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2.3: Corporate Governance

  • Page ID
    4247
  • Knowing the governance of a firm is important in understanding how it functions. In an organization such as a C corporation, decision rights are allocated between those internal to the firm such as shareholders, boards of directors, senior managers, and those external to the firm such as outside auditors, regulatory agencies, analysts, and other stakeholders. Organizations are designed to create jobs that address certain tasks which must be accomplished, and these jobs include varying levels of authority to decide how to best complete those tasks.

    Think about this concept in regard to a convenience store that sells refined fuels such as gasoline and diesel fuel, a limited selection of grocery products, convenience foods, and similar products. This store has two cash registers. Consider point A, where there are few tasks to accomplish and limited authority to make decisions. This job might be a clerk who is contracted to run the cash register and has limited authority to make decisions. Point B has more tasks to perform but limited decision-making authority. An example might be a shift leader who runs the cash register, is the supervisor for the other clerk, and may do certain jobs within the store such as stock shelves, but who has limited authority to make other

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    decisions. Point C involves more tasks and more authority. This would be the store manager who has supervisory responsibilities for all employees in the store and is responsible for inventory control. Point D involves many tasks and more authority to make decisions. The store owner or franchise owner who owns this store and perhaps other stores has the responsibility to make decisions regarding pricing, but is subject to the franchise contract with regard to brand selection, services being offered, and choice of suppliers.

    Organizations are complex as they grow in size. Managers with more and more responsibility thus find that the tradeoff between the authority to make decisions (decision rights) and the required tasks is complex, because now the manager is responsible for many employees who are themselves assigned tasks and decision rights. Achieving the right alignment between tasks and decision rights is difficult in larger organizations.

    The authority to make decisions can be broken down into a series of steps. An organization 1) seeks proposals to use resources such as capital, labor, and structure contracts to assign the resources to the appropriate user, 2) makes a decision to choose the appropriate proposal, 3) implements the decision, and 4) monitors the performance of the implemented decision, and rewards accordingly. Steps 1 and 2 are often called decision management while steps 3 and 4 are called decision control.

    The design of a corporation’s governance is crucial, and it is good practice to separate decision management from decision control. Otherwise, those making the decisions may choose what is best for themselves rather than for the organization. Many organizations have a board of directors that is responsible for monitoring the performance of the individual managing the firm, such as the Chief Executive Officer (CEO). The board has decision control, while the CEO has decision management. This separation of decision management from decision control leads to a hierarchical structure, as managers have decision management responsibilities in their job and decision control responsibilities over others below them who themselves have decision management responsibilities.

    Organizations are evaluated on their governance system through three different methods: 1) the motivation of value-maximizing decisions, 2) protection of assets from unauthorized use, and 3) financial statements that comply with legal requirements. Because much of the ownership of publicly-traded corporations is by institutional investors who own a small amount of stock in the firm, there is separation of ownership and control. This is in contrast to a small business, where the manager owns and controls the business and has direct incentives to be very efficient with the use of assets.

    There are many benefits to organizing a firm as a corporation. Access to equity capital can occur through sales of stock to investors. The cost of equity is less because these investors own diversified portfolios, so the premium paid to them for the risk associated with uncertainty in the corporation’s cash flows is less. The corporation serves as the center of many contracts and is always one party to these contracts signed with buyers, suppliers, employees, lenders, and other entities. These contracts specify the decision rights to each party. The corporate charter, which includes the articles of incorporation and bylaws, specifies the rights of shareholders.

    The top-level authority in a corporation is divided between shareholders, the board of directors, and senior management. The decision authority of shareholders includes the right to elect directors to a board, ratify the choice of an independent auditor, and be involved in other issues specified in the charter or bylaws including mergers, issuance of additional shares of stock, or changes in legal structure. Before an annual meeting, shareholders are sent information from the corporation that describes various proposals that require their vote, such as elections of directors to the board. Management, subject to board approval, makes recommendations to the shareholders regarding these issues. Shareholders are the residual claimants to the corporation in the event of dissolution. Thus, their voting control is often linked proportionally to their ownership interest.

    The primary legal authority for managing a corporation lies with its board, although it may delegate much of this to professional managers hired for that purpose. The board has top-level decision control to oversee the corporation and ratify important decisions. These decisions include recruiting, interviewing, hiring, evaluating, and compensating the CEO. Large capital expenditures require board approval. Boards have legal indemnification from lawsuits provided it can be shown that they were

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    acting prudently. Corporate boards generally have 9–12 directors, and usually include several members of senior management. A committee structure is used to handle nominating, compensation, audit, and other issues that are under the purview of the board. The CEO is the senior most individual in the corporation. The job of the CEO is to focus on the broad issues affecting the firm and develop, implement, and monitor its strategy. The CEO delegates decision rights among senior level managers.