AB3602

Strategic Management

Week 10 - Corporate Governance

Caleb Tse
Strategy, IB and Entrepreneurship Division
Nanyang Business School
Nanyang Technological University

AY2023-24 S2
 Agenda
❖ Define corporate governance
❖ Explain the principal-agent relationship and agency issues
❖ Explain how internal and external governance mechanisms
mitigate agency problems
❖ Sustainability considerations in corporate governance
Strategic Management Framework
Corporate Governance
❖ The set of mechanisms used to:
▪ Manage the relationships among stakeholders
▪ To determine and control the strategic direction and performance of organisations

❖ Two types of governance mechanisms:

▪ Internal
▪ External

❖ Corporate governance mechanisms mitigate agency problems in publicly-

listed firms
Agency Theory
Ownership and Managerial Control
Agency Relationship Problems

❖ Shareholders and managers have divergent interests and goals.

▪ Managers make decisions that result in the pursuit of goals that may conflict with
those of shareholders.
▪ Agency conflict - managers (as agents) do not fully represent the best interests of the
owners (principals)

❖ It is difficult or expensive for the shareholders to verify that the managers

have behaved appropriately.
▪ Shareholders lack direct control over large public corporations.
Examples of the Agency Problem

❖ Use of Free Cash Flows

▪ Shareholders prefer the funds as dividends, so they control how the funds are
invested.
▪ Managers prefer to invest these funds in additional product diversification, including
unrelated diversification (see below).

❖ The Problem of Product Diversification

▪ In general, shareholders prefer riskier strategies that are likely to bring higher returns
as well as more focused diversification.
▪ Managers may prefer a level of diversification that maximizes firm size and their
compensation while also reducing their employment risk.
Primary Corporate Governance Mechanisms
Corporate Governance Mechanisms

Internal Governance Mechanisms:

▪ Ownership Concentration
▪ Relative amounts of stock (high %) owned by individual shareholders and institutional
investors
▪ Board of Directors
▪ Individuals responsible for representing the firm’s owners by monitoring top-level
managers’ strategic decisions
▪ Executive Compensation
▪ Use of salary, bonuses, and long-term incentives to align managers’ interests with
shareholders’ interests
Corporate Governance Mechanisms

External Governance Mechanisms:

▪ Market for Corporate Control
▪ The purchase of a company that is underperforming relative to industry rivals in
order to improve the firm’s strategic competitiveness
▪ Regulators
▪ Monitoring of corporate governance practices for corporate fraud
▪ Creditors
▪ Priority in receiving debt and interest payments
Internal Governance Mechanisms:
Ownership Concentration

❖ Large block (5% ownership) and institutional (mutual/pension funds)

shareholders have incentive to monitor management closely:
▪ Large stakes make it worthwhile to spend time, effort and expense to monitor closely.
▪ May also obtain Board seats which enhances their ability to monitor effectively.

❖ Shareholder activism refers to actions shareholders take with the intent of

influencing corporate policy and practice
▪ Shareholder activism may include proxy fights or battles.
▪ Concentrated on the performance and accountability of CEOs/Board of Directors
Internal Governance Mechanisms:
Board of Directors

❖ Board of directors
▪ Group of elected individuals that acts in the interests of investors to monitor and
control top executives

❖ Board has the power to:

▪ Direct the affairs of the organization
▪ Punish and reward managers
▪ Protect owners from managerial opportunism
Internal Governance Mechanisms:
Board of Directors

❖ Composition of Boards
▪ Insiders: the firm’s CEO and other top executives
▪ Related Outsiders (or Affiliate): directors uninvolved with day-to-day operations, but
who have a relationship with the firm
▪ Outsiders (or Independent): directors who are independent of the firm’s day-to-day
operations and other relationship

▪ In Singapore/HK, inside directors are typically referred to as executive directors,

related-outside directors as non-executive non-independent directors, and outside
directors as independent directors.
Internal Governance Mechanisms:
Board of Directors

❖ Criticisms of Boards of Directors include:

▪ Too readily approve managers’ self-serving initiatives
▪ Are exploited by managers with personal ties to board members
▪ Board members may NOT devote enough time to the firm
▪ Lack of agreement about the number of and most appropriate role of outside
directors
▪ Board chair NOT independent (e.g. CEO duality)

❖ What is correct balance of insider/outsider board members?

