Countersignature Corporate Governance Agreement Made Easy

Countersignature corporate governance agreement

the first video focused on the the issue of the agency problem in in public companies where owners and managers are separated in the second video we will now discuss the various mechanisms that shareholders can use to make sure that managers pursue shareholder interests and how they oversee the firm there are two broad categories of corporate governance mechanisms the first set of mechanisms are internal mechanisms and these are specific structures involved within the firm that help oversee managers you'll note here it says proxy statement and parentheses all of these internal mechanisms are there's a goal to be transparent by the Securities and Exchange Commission or the SEC and so each year prior to the annual meeting a public company must file a file what's called a proxy statement and you can find information about these three mechanisms within that proxy statement so that you can see how the oversight of firms is occurring the second set of mechanisms are external mechanisms or mechanisms outside of the firm in the industry and in government space where these are designed to make sure management stays in check from the external side over the next few slides will now delve into these in more detail the first internal mechanism involves ownership concentration ownership concentration is the percentage of outstanding shares owned by a single owner higher concentration means that there is a higher percentage of shares in the hands of a few investors in other words two or three or maybe four investors on a significant proportion of the firm's shares what this does is this place is more power in the hands of fewer people this ownership concentration has been increasing over time as more and more institutional investors have grown in the market including mutual funds private equity firms hedge funds etc these large owners have incentives to monitor actively for two reasons one they have an ability through their large equity stake two because they have a large number of votes to influence managerial activity and - because they own such large proportions of the equity it often represents a significant proportion of their wealth thus they are concerned more concerned than smaller shareholders about the managers taking actions that pursue growth and stock prices and follow shareholder interest less or higher ownership concentration leads to more active monitoring and more shareholder power to oversee management executive compensation involves providing managers incentives to motivate them to take appropriate actions and decisions that follow shareholder desires the key components of executive compensation are listed here salary involves the annual salary paid now the greater proportion of salary paid actually increases risk aversion and managers because there's no benefit for them to take risk and put that salary at risk so higher salary means greater risk aversion bonus is fairly similar in the sense that there is some incentive to take some risk but once that bonus is achieved it induces risk aversion because now once that bonuses has that target level has been achieved managers will want to preserve that bonus so there is some level of risk seeking followed by a level of risk aversion once achieved stock provides managers pay or compensation through shares of stock and you can see here unrestricted versus restricted unrestricted means I simply pay them in shares of stock that they own as soon as it's given to them restricted shares of stocks as I give them shares of stock but they don't actually have access to that stock until one or two years later or until several targets are met now by making managers shareholders they begin to think like shareholders which should align their interests however by giving them stock you have given them downside risk in the form of if the stock price declines managerial wealth declines thus some small amount of stock pay actually encourages risk-taking and encourages them to think like shareholders however as that level of stock compensation increases it actually increases their risk aversion because more and more of the managers wealth is tied up Dok therefore they will try to make decisions that will not harm the stock price rather than thinking about increase in the stock price stock options involved giving the managers an option to buy stock at a certain price and what this does is it removes the downside out the downside risk associated with just simply shares of stock so by providing stock options you're providing them an opportunity to gain if the stock price goes up and then think like think in terms of increasing stock price without the associated risk and then though I asked what is the long-term incentive pay where you are giving managers longer-term incentive targets and if they reach those they're given cash so it's instead of an annual bonus like the second component listed here long term and said to pay is like a multi-year bonus now you'll notice that these various incentives have different time horizons they induce different risk preferences they involve different risk bearing levels for managers as a result shareholders will want to design a compensation package that will foster the appropriate level of risk seeking and to foster the correct behavior and managers that they're trying to obtain however sometimes these packages have unintended consequences and I'll go back to the example of stock here the idea of paying managers with stock is supposed to make them think like shareholders however if you give them too much stock they actually become very risk-averse which is the opposite of what you're trying to achieve in addition some of these incentives may create the desire or the motivation to behave on you know in legal or ethical gray areas or even beyond there into our ethical behavior in order to achieve incentive targets and so shareholders have to be cautious here that they're not motivating the wrong behaviors when trying to actually incentivize correct behaviors the final internal mechanism is the Board of Directors now the Board of Directors are a set of individuals who are elected by the shareholders and their job or their responsibility is to protect the interests of shareholders through the setting of compensation as we just talked about through advising the CEO and top management team through working with reporting and managing the financial relationship with external auditors who oversee the validity of the financial statements and by representing shareholder interests when the strategy is designed and proposed for a vote now the board has several legal duties that they are required to uphold or they are personally liable for one is the duty of care that they'll that they will basically understand the firm's business and make sure that they follow it second is the duty of loyalty where they're supposed to act in the best interest of the corporation and this is important because at times there may be a conflict of interest between the directors interests and the firm's interests and therefore they must always choose the firm's interest at heart and then there's the business judgment rule where at a time that the board is shielded from liability if they take reasonably actions reasonable actions on behalf of the firm that yield poor results essentially the Board of Directors has a fiduciary duty if I do cheri responsibility to protect shareholder interests and these duties here are the legal duties that they are held bound to and if they fail in these duties and if they're negligent or if they fail to follow these these directors can be sued for not performing their activities to protect shareholder interests the previous three mechanisms were internal mechanisms or mechanisms that directly involve aspects of the firm's governance system the external mechanisms listed here are are outside of the firm and these still offer oversight and control of management but they tend to be more more incurred or they they may happen when the firm is grossly under managed or poorly managed the first one the market for corporate control essentially refers to the merger and acquisition market here if firm management is not doing their job or doing their job poorly and the firm is underperforming then that company may a takeover target and a purchaser or an acquirer will buy that firm because it's performing poorly replace the ineffective management and then turn it around and and possibly sell it back out or spin it back out or keep or hold on to it but essentially you have this becoming more and more prevalent with activist investors taking stakes and firms and forcing change a second external mechanism is government action and this really only occurs when the firm has broken laws or has failed to comply with regulations and so here you have several government bodies such as the Securities and Exchange Commission the Environmental Protection Agency or the Internal Revenue Service which oversee firms in terms of their following publicly traded firm guidelines following environmental guidelines and/or following tax guidelines and so the government will become involved that the firm violates any legal standards in their in their poor management decisions but again this is only an enforcement should something go wrong or look like it's going wrong this is not necessarily going to be an ongoing oversight mechanism similar to the the internal mechanisms and then finally you have a set of third-party corporate watch dogs such as rating agencies and other governance rating companies and these companies really are basically hired by investors they're paid by investors in various forms to keep an eye on firms and they rate firms and and provide these ratings so that outside investors can see how the firm is operating from a governance perspective are the firm is the firm well structured is management doing what they're supposed to be doing are there issues in terms of the bylaws of the company or in terms of the management of the company that may put investors at risk thus these external mechanisms help investors make sure management is acting in an inline with shareholder interests and when combined with the internal mechanisms provide a relatively comprehensive system to oversee public companies however it's important to note that even though this governance system exists there's always unintended consequences or there's always opportunities for firms to try to find loopholes or to try and find ways to get around these governance mechanisms to pursue self-interest thus the system of corporate governance particularly in the u.s. is a constantly evolving system involving changes in regulations changes in behaviors changes in investment investor activity to try and stay on top of management to pursue shareholder value maximization