the_structure_of_corporations

the_structure_of_corporations - THE SlRllflllRl 0i...

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Unformatted text preview: THE SlRllflllRl 0i (ORPURMIONS Capitalism is an economic system of business based on private enterPT153~ Individuals and businesses own land, farms. factories. and equipment. and profits. Capitalism is a good eco- for those 1.vho work ltard and who or better products and ser— nomy is the accumula- fuel to generate new andard of they use those assets in an attempt to earn nomic system because it can provide rewards are inventive and creative enough to figure out nevtr vices. One potential reward for creating value in an eco tion of personal wealth.'l'he wealth incentive providefi lhfl ideas and to foster economic value that provides iobs and raises out 51; living The main goal of a company is to create an environment conducive to care— ing long—term profits. which stem from two tnain sources First. a business must Provide products andtor services to a customer base A lHIgfi PHI-lo" “f ‘1 firmis value derives from the current and future profits of its business activity. Finding ways to increase profits from core operations can increase economic value. Second. increased profits can come from a growth in the sales of an existing Prfld‘ product. uct or sales resulting from the introduction of a new Expansion usually requires additional money. or capital. Business activilifi also entail risk. The abilities to access capital and to control risk are important ill the success or failure of a firm. Access to capital and the abilitlr' to Emmi risks are influenced by the manner in which a firm is organized: A business can be a sole proprietorsbjp, a partnership, or a corporation. Each orgaflifllticlrlal farm involves different advantages and disadvantages. 2 _ CHAPTER 1 Tneflucmior Confessions _ __—— FORMS or Busmess flWNERSHIP The first business form. a sole proprietorship. is owned by a single person. These businesses are relatively easy to start up and business tax is computed at the per; sonal level. Due to its simplicity. sole proprietorships are ubiquitous, representing ntore than Tl} percettt of all 1.1.3 businesses.1 However, there are several signifi— cant drawbacks. Such firms often have a limited lifespan {they die with the owner‘s death or retirement]. they have a limited ability to obtain capital. and the owner bears unlimited personal liability for the firm. The second form is a partnership. which is similar to a sole proprietorship but there is more than one owner. As such. a partnership shares the advantages and disadvantages of the sole proprietorship. While one obvious advantage of a part- nership is the ability to pool capital. this advantage may not be as important as combining service—oriented expertise and skill. especially for larger partnerships. Examples of such partnerships include accounting firms. law firms, investment banks. and advertising firms. This test focuses on the third business form, the corporation. Fewer than 2U percent of all US. businesses are corporations but they generate approximately 91) percent of the country’s business revenue.Z The corporation is its own legal entity. as if it were a person. For example. the corporation can engage in business transactions and other business activities in its own name. Corporate officers act as agents for the firm and authorize those activities. The biggest advantage of the corporate business form is access to capital markets. Public companies can raise money by issuing stocks and bonds to investors. While sole proprietorships and partnerships may access millions of dol— lars through the business owners’ wealth and through banks, corporations may eventually access billions of dollars. Access to this capital causes entrepreneurs like Bill Gates of Microsoft. Steve Jobs of Apple. and Larry Ellison of Oracle to take their companies public. To raise money for expansion in the capital markets. the business sells stock to investors For example. between 19?? and 1980.Apple Computer sold a total of 121.011} computers. To meet the potential dEmand for millions of computers per year, Apple needed to expand operations significantly. As a result. in 1930 Apple became a public corporation and sold $65 million worth of stock. Steve Jobs. cofounder of Apple, still owned more shares than anyone else, but he owned less than half of the firm. He gave up a great deal of ownership to new investors in exchange for the capital to expand the firm. (Incidentally. as we will describe later. this decision would later come back to haunt Jobs} Stockholders or shareholders are the owners of a public corporationThe-se shareholders receive any value that is created by the firm, but they can also lose their investments if the firm goes bankrupLThe process has two benefits First. any individual, as long as she or he has some money, can invest in business and in crease their wealth over the long term. Second, businesses with growth potential CHAPTER 1 THE Sraucrust‘: or Eonpossrlohts 3 can obtain capital needed to expand, which creates economic value, jobs, and taxes A corporation has an infinite life unless terminated by bankruptcy or merger with another firm. The owners of corporations enjoy limited financial liav bility because they catt lose only, at most, the value of their ownership shares. Further, corporate ownership is usually quite liquid, and ownership stakes can be easily bought and sold as stocks in a marketplace such as the New 1fork Stock Exchange {NYSE} or Nasdaq. The advantages of the corporate business form are appealing, but there are - also major disadvantages. Corporate profits are subject to business taxes before i any income goes to shareholders in the form of dividends