Enhancing the Effectiveness of the
Board of Directors
❖ The demand for improved performance
and greater accountability is
stimulating many boards to make ▪ Establishing and consistently using formal
changes, such as: processes to evaluate board members’
performance.
▪ Increasing the diversity of the ▪ Modifying the compensation of directors,
backgrounds of board members. especially reducing or eliminating stock
options as part of their package.
▪ Strengthening internal management and
accounting control systems. ▪ Creating a “lead director” role that has
strong powers with regard to the board
▪ Increasing attention to issues of corporate
agenda and oversight of non-
social responsibility (i.e., sustainability
management board activities.
and global warming).
Shareholder Governance Mechanisms:
Executive Compensation

❖ Forms of compensation:
▪ Salaries, bonuses, long-term incentive plans (e.g., stock awards and options).

❖ Factors complicating executive compensation:

▪ Strategic decisions by top-level managers are complex and non-routine.
▪ Strategic decisions affect a firm over an extended period.
▪ Other variables affect a firm’s performance over time (e.g. unpredictable events).
Shareholder Governance Mechanisms:
Executive Compensation

❖ Limits on the effectiveness of executive compensation:

▪ Inadequate link with firm performance.
▪ Short-term compensation encourages short-term objectives (e.g., decrease R&D
investments).
▪ Long-term incentive plans transfer risk to top executives.
▪ Compensation plans may be manipulated by executives.

Amazon’s CEO Andy Jassy makes

about $213 million = 6,500x the https://aflcio.org/paywatch
median salary at Amazon
External Governance Mechanisms:
Market for Corporate Control

❖ Individuals/firms buy or take-over undervalued corporations.

▪ Ineffective managers are usually replaced

❖ Threat of hostile takeover may lead firm to operate more

efficiently/effectively and improve firm performance.

❖ Limits on the effectiveness of the market for corporate control:

▪ Managerial defence strategies increase the costs of mounting a takeover
 External Governance Mechanisms:
Market for Corporate Control

❖ Common Managerial Defensive Tactics:

Success as a Effects on
Defensive Strategy Strategy Shareholders’
Wealth
Golden parachute: A lump-sum payment of cash that is given to one or Low Negligible
more top-level managers when the firm is acquired in a takeover bid.
Poison pill: An action the target firm takes to make its stock less Low Positive
attractive to a potential acquirer.
Litigation: Lawsuits that help the target firm stall hostile takeover High Positive
attempts. Antitrust charges and inadequate disclosure are examples of
the grounds on which the target firm could file.
External Governance Mechanisms:
Regulators
❖ Observers of firms’ governance practices have been concerned about more
egregious behaviour beyond mere ineffective corporate strategies (e.g.
Enron, WorldCom, Volkswagen, etc.)

❖ Partly in response to these behaviours, the U.S. Congress enacted:

▪ Sarbanes-Oxley Act (SOX) in 2002.
▪ Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in mid-
2010.

❖ In Singapore, Code of Corporate Governance (issued by Monetary

Authority of Singapore):
▪ Companies Act
▪ Securities & Futures Act
External Governance Mechanisms:
Creditors
❖ Creditors, using legal institutions and negotiations tactics, can have a
profound influence on the decisions the firm makes when a firm is in
default, though actual defaults are not that common.
▪ More prevalent is a firm violating financial covenants associated with a loan.

❖ It is not uncommon for a board seat to be held by a representative of a

large creditor.
▪ Research has shown that bank-appointed directors can serve a certification role, in that
their presence increases the confidence of other creditors that their interests are being
represented.

