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Corporate Governance

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Autor:  anton  18 December 2010
Tags:  Corporate,  Governance
Words: 2586   |   Pages: 11
Views: 387

Corporate Governance – Effective or Inefficient?

In the wake of the corporate sandals involving Enron and WorldCom at the start of the 21st century, public awareness incited a new era of corporate governance with the passage of the Sarbanes-Oxley Act. This legislation, in addition to further amendments to the stock exchange’s regulations, was meant to prevent further misconduct by aligning the incentives of shareholders with those of management. In order to redirect the manager’s interests, SOX alters corporate structures through changes in board composition, executive compensation, audit requirements and reporting standards. However, these regulations had an unanticipated affect on firms in the initial announcement period, creating a positive abnormal return in firms initially perceived as less compliant with the laws. Moreover, there is also ‘variation in response across firm size. Large firms that are less compliant earn positive abnormal returns but small firms that are less compliant earn negative abnormal returns, suggesting that some provisions are detrimental to small firms.’ (c.g. and firm value 1) In addition to the affect on stockholders, the bond market is also significantly affected by the announcement. In the long run however, a series of recent studies have managed to ‘document negative relations between various indices of antitakeover provisions (ATPs) and both firm value and long-run stock return performance (c.g. and acquirer returns) It is of great economic importance that legislators and investors understand how these major corporate governance mechanisms operate as well as their affect on share-holder wealth, yet the results of many studies are ambiguous as to whether following these provisions actually leads to more effective monitoring and improved firm value.

Corporate governance is the set of guidelines, procedures and organizational and reporting structures that supervise the way a corporation is run. The principal entities and relationships considered when administering corporate regulations are the shareholders, managers and board of directors. “These rules include different provisions whose purpose is to ensure alignment of incentives of corporate insiders with those of investors, and to reduce the likelihood of corporate misconduct and fraud.” (Journal of Finance, Vol. LXII, No.4. Aug 2007) For example, SOX requires more timely disclosure of equity transactions by company executives, as well as imposing more stringent punishments of those found guilty of unethical behavior. Moreover, Sarbanes – Oxley dictates that audit committees and the board of directors must be largely independent of corporate influence in order to improve monitors systems and lead to higher corporate value. The perception of strong corporate governance can not only impact the company’s share price in the market, but also the cost of raising capital, both important factors in continued firm performance. As such, the secondary focus of corporate governance legislation is to ensure that economic efficiency is improved or maintained by the provisions, so as not to overly encumber businesses in their pursuit of profit. On the whole, most research shows that “portfolios of firms that are less compliant with the rules earn positive abnormal returns compared to portfolios of firms that are more compliant.” (C.G. and Firm Value, 1791)

Topic has been studied in a variety of ways and has come to ambiguous conclusions on whether the SOX provisions have a significant impact, as well as if all firms benefits from them. The most advantageous governance structure depends on a corporation’s monitoring requirements in addition to the inherent cost and benefits of the monitoring processes utilized. Firms of differing size or industry may benefit most from varying control mechanisms, while others may be inefficient or ineffective once implemented. As such, “imposing one structure on all firms might be suboptimal at least to some firms.” (Journal of Finance, Vol. LXII, No.4. Aug 2007) Holmstrom and Kaplan posited that small firms incur higher costs relative to their size by complying with the internal control provisions of SOX because it is more difficult and costly for smaller firms to obtain talented independent directors for their board committees. (Journal of Finance, Vol. LXII, No.4. Aug 2007) When studied, results showed that when the internal control and director independence provisions were examined, abnormal positive returns after the announcement of SOX were found only in larger firms. Moreover, Gomes, Gorton and Madureira (2007) studied the effect of Fair Disclosure regulation on firms’ cost of capital, and found that the legislation reduced cost of capital in larger firms, but increased the burden on smaller firms.

