Corporate Strategy

Fall 2008

Session 7 - Lecture 3

Corporate Governance

Dr. Olivier Furrer

Office: TvA 1-1-11, Phone: 361 30 79 e-mail: o.furrer@fm.ru.nl Office Hours: only by appointment

Session 07 Furrer 2002-2008

Corporate Governance
Market, hierarchy, and the limits to the scope of the firm. => Transaction Costs Theory.
(Williamson, 1975, 1985)

Principals, agents, and the limits of the control mechanisms. => Agency Theory.
(Fama and Jensen, 1983)

Stakeholders, Stewards, and the limits of transaction and agency theories.

(Carroll, 1979, 2003; Davis, Schoorman & Donaldson, 1997; Ghoshal, 2006)
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Agency Theory
An agency relationship exists when: Agency Relationship Shareholders (Principals)
Firm Owners
Risk Bearing Specialist (Principal)

Hire

Managerial DecisionMaking Specialist (Agent)

Managers (Agents) Decision Makers

which creates
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Session 07 Furrer 2002-2008

Source: adapted from Fama and Jensen (1983)

Managers Self-Interest
Maximizing Growth, Not Earnings
Diversifying Risk Managerial Risk Aversion

Managerial Self-Preservation (managerial entrenchment)

Managerial Enrichment

Session 07 Furrer 2002-2008

Manager and Shareholder Risk and Diversification

Risk

Shareholder (Business) Risk Profile

Managerial (Employment) Risk Profile M

Dominant Business
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Related Constrained

Related Linked

Unrelated Businesses
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Level of Diversification

Hubris Hypothesis of Takeovers

The hubris (or pride) hypothesis (Roll, 1986) implies that managers seek to acquire firms for their own personal motives and that the pure economic gains to the acquiring firm are not the sole motivation or even the primary motivation in the acquisition. Roll (1986) states that if the hubris hypothesis explains takeovers, the following should occur for those takeovers motivated by hubris: The stock price of the acquiring firm should fall after the market becomes aware of the takeover bid. This should occur because the takeover is not in the best interests of the acquiring firms stockholders and does not represent an efficient allocation of their wealth. The stock price of the target should increase with the bid for control. This should occur because the acquiring firm is not only going to pay a premium but also may pay a premium for excess of the value of the target. The combined effect of the rising value of the target and the falling value of the acquiring firm should be negative. This takes into account the costs of completing the takeover process.
Roll, Richard (1986), The Hubris Hypothesis of Corporate Takeovers, Journal of Business, 59 (2), 197-216.
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Hubris Hypothesis of Takeovers

CEO Recent Performance CEO Media Praise HUBRIS

Board Vigilance

CEO Inexperience
CEO Self-Importance

Acquisition Premium

Session 07 Furrer 2002-2008

Hayward, Mathew L. A. and Donald C. Hambrick (1995), Explaining Premiums Paid for Large Acquisitions: Evidence of CEO Hubris, Unpublished Manuscript, July

The Winners Curse Hypothesis of Takeovers

The winners curse of takeovers states that bidders who overestimate the value of a target will most likely win a contest. This is due to the fact that they will be more inclined to overpay and outbid rivals who more accurately value the target. This result is not specific to takeovers but is the natural result of any bidding contest (Baserman and Samuelson, 1983). In a study of 800 acquisition from 1974 to 1983, Varaiya (1988) showed that on average the winning bid in takeover contests significantly overstated the capital markets estimate of any takeover gains by as much as 67%. Varaiya (1988) measured overpayment as the difference between the winning bid premium and the highest bid possible before the market responded negatively to the bid. This study provides support for the existence of the winners curse, which in turn, also supports the hubris hypothesis.
Session 07 Furrer 2002-2008

Varaiya, Nikhil (1988), The Winners Curse Hypothesis and Corporate Takeovers, Managerial and Decision Economics, 9, 209-219.