❖ Firms with better governance characteristics can often obtain lower interest
rates on their debt.
Link
The Stakeholder Model
of Above-Average Returns
❖ External-internal constituencies
Analyses
❖ Identify stakeholders and their
respective interests
❖ Assess reciprocity (org. justice)
❖ Allocate resources to satisfy
their needs
External-internal Analysis to
determine stakeholders and
legitimate interests
Develop fairness, respect,
and trust-based relationships
Strategic formulation
❖ Resource allocation
❖ Value creation
❖ Strategic implementation
Corporate Governance:
Stakeholder Perspective (Sustainability)

❖ Stakeholders are individuals, groups, and organizations that can affect the
firm’s vision and mission, are affected by the strategic outcomes achieved,
and have enforceable claims on the firm’s performance.

❖ Because firms are not equally dependent on all stakeholders at all times,
stakeholders possess different degrees of ability to influence an organization.
▪ Greater dependence gives the stakeholder more potential influence over a firm’s
commitments, decisions, and actions.
Corporate Governance:
Stakeholder Perspective (Sustainability)

Let’s not forget the

Environment, whose
“voice” is typically
expressed through non-
governmental
organizations (NGOs)
such as Greenpeace,
WWF (World Wide Fund
For Nature) etc.
Governments are also
increasingly enacting
environmental
regulations.
Corporate Governance:
Stakeholder Perspective (Sustainability)
17 Goals of the Sustainable Development Agenda
Corporate Governance:
Stakeholder Perspective (Sustainability)

❖ Effective governance mechanisms ensure that the interests of all

stakeholders are served. Thus, strategic competitiveness results when firms
are governed in ways that permit at least minimal satisfaction of the various
stakeholders.

❖ Otherwise, a firm risks seeing its dissatisfied stakeholders withdraw their

support from the firm and provide it to another.
▪ Example: Customers will purchase products from a supplier offering an acceptable
substitute.
Corporate Governance:
Stakeholder Perspective (Sustainability)

❖ Some believe that the internal corporate governance mechanisms designed

and used by ethically responsible leaders and companies increase the
likelihood the firm will be able to, at least, minimally satisfy all stakeholders’
interests.

❖ The most effective boards of directors set boundaries for their firms’ business
ethics and values. As agents of the firm’s owners, the board—acting as an
internal governance mechanism—holds top-level managers fully accountable
for developing and supporting an organizational culture in which only ethical
behaviors are permitted.
Corporate Governance: Analysis

❖ Corporate governance information may be found in several sections of the

Annual Report, such as the Directors’ Report, Statistics of Shareholdings,
Corporate Governance Report etc.

❖ Unfortunately, these sections may have different names across different

annual reports.

❖ Hence, a meaningful analysis requires you to know what you want to collect
and scan the annual report for the relevant sections where the data can be
found.
Corporate Governance: Analysis

❖ When assessing a firm’s governance mechanism, always place more

emphasis on the substance over the form of governance.

❖ Because the code of governance normally adopts a “comply or explain”

approach, you should assess whether explanations of deviations by a firm
makes sense and whether you are convinced by the reasons provided.
Corporate Governance: Analysis

❖ While assessing a firm’s corporate governance mechanisms requires you to

extract/compute numbers from the annual report, you need to go beyond
the numbers and examine the qualitative data behind these numbers.

❖ In other words, be critical in your assessments.

❖ It is entirely possible for a firm to comply fully with the code of governance
(the form) and yet fail to convince an investor that the governance
mechanism will protect his/her interest.
Corporate Governance: Analysis

❖ Firms in some jurisdictions may be required to publish sustainability

reports. For instance, SGX-listed firms must publish an annual sustainability
report.

❖ Sustainability reports are useful to better understand how firms govern

their sustainability activities from a stakeholder perspective.

❖ However, be critical in your assessments of the contents in sustainability

reports due to concerns over greenwashing.
10-min Break
Vote: Strategic Audit Presentation Date

April 9 th or April 16 th
 Group Activity

• Examine the Corporate Governance of your chosen public company:

– What is the ownership concentration?
– What is the composition of their board of directors?
– Executive Compensation?

– Any take-over attempts in its history?

– Any regulatory actions taken against the company? (e.g. if yes, why?)
– Any battle with creditors?
– Any issues with sustainability?
 Next week:

Course Review &

The Rise and Demise of Airbus
A380 Case