Governance and Risk
Management
Chapter 17
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 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 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 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’ two duties to shareholders under
Delaware law:
1. Duty of care
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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 Duties
• Delaware law (continued)
2. 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
• 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 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
• 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
• 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:
1. Counterparty risk
2. Interest rate risk
3. Liquidity risk
Risk Management
1. Counterparty risk: risk that an organization/person
with which a corporation has a business relationship,
fails to perform its obligations
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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)
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Easier for large company to do than for small, entrepreneurial
firm
Risk Management
2. 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).
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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
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Easier for large financial firms to do than for smaller and nonfinancial firms
Risk Management
3. 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:
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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
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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 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!