Contextual Factors that Exacerbate Agency Problems

Antitrust Enforcement
Life Cycle and Free Cash Flow Market Pressure (Quarterly Earnings)

Executive Compensation
Disengaged Shareholders

Session 07 Furrer 2002-2008

Governance Mechanisms

Ownership Concentration Boards of Directors Executive Compensation

Multidivisional Organizational Structure Market for Corporate Control
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Governance Mechanisms
Ownership Concentration
- Large block shareholders have a strong incentive to monitor management closely - Their large stakes make it worth their while to spend time, effort and expense to monitor closely - They may also obtain Board seats which enhances their ability to monitor effectively (although financial institutions are legally forbidden from directly holding board seats)
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Governance Mechanisms
Boards of Directors
- Insiders - Related Outsiders - Outsiders

- Review and ratify important decisions

- Set compensation of CEO and decide when to replace the CEO - Lack contact with day to day operations
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Governance Mechanisms
Recommendations for more effective Board Governance
- Increase diversity of board members backgrounds - Strengthen internal management and accounting control systems - Establish formal processes for evaluation of the boards performance
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Governance Mechanisms
Executive Compensation
Salary, Bonuses, Long term incentive compensation Executive decisions are complex and non-routine Many factors intervene making it difficult to establish how managerial decisions are directly responsible for outcomes In addition, stock ownership (long-term incentive compensation) makes managers more susceptible to market changes which are partially beyond their control Incentive systems do not guarantee that managers make the right decisions, but they do increase the likelihood that managers will do the things for which they are rewarded
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Governance Mechanisms
Multidivisional Organizational Structure
Designed to control managerial opportunism - Corporate office and Board monitor managers strategic decisions - Increased managerial interest in wealth maximization M-form structure does not necessarily limit corporate- level managers self-serving actions - May lead to greater rather than less diversification Broadly diversified product lines makes it difficult for top-level managers to evaluate the strategic decisions of divisional managers
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Governance Mechanisms
Market for Corporate Control
Operates when firms face the risk of takeover when they are operated inefficiently
The 1980s saw active market for corporate control, largely as a result of available pools of capital (junk bonds) Many firms began to operate more efficiently as a result of the threat of takeover, even though the actual incidence of hostile takeovers was relatively small Changes in regulations have made hostile takeovers difficult

The market for corporate control acts as an important source of discipline over managerial incompetence and waste
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Governance Mechanisms
Legislation
Beginning in late 2001, several large American companies (Enron, Worldcom, etc.) experienced spectacular bankruptcies because of fraud on the part of their executives and less than optimal corporate governance practices on the part of their boards.

Sarbannes-Oxley Act
- CEOs and CFOs of the largest corporations should personally sign off financial statements, certifying they are true and accurate (Penalty: up to 20-year prison sentence) - A new definition of independent director, also changed the rules as to how to audit firms.
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Governance Mechanisms
Shareholders Service Organizations and Corporate Governance Rating Firms
Companies such as GovernanceMetrics, Moodys, and Standard & Poors offer rating of corporate governance systems.

Alternative theories
- Stewardship Theory (Davis, Schoorman & Donaldson, 1997) - Stakeholder Theory (Freeman, 1984) - Corporate Social Responsibility (Carroll, 1979, 2003) Global Convergence in Corporate Governance
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Stewardship Theory

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Reference: Davis, Schoorman & Donaldson, 1997 19

Stewardship Theory

Reference: Davis, Schoorman & Donaldson, 1997

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Stakeholder Theory
Local community organization Governments Owners Consumer advocates

Suppliers

Environmentalists

Firm

Customer

SIG Employees
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Competitors Media
Reference: Freeman, 1984
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Carrolls Corporate Social and Economic Responsibilities

Be a good corporate citizen Desired Be ethical Expected Obey the law Required Be profitable Required
Adapted from Carroll, 1979, 2003
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Social Responsibilities

Philanthropic

Ethical

Legal
Economic

Economic

Session 07 Furrer 2002-2008