Appunti Corporate Governance

CEO

2. Non-duality: separation of the Chair and the CEO position

The Chairman has power within the board as he calls the meetings, is in charge of distributing

information, and organizes the structure of the meetings. He is the core element of the board.

The CEO may also be the Chairman, in this case, we have a very powerful individual which is not so

convenient for the firm; some are in favor of this option as it would avoid conflicts.

For example, if something goes wrong, the CEO may adjust information or postpone the meetings.

3. Proportion of non-executives, independent directors: how are they identified and selected, usually

there are two origins:

a) people from your organization (e.g., marketing manager, human resources manager…) that will

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have more than one role subordinated from the CEO inside the organization (hierarchical

power), so unlikely to challenge the CEO on the board.

b) people from outside the organization with a link →

it can happen that a person from a consulting firm is on the board relationship

c) people independent from the CEO, without any relationship: they can express their ideas more

freely

It’s important to have independent members, the more they are the better (at least the majority). The

proportion may vary, but the optimal proportion has been questioned. In the US usually we have all

independent members except for the CEO. However, there are some models, not compulsory, based

on the code of best conduct.

→ It’s not easy to verify the independence though, it’s just a declaration that may not be the real

substance.

→ If the board is not properly composed there’s a sanction coming from the market 17

The board can’t function based on the majority rule! If just one director questions the decision of the

other the consequences may be very strong (from the market)

4. The leader of independent directors: the leader of the independent directors, is in charge of

organizing the activity of all the independent directors out of the board. He speaks for the other

independent directors like a filter, protecting the names of each independent director.

5. Director representing minority shareholders: position reserved exclusively for minority; however,

this director can’t disclose information to the minority (insider trading)

2) Incentives

1. Shares held by directors and managers

Advantage: greater effort

Disadvantages: conflict of interests

The discrimination is the size, the percentage of shares, and if the share has vote rights

2. The quorum for the votes in the shareholder's meetings (to influence the shareholders’ meeting for

their purpose, by voting)

3. Age and tenure: time horizon as a motivational aspect (time-horizon: motivational aspects (length of

the remaining time in office) & cognitive aspects (fixed paradigms)

3) Dimensions and functioning

1. Board size: on one hand you want to increase the size of the board to have more resources, on the

other hand too many people may relax expecting the others to do stuff (the larger the size, the less the

effort; e.g., free riding or social loafing).

Good size: 7-15

2. Number and/or frequency of board meeting

3. Number and relevance of outside engagements, interlocking directorates (e.g., possible conflicts

of interests): look for connections between the corporations and see where the interconnection goes,

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check the sector (related activities, value chain) collecting support →

Double interlocking directorates: the risk is that there is no independence reciprocal retaliation

4. Division of labor: the board committees for the nomination, remuneration, audit/control, or others.

The committees can be established on a voluntary base by the board, typically they have the first three.

They do not decide but they do the preparatory work for board discussions.

5. Division of labor: the control system 18

Internal control system

Is the set of rules, procedures, and organizational structures aimed at allowing (through an adequate process

of identification, measurement, management, and monitoring of the main risks) healthy, correct, and consistent

management of the company with the set objectives.

Is the skeleton of the organization, it’s an information system

Goals:

1) ensure the efficiency, knowability, and verifiability of operation/management

2) ensure the reliability of accounting and management data;

3) ensure compliance with the law;

Risk mapping

Risk classes: strategic, operational, image, deriving from laws and regulations, financial, information

management, emerging.

Fundamental principles:

a. Separation of roles i.e., who decides, who controls

b. Full trackability of choices: full reporting, the possibility of always identifying the responsibilities and

reasons related to a choice

c. Objectification of decision-making processes, the existence of predefined and verifiable criteria; no total

discretion of the decision maker)

Legislative Decree 231/2001

Regulation of the administrative liability of legal persons, companies, and associations, including those

without legal personality.

Establishes the administrative liability of the entity for crimes committed by administrators, managers, and/or

employees in the interest of or to the advantage of the entity itself. The State, local public bodies, and bodies

with functions of constitutional importance are excluded.

Some crimes: are misappropriation to the detriment of the State; fraud against the State; extortion, and corruption.

