CANS 406 Lecture Notes - Lecture 15: Public Company Accounting Oversight Board, Sarbanes–Oxley Act, Activist Shareholder
Corporate governance and Organization structure and controls
March 20th
Corporate governance:
• Set if the mechanisms used to manage relationships among stakeholders and to determine and
control the strategic direction and performance of organizations
o Can also apply to non-profits and foundations
o Board links the organization to its external environment, to secure critical resources and to
build prestige and legitimacy (Roche, 2008)
• Concerned with identifying ways to ensure that strategic decisions are made more effectively
• Used in corporations to establish harmony between the firm's owners and its top-level managers,
whose interest may be in conflict
o Board's 3 key functions:
• Monitoring the managers' actions on behalf of shareholders
• Advising the managers on strategic direction and key strategic decisions
• Interfacing with stakeholders/institutions in external environment to help provide
legitimacy, expertise and access to critical resources
Agency
• Agency theory
o Berle & Means (1932)
• Separation of ownership and control
▪ Delegation of management control to a small group within the company
▪ In practice: shareholders/owners of capital end up losing function of
management and effective rights to exercise control/modify terms of initial
delegation arrangements
• Due to scattered ownership shares among numerous shareholders
• Shareholder interests vs managerial interests
o Opportunistic behaviour by managers:
• Empire-building vs returning profits to shareholders
• Maagerial disretio aagerial "perks": orporate jets, …
• Agency relationship
o
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• Agency relationship exists when shareholders hire managers and pay them
• Can also refers to relationship between clients (principals) and consultants (agents)
o Problems:
• Principal and agent have divergent interests and goals
• Shareholders lack direct control of large, publicly trade corporations
• Agent makes decisions that result in pursuit of goals that conflict with those of the
principal
• It's difficult/expensive for the principal to verify that the agent has behaved
appropriately
• Agent falls prey to managerial opportunism
▪ Managerial opportunism: seeking of self-interest with guile (cunning or deceit)
(ruse, astuce)
• Agency costs and governance mechanisms
o Agency costs: sum of incentive costs, monitoring costs, enforcement costs, and individual
financial losses incurred by principals
• Governance mechanisms cannot guarantee total compliance by the agent
o Principals may engage in monitoring behavior to assess the activities and decisions of
managers
• However: dispersed shareholding makes it difficult and inefficient to monitor
management's behavior
o Boards of directors have a fiduciary duty to shareholders to monitor management
• But boards of directors are often accused of being lax in performing this function
• Managerial opportunism
o Seeking of self-interest with guile
o It's an attitude (inclination) and set of behaviors (specific acts of self-interest)
o Prevents the maximization of shareholder wealth (primary goals of owner/principals)
o Response to managerial opportunism
• Principals do not know beforehand which agents will or won't act that way
• Thus, principals establish governance and control mechanisms to prevent managerial
opportunism
• Ways of addressing problems, arising from separation of ownership and managerial control (first 3
are internal, last one is external)
o Ownership concentration
• Relative amounts of stock owned by individual shareholders and institutional
investors
o Board of directors
• Individuals responsible for representing the firm's owners by monitoring top-level
managers' strategic decisions
o Executive compensation
• Use of salary, bonuses, and long-term incentives to align managers' interests with
shareholders' interests
o Market for corporate control
• Purchase of a firm that is underperforming relative to industry rivals in order to
improve its strategic competitiveness
• Ownership concentration
o Large block shareholders (5% share) have a strong incentive to monitor management closely
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• Their large stakes make it worth their time, effort and expense
• May obtain board seats, which enhances their ability to monitor effectively
o Financial institutions are legally forbidden from directly holding board seats
o Increase influence of institutional owners (stock mutual funds and pension funds):
• Have the size (proxy voting power) and incentive (demand for returns to fund) to
discipline ineffective top-level managers
• Can affect firm's choice of strategies
o Shareholder activism
• Shareholders can convene to discuss corporation's direction
• If a consensus exists, shareholders can vote as a block to elect their candidates to the
board
• Proxy fights
• There are limits on shareholder activism available to institutional owners in
responding to activists' tactics
• Board of directors
o Group of elected individuals that acts the owners' interest to formally monitor and control
firm's top level executives
o Board has the power to:
• Direct the affairs of the organization
• Punish and reward managers
• Protect owners from managerial opportunism
o Basic roles and tasks of the Board (Hitt)
• Monitor
▪ Stay on top of developments inside and outside the corporation
• Evaluate and influence
▪ Evaluate management's proposals, decisions, actions
▪ Offer advice, suggestions, alternatives
• Initiate and determine
▪ Involvement in setting corporation's mission and specifying strategic options
(more rarely, intensive involvement)
o Composition of Boards (not specific rule as to how many people)
• Insiders: firm's CEO and other top-level managers
• Related outsiders: individuals uninvolved in day-to-day operations, but who have a
relationship with the firm
▪ Affiliated diretors suppliers, aks, legal, aoutig series…
▪ Ex-officers/ex-CEO
▪ Family members
• Outsiders: individuals who are independent of firm's day-to-day operations and other
relationships
▪ Pressure from institutional investors to designate one of independent outsider
directors as lead, or president director
o Sarbanes Oxley Act of 2002
• What did it do?
▪ Establishes Public Company Accounting Oversight Board
▪ Audit committees of corporations must consist of independent directors, with
no links to firm
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