A number of corporate control mechanisms exist that help mitigate the manager-shareholder conflict of interest, such as the market for corporate control

Corporate issues involving fraudulent accounting, malfeasance and data quality issues frequently dominate news headlines; CEOs and Boards of Directors (BoD) are under public scrutiny and, as a result, regulatory requirements have emerged to address these issues using commonly accepted principals of corporate governance

Numerous reports on corporate governance have emphasised the desirability of increasing the number of outside directors on boards. An equally important and related issue is a growing insistence that the role of chairman and chief executive should be separate, though on this issue there is less unanimity in the U.S. than in other countries. Choosing the right Chief Executive officer is the key task for the board of directors. Pressure on chief executives to perform in ever decreasing time frames makes it essential that the CEO and the Board work closely together. An effective chief Executive will drive company strategy, lead the top team and fulfill shareholder ambitions . A good CEO will transform Board dynamics by keeping an open line of communication, placing a high value on Board input, and promoting the belief that management and the Board is working toward common goals. The average Board size is between eight and nine members. It used to be that Boards were constructed of executives with one or two non-executives; but trends are swiftly driving executives out of the boardroom as even the CEO’s familiar role as chairman has been called into question. There has been a notable shift from executive director to non-executive director in the boardroom. The supposed advantages to these changes are to provide greater board independence from management, greater objectivity, and a representation of multiple perspectives. Bosch believes that the fundamental principle underlying this composition is accountability; if you have strong independent directors, a separation of the Chair/ Chief executive role will safeguard accountability . An opinion widely held is that separating the role of chairman from chief executive- would secure a board sufficient power to challenge CEO dominance. Although in many cases that rationale holds true, there are considerable benefits to CEO duality. Researchers have suggested that chairman/chief executive duality is a double-edged sword . While some stockholders are put off by the absence of board control and checks and balances, others are reassured by the presence of unity of command and the absence of potentially acrimonious conflict between strong-minded individuals. Finkelsein and D’Aveni found that a major factor in divining the success of this duality was the level of CEO informal power. ‘Either perceptual or objective data can be used to measure informal CEO power. Although some researchers have used perceptual measures of power, power is a sensitive subject for many managers. In using perceptual measures, a researcher assumes that social actors are knowledgeable about power within their organizations; informants are willing to divulge what they know about power distributions; and such a questioning process II Advantages of CEO Duality When it comes to insiders versus outsiders on the board, a predominant role for insiders finds support more often, probably because insiders are more familiar with the issues, the technology, and the practice of the firm . Only they who are deeply involved and can make it work add value. It is simply not viable for twice removed outsiders, no matter how expert, to provide anything other than a cursory perspective and maybe act as an eventual deterrent to abuses of executive power. According to organizational theory, this CEO duality can establish strong, unambiguous leadership . By consolidating two of the most prestigious offices in a company stakeholders are often reassured, because it clarifies decision-making authority . ‘An additional problem with nonduality is that it weakens and disrupts CEOs ability to manage the task environments their organization faces. For example, several laboratory studies suggested that the participation of constituencies who review negotiator action lead to less effective and more difficult negotiation processes. As a result, “The reasons the positions of chairman and CEO are usually combined is that this provides a single focal point for company leadership”(Anderson/Anthony)’ A powerful and effective CEO creates an image of stability and instills a sense of well being to its employees as well as its shareholders, projecting a clear sense of direction. III Negative aspects of CEO Duality When a company’s chief executive officer is also the chairperson of its board, directors often have contrary objectives . Boards of directors are charged with ensuring that Chief Executive Officers (CEO’s) carry out their duties in a way that serves the best interests of the shareholders. Therefore, the Board of Directors maintains equilibrium between CEO and shareholder interests. ‘Two theories have been put forth to explain why a firm would adopt a dual leadership structure. Fama and Jensen (1983) suggest that the leadership structure of the firm can help control the agency problems created by the separation of residual risk bearing and control typically found in most corporations. More specifically, they believe that the separation of the decision management (initiation and implementation of investment proposals) and decision control (ratification and monitoring of investment proposals) functions within a firm reduces agency costs and leads to enhanced firm performance. At the apex of the leadership structure, this means that the highest-level decision management agent (the CEO) should not control the highest-level decision control structure (the board of directors). As the chairman of the board has the greatest influence over the functioning of the board, Fama and Jensen's theory implies that the effective separation of decision management and decision control requires that the chairman of the board must not also be the CEO of the firm. Further, if Fama and Jensen are correct, firms that switch to a dual leadership structure should experience an improvement in performance following the leadership structure change.’ ‘Other authors, however, found that separating the chair and CEO positions led to improved firm performance. Rechner and Dalton (1991) used three accounting measures of profitability to investigate the performance of a sample of Fortune 500 firms that maintained the same leadership structure from 1978 through 1983. These authors found that firms with a dual leadership structure consistently outperformed firms with a unitary leadership structure. Pi and Timme (1993) found some evidence that banks with a dual leadership structure were more profitable and were more cost efficient than firms with a unitary leadership structure.’ Agency theorists view the board of directors as a type of checks and balances system, similar to that of our government. Agency theorists are typically opposed to CEO duality, whereas organizational theorists offer more support. It has been reported that a vigilant and conscientious board is made up of independent outside directors, otherwise unaffiliated with the company other than that they hold large sums of that company’s stock. ‘Outside directors are more vigilant than directors with other firm affiliations because (1) they focus on financial performance, which is a central component of monitoring. (2) They are more likely than insiders to dismiss CEOs following poor performance, and (3) protecting their personal reputations as directors gives them incentive to monitor. Although insiders tend to have more detailed information about firm operations, they are likely to be reluctant to confront a CEO in a boardroom situation. ’ Several authors have suggested that CEO’s may use their leadership position on the board to dictate the agenda of the board meetings and minimize dissent. ‘Traditional agency and legal perspectives on corporate boards generally do not address how top managers respond to the threat of greater board monitoring and control over their decision making. But losing structural sources of power as a result of greater structural board independence from management may prompt CEOs to initiate specific interpersonal influence attempts, such as ingratiating and persuasion toward board members. CEOs may be especially prone to such behavior because of their high intrinsic power motivation. In addition, the ambiguity and uncertainty inherent in CEOs performance provides ample opportunities for interpersonal influence. These factors may reinforce a more basic, psychological response to the threat of losing control.’ Frequently CEO/chairman duality reduces the ability or willingness of outside directors to challenge the CEO. Comparatively, when CEOs are deprived of official administration over affairs as the chairman, they lose their command over the agenda of the board . IV Qualifying factors affecting CEO Duality Special factors affecting CEO duality include informal CEO power, and board vigilance. A CEOs source of informal power does not necessarily depend upon his position. Informal power can be acquired through reputation, prestigious contacts or affiliations with other companies . CEO duality can often reflect informal CEO power. ‘Pfeffer(1978) argued that centralized structures such as CEO duality is more likely to arise when informal power is concentrated in a CEO.’ Board vigilance depicts a powerful board that has a strong influence on the company. There exist two types of powerful boards, they either share leadership with or command power over the CEO. Board vigilance combines those two categories into one characterized by high board power irrespective of the relationship with the CEO . CEOs often consider powerful boards to be supportive and encouraging of their efforts. A powerful board will, however, step in when the firm's strategy falters. Powerful boards have greater expertise, more awareness of their responsibilities, and more efficient internal processes than do weak boards (Pearce & Zahra, 1991). V Conclusion In conclusion, Vigilant boards seem to favor CEO duality because it promotes a totality of command at the top of a corporation that safeguards the existence of strong leadership. ‘The agency problem theory implies that firm’s do so to reduce the agency costs associated with the separation of ownership and control. The normal succession theory suggests that firms adopt a dual leadership structure as part of the normal process used to replace a retiring chair/CEO. The evidence in this study supports both theories. Specifically, firms most likely to use the dual leadership structure to control agency problems experience statistically significant improvements in performance over the three-year period following the leadership structure change. Further, the firms in this subsample that also replace one or both senior managers experience greater performance improvements than those firms that only change leadership structure. These findings are consistent with the agency problem theory. Firms that are most likely to use the leadership structure change as part of a normal succession process show no signs of performance improvement after the leadership structure change. This finding is consistent with the implications of the normal succession theory’. Conceptualizing CEO duality as a double-edge sword, researchers have drawn two conclusions: 1) Research on corporate governance may benefit when potentially contradictory theories on organizations and agency relations are considered simultaneously . 2) It is especially important that researchers investigating corporate governance recognize that CEOs and boards do not always have different interests . Therefore, it is not possible to draw a positive conclusion in addressing this issue. There are apparently numerous factors involved, and so many conditions that apply, it seems that a firm would have to base their decision on the dynamic existing among executive management and the board members.

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