Furthermore, corporate crimes recognized by law 366/2002: false corporate communications, lac kof control, illicit

influence on the assembly, market manipulation, obstacle to the exercise of the functions of the supervisory authorities,

illicit transactions on shares or quotas of the company or its subsidiaries...

Exclusion for the entity’s liability: proof of the fact that organizational, management, and control models

suitable for preventing crimes of the type that subsequently occurred have been adopted.

→ the judge is in charge of judging the system

Economic incentive for greater control by shareholders, the economic burden due to illicit acts/crimes

falls, possibly, on the company, and ultimately on the shareholders' assets. 19

Task assignment

“Divide and command”

Audit committee:

− Only non-executive directors

− > 50% independent

− 100% independent if the firm is owned by another listed company

− At least 1 director with experience in accounting/finance

Supervisor to the ICS:

− no responsibility for operations

− no hierarchical dependence on any operating unit

− access to all necessary information

− have means/resources to perform their duties

First task, first circuit: implementation – adaptation

The CEO implements the circuit as he is the first responsible one in

case something goes wrong.

Second Circuit: verification and evaluation →

The evaluation is based on the reports of the CEO, and the reports of the audit committee can be compared,

disincentive for the CEO to lie.

→ There are also supervisors working inside the firm who verify the functioning of the system and report to

the auditor committee. 20

Third Circuit: communication

The whole system 21

Stock options

Is a compensation instrument, an incentive mechanism, that induces people to do something. This is a key

mechanism based on the agency perspective: “you have an agency problem, and you have two mechanisms

to solve this: incentive compensation vs monitoring from the board”.

→ Monitoring is weak and does not function very well.

→ Incentive compensation may be helpful, allowing them to have the possibility to become rich by also

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enriching shareholders alignment of interests of both “sides”

We need both mechanisms

We want the CEO to start thinking as a shareholder, we do that by giving him/her money to do so.

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The compensation of CEOs is not very sensible to the performance The solution proposed was to give them

stock options.

Irrelevance of basic salary

After Jensen theory diffusion of stock option

Mark Zuckerberg (Facebook), Sergey Brin (Google), Larry Page (Oracle) have a base salary of $1.

Before them, Steve Jobs always received an annual salary of $1.

However, he held at least 5.5 million shares of Apple stock, as a result of a 2003 grant that vested in 2006.

o The market value of this grant, in 2007, was US$ 949.75 million

In 1999 he was also awarded a plane, worth US$90 million

o

Definition

Stock options are contracts that give the owner the right (but not the obligation) to purchase a pre-

determined number of shares of the company in a future period (exercise period) at a pre-determined

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price (exercise price) condition that they do make improve the performance, otherwise there’s no gain.

Stock options “call options”: shares of the company in which the beneficiary works, or shares of the parent

company. 22

Basic elements:

• Grant date: date of the (free) assignment, can be at any moment

• Exercise price: price that the CEO will have to pay in the future to purchase the shares of the company

he manages

• Exercise period: future period in which one can purchase shares

• Conversion ratio, is normally 1:1, one share for one stock option.

The changing role and position of the CEO manager: becoming a shareholder of the company.

By exercising this right, and paying the exercise price the CEO becomes a shareholder of the company

Stock options render the CEOs participant in the destiny, performance and risk of the company (the link

between management and ownership – which was cut out in public companies – is re-established)

The incentive power of stock options depends on the design of the

stock option plan

Note: the CEO/manager is assigned stock options relating to the

stock of the company he manages. The share security (to which the

stock option refers) is called the underlying

The purchase price of the shares, however, is not necessarily the market price, but a lower price (exercise

price). This creates a «Dilution Cost». →

1) The CEO joins the ownership structure The number of shareholders increases: the same value of 1000

(previously divided among 10 shareholders) is now divided by 11 shareholders/owners.

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So, each shareholder has a little bit less, and shareholders become poorer it’s a cost for shareholders

but the assumption is that the future performance would be better so much more wealth would be created.

cost < future wealth created

2) The dilution cost is created because the CEO pays a price (exercise price) that is lower than the value of

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the shares if the exercise price – conferred by a CEO – is equal to the market value of the stock, there

is no dilution cost

The key is the level of the exercise price vs the market price, only if the exercise