’t engage, they might not be competitive anymore in the new world
Traditional: shareholder VALUE maximisation
ie. firms should maximise profit or market value
vs New: shareholder WELFARE maximisation
ie. firms should maximise profit/market value, as well as everything else that goes into a shareholder’s utility function
4 principles underlying shareholder VALUE maximisation (traditional corporate governance) + “arguments” for the New corporate governance
- Firms should be run in the interests of SHAREHOLDERS
- Firms are operating in a COMPETITIVE environment
- Shareholders care only about MONEY
- If (3) not true, shareholders can use their value/wealth to REVERSE any corporate activity {& fix the firm’s problems themselves}
Shareholder WELFARE maximisation
3. Research found that 2/3 of pension fund members are willing to sacrifice financial gains if they can invest in companies that do social good, better the world
» in our current world, principle (3) likely doesn’t hold anymore
4. It is MORE EFFICIENT for firms to adopt shareholders’ social objectives {and not only focusing on performance}
- since “it is cheaper to not pollute than to pollute and clean up”
2 ways share- and other stakeholders can pressure firms
eg. OpenAI employees pressured the board to make changes and reinstate the CEO. so we need to think beyond shareholders
-
Exit
eg, investors divesting from polluting firms, consumers boycotting their products, employees leaving firm
- LOWERS the MARKET VALUE of a dirty firm, inducing some value-maximising managers to switch to cleaner technologies
- won’t work unless EVERYONE CARE: if only a few care, the others will simply the products instead {and they will just benefit from the lower prices}; if nobody cares, nobody will exit
» exit strategy worked for OpenAI since about 90% of employees pressured to leave -
Voice
eg. voting/engaging with management
- pressures firms to adopt the cleaner technologies DIRECTLY
- works if shareholders are DIVERSIFIED b/c the capital loss from the firm is negligible, but the gain from the NET SOCIAL BENEFIT from the cleaner technologies is large {everyone shares the costs but also everyone sharing the benefits}
However, firms may anticipate this engagement/behaviour that will cause firms to reduce future profitability, so they will impose CG features to make engagement more difficult ex ante
eg. staggered boards, dual-class voting structures, supermajority provisions
Facebook, Inc.: A Look at Corporate Governance - Points covered FYI
- very unique governance structure, CEO-founder retains much power
- thus, an investment in Meta is an investment in Zuckerberg
- Summary compensation table
- Dual-class voting structure
- Board of directors
- Outstanding equity awards
- CEO pay ratio disclosure
3 pros & 2 cons of Stock-based pay
Stock-based pay = unrestricted & restricted (comes with time/performance conditions) stock, and options
» value of ultimate realised may differ since depends on future
Pros
1. preserves cash
2. aligns incentives {reduces principal-agent problems}
3. EMPLOYEE RETENTION ie. restricted stock
Cons
1. SHARE DILUTION
2. RISK AVERSION {not necessarily that SBC will trigger more risk-taking incentives since share price is tied to firm value}
3 risk-taking effects of stock-based pay
(Ross, 2005)
The combined effect may be negative, which implies that stronger incentives can “backfire”.
1. Convexity effect
- larger payouts make employees MORE WILLING to take risks
-
Magnification effect
- larger payouts magnify employees’ EXPOSURE to inherent risks, which may REDUCE their WILLINGNESS to take risks
» personal wealth will FLUCTUATE with value of firm; very connected -
Translation effect
- depending on how the PAYOUT STRUCTURE is designed, payouts may shift focus to a particular portion of the employees’ utility function
- which may make them MORE/LESS WILLING to take risks
