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Governance and Risk Management. Chapter 17. Basics of Corporate Governance. Corporations : group of consensual, contractual relations among several constituencies

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basics of corporate governance
Basics of Corporate Governance
  • Corporations: group of consensual, contractual relations among several constituencies
  • Corporate charter (or Articles of incorporation): agreement between corporation and state in which it is incorporated as to how the corporation will be run; includes:
    • Authorized shares of corporation
    • Corporation’s name
    • Corporation’s purpose
basics of corporate governance3
Basics of Corporate Governance
  • Corporate charter (continued)
    • In return, corporation pays franchise tax to state based on authorized capital of company
    • May be amended after they are originally filed by incorporators by majority or super-majority vote of shareholders
    • For public companies, vote requires:
      • Proxy filing with Securities and Exchange Commission (SEC)
      • Hiring of proxy solicitor to encourage shareholders to vote their shares
basics of corporate governance4
Basics of Corporate Governance
  • By-laws
    • “Fill the gaps” left by charter
    • Address board elections and composition, appointment of officers, timing and conduct of corporate annual meetings, etc.
    • Amended by board if permitted by state of incorporation and charter; otherwise, amendable by shareholders
basics of corporate governance5
Basics of Corporate Governance
  • Board of directors
    • Elected by shareholders at annual stockholders’ meeting
    • Each share is generally entitled to one vote per director unless there is cumulative voting or multiple classes of stock
    • Directors who receive most votes win
    • Directors are expected to maximize value per share
directors fiduciary duties
Directors’ Fiduciary Duties
  • Directors’ two duties to shareholders under Delaware law:
    • Duty of care
      • Director must act in good faith and strive to exercise ordinary prudential care in making business decisions through processes
      • “Business judgment rule”: presumption in favor of director’s decision-making even if expected results of decision are not realized
      • “Total fairness standard”: if director has a conflict of interest, he/she must prove that his/her decision was fair to all parties
directors fiduciary duties7
Directors’ Fiduciary Duties
  • Delaware law (continued)
    • Duty of loyalty
      • Director must act in best interests of corporation and not do things that harm corporation
        • Director cannot compete directly with corporation unless other directors have expressly permitted competing enterprise
    • Failure to adhere to these two duties may lead to personal liability by director
daily governance of the corporation
Daily Governance of the Corporation
  • Chief executive officer (CEO)
    • Board recruits and hires CEO to run day-to-day operations
    • CEO serves as management’s representative to board and is frequently same person as chair of board
    • CEO hires management team (chief financial officer, chief marketing officer, and other “C-level” executives)
    • Board holds CEO accountable for corporation’s operating performance and stock price performance
daily governance of the corporation9
Daily Governance of the Corporation
  • Managers have fiduciary duties of care and loyalty that prohibit them from:
    • Competing with their employer
    • Usurping business opportunities
    • Misappropriating corporate trade secrets and confidential information
  • Consequences for breaching duties to corporation:
    • Managers may be sued personally.
    • Manager’s employment may be terminated.
daily governance of corporation
Daily Governance of Corporation
  • Sarbanes-Oxley Act: Management of public companies is responsible for structuring corporation with adequate “internal controls” so that company has integrity in its financial reporting and other processes
    • Corporation must report any deficiencies in and status of its internal controls in its public filings with SEC.
    • This process provides current/prospective shareholders with a view on the riskiness of corporation’s internal management systems.
risk management
Risk Management
  • The board of directors and management must appropriately select and manage the risks that a corporation takes as it seeks to increase the per share value of its stock.
  • Three key risks:
    • Counterparty risk
    • Interest rate risk
    • Liquidity risk
risk management12
Risk Management
  • Counterparty risk: risk that an organization/person with which a corporation has a business relationship, fails to perform its obligations
    • Borrowers default on their loan agreements with banks.
    • Prospective buyers “fail to close” on purchase contract with home sellers.
    • Domino-like effect (must consider counterparties’ counterparty risk)
    • To mitigate this risk, avoid concentration of lenders, vendors, customers, etc. (i.e. diversify)
      • Easier for large company to do than for small, entrepreneurial firm
risk management13
Risk Management
  • Interest rate risk: risk that a shift in interest rates will adversely affect either company’s assets or liabilities
    • If a corporation has $100 million of floating rate debt outstanding, a rise in interest rates will increase company’s interest expense burden.
    • If interest rate increases, value of investor’s fixed rate bonds will be reduced (since bond prices rise when interest rates fall and vice versa).
      • The lower the coupon payment and the longer the bond has until maturity, the greater the interest rate risk.
    • To mitigate this risk, balance duration (weighted average cash flows) and mix of fixed/floating interest rate instruments between assets and liabilities
      • Easier for large financial firms to do than for smaller and non-financial firms
risk management14
Risk Management
  • Liquidity risk: possibility that firm will not have sufficient cash on hand or immediately available credit to pay its bills as they come due
    • Some possible causes:
      • Accounts receivable go bad (due to counterparty risk)
      • Lenders get nervous and call loan before due date
      • Unexpected order which necessitates emergency purchase of inventory
    • To mitigate this risk, keep higher cash balances
      • Cash is expensive
      • Without sufficient profitability, raising equity to provide that cash is also expensive
      • Keeping cash rather than re-investing can be costly
      • Nevertheless, a failure to have sufficient cash can cause financial distress or bankruptcy
risk management15
Risk Management
  • Other types of risk:
    • Product obsolescence risk
    • Exchange rate risk (for companies doing business internationally)
    • Succession risk: risk that company cannot adequately replace its current CEO
  • Corporate boards and audit committees must identify particular risks and ways to mitigate/eliminate those risks!