Subsequently, share- holders must also pay personal taxes on dividend income. Therefore, sharehold— ers are exposed to double taxation. In addition, running a corporation can be quite expensive. For example. the costs of hiring accountants and legal experts, | the costs of communicating with all shareholders, the costs of complying with regulations, and so forth, can cost millions of dollars per year. Finally, and per- I haps the most important disadvantage, corporations suffer from potentially ' serious governance problems. Most investors only own a small stake of a large public corporation, and they consequently do not feel any true sense of owner- ship. or control, over the firms in which they own stock, as they would for a sole proprietorship or partnership. —_— PEDPLE IN BUSINESS There are four groups of people involved with a public corporation: the ' shareholders, directors, officers, and employees. Shareholders literally own a public firm. As owners, they capture the economic value of the firm in the form of stock price increases and dividends, and they also suffer the losses when a firm fails. Directors itire, oversee, evaluate, and fire the officers of the firm. in doing so, they are supposed to represent the interests of the shareholders The officers, such as the chief executive officer {CED} andfor president, represent the firm’s top level of management, and they are ultimately responsible for the day-to—day operation of the firm. Employees have a stake in the firm because they dedicate their human capital, i.e.I their labor, to the firm: they may also be owners by hold- ing company stock in their retirement plans. The firtn has other stakeholders as well, including creditors, government, suppliers, and customers, but these should be thought of as those who deal with the firm, rather than as an explicit part of the firm. Given the number of people involved with the company, who actually con- trols the corporation? Who makes the crucial decisions and has the most power? One might think that the owners control the firm, or that the board of directors.I who hire the officers, tnight have the control. However, for the most part, the offi- cers control the firm. 4 __ CI-_I§PTER 1 THE STRUCIlRlEEF Consonanth —_—— SEPARATION OF DWNERSHIP AND CONTROL Corporate ownership and control are divided between two parties—velockholdcrs and officers. The stockholders own the firm and officers for executives} con trol the firm_Tl1is situation comes about because the thousands, or even hun— dreds of thousands, of investors who own public firm-s could not collectively make the daily decisions needed to operate a business. Firms hire managers for that work. Most shareholders do not wish to take part in a firm‘s business activities. These shareholders act like investors not owners. The difference is subtle. but important. Owners focus on the business performance of the firm and investors focus on the risk and return of their stock portfolios. 1|While diversifying reduces risk for the investor, ownership of many companies also makes participation and influence in those companies less likely. Therefore, investors tend to he inactive shareholders of many firms. There is a problem with this separation of ownership and control. 1|Why would the managers care about the owners? It is not far-fetched to imagine that man- agers may act in their own personal interest if possible1 even at the expense of owners. In academic terms, this situation is known as the principal-agent problem or the agency problem. Gcnsider the owner of a nightclub [the principal} who hires a bouncer {the agent} to check identification at the front door and to receive the cover charge from entering customers. The bouncer may pocket some of the cash if he thinks no one is looking and try to maximize his own wealth at the expense of the owner. If the owner cannot effectively monitor the transactions and the activities of the bouncer, he or she could lose money'lherefore, monitoring is important to help overcome the agency problem. The shareholders of a corporation are the principals, and the managers who run the company are the agents “shareholders cannot effectively monitor the managers’ behavior, then managers may be tempted to use the firm’s assets for their own ends. such as improving their lifestyles. Executives may enjoy perks such as liberally charging the corporate expense account1 chartering the com— pany jet1 ordering top-grade office furniture, and so on, all at the expense of shareholders. Solutions to this problem tend to come in two categories, incentives and monitoring. The incentive solution is to tie the wealth of the executive to the wealth of the shareholders, so that executives and shareholders want the same thing. This is called aligning executive incentives with shareholder desires. Managers would then act and behave in a way that is also best for the other shareholders. How can this be done? For most US. companies, executives are given stock, stock options, or both as a significant component of their compensa‘ tion. The advantages and disadvantages of this incentive solution are explored in the next chapter. Suffice it to say.-there are problems CHAPTER 1 THE Smurruns oF Conventions 5 The second solution is to set up mechanisms for monitoring the behavior of managers Indeed. several monitoring mechanisms are discussed helow. _'____#—#___ CAN INVESTORS INFLUENCE MANAGERS? Theoretically, managers work for owners [shareholders]. In reality. because shareholders are usually inactive, the firm actually seettts to belong to manage— ment. Some active shareholders have tried to influence management. but they have often met defeat. Recent evidence of unsuccessful outcomes of shareholder proposals is quite telling. Shareholders have the power to make proposals that can he voted on at the annual shareholders meeting. There are generally two types of proposals. those related to governance (eg. suggesting changes in board structure} and those oriented to social reform {e.g., proposing to stop selling chemicals to rogue countries}. About half of all shareholder—initiated proposals progress far enough in the process to reach the voting stage When there is a vote. such proposals usually are defeated} A huge factor in whether a proposal is successful depends on management’s opinion. Without management approval, proposals have little chance of succeed" ing. Traditionally, shareholders have trusted management to know what is host for the firm. Most shareholders will go along with whatever management wants. EXAHPLE-HEWLETT— PICKAHD IHI] COHEN“ For an illustration of management control and influence,consider the 2002 merger between Hewlett-Packard {HP} and Compete.”l Carly Fiorina. the Hewlett- Packard CED. announced on September 4, 2CD] , that HP would acquire Compaq for $25.5 billion. The stock. markets, industry experts, and the business media reacted negatively to the news. Hewlett-Packard stock was down 13 percent fol- lowing the announcement. and even Compaq's stocit declined by to percent. which is very rare for a target firm. Cit particular note. David W. Packard and Walter Hewlett. both significant shareholders {when including the Packard Foundation. the pair owned 13 percent of HP stock] and sons of HF’s founders, were also strongly opposed to the acquisition. In fact. they took out newspaper ads asking other HP shareholders to vote against the merger. However. Fiorina went ahead with her plan. despite attacks from both Packard and Hewlett, and on March 19, 2m. most of the other shareholders voted in favor of the acquisition. Despite the controversy and the drop in stock prices, most share- holders voted with management's wishes and approved the acquisition.'I'his exam. ple reinforces the idea that even though some investors may want to influence business strategy and direction. management controls the firm. 5 CHAPTER 1 THE STRUCTURE or Consonanous —_—_— ARE INVESTORS HELPLESS? Generally speaking, the investing public does not know what goes on at the firm’s operational level. Managers handle day-to-day operations, and they know that their work is mostly unknown to investors. Consequently, managers mayr not act in the shareholder‘s best interest, which demonstrates the need for monitors. Figure 1.1 illustrates the Separation of ownership and control between stock- holders and managers In addition, the figure shows that monitors exist inside the corporate structure, outside the structure, and in government. The monitors inside a public firm are the board of directors who oversee management and are supposed to represent shareholders” interests. The board evaluates management and can also design compensation contracts to tie man— agement‘s salaries to the firm*s performance. You may remember that Apple Computer was cofounded by Steve Jobs. When the firm became a public corpora~ lion, Jobs was the largest shareholder, and he also became CEO. However, the Apple board of directors felt that Jobs was not experienced enough to steer the firm through its rapid expansion. "therefore, they hired John Sculley as CEO in 1983. In 1935, a power struggle ensued for control of the firm. and the board hacked Sculley. Jobs was forced out of Apple and no longer had a say in business operations even though he was the largest shareholder. (Interestingly, when Apple Computer experienced difficulties in the late 199ils, the board hired Jobs back as CEO!) ._ _.._._ janTEELTn-msmrwwt __.. _ _. _ 5" As shown in the figure, outsiders—including auditors, analysts, banks, credit rating agencies, and outside legal counsel—ail interact with the f'u'nt and monitor manager activities. Auditors examine the firm's accounting systents and comment on whether financial statements fairly represent the financial position of the firm. Investors and other stakeholders use the public financial statements to make decisions about the firm‘s financial health, prospects, performance, and value. Even though investors may not have the ability or opportunity to validate the firm's activities, accountants and auditors can attest to the lion's financial health and verify its activities Investment analysts who follow a firm conduct their own, independent eval— uations of the company‘s business activities and report their findings to the investment community. Analysts are supposed to give unbiased and expert assessments Investment banks also interact with management by helping firms access the capital markets. When obtaining more capital from public investors. firms must register documents with regulators that show potential investors the condition of the firm. Investment banks help firms with this process and advise managers on how to interact with the capital markets The government also monitcu's business activities through the Securities and Exchange Corruuission {SEC} and the Internal Revenue Service (IRS). The SEC- regulates public firms for the protection of public investors. and it makes policy and prosecutes violators in civil court. However, for criminal prosecution the SEC must turn to the LLB. Justice Department. The IRS enforces the tax rules to ensure corporations pay taxes,just as it does 1tvith individual American citizens As a group, this is a pretty impressive set of monitors Unfortunately, all of these mechanisms can fail at one time or another. An important purpose of this text is to describe each of these corporate monitors and the problems that may exist with each of them. ———__ AN INTEGRATED SYSTEM OF GOVERNANCE The corporate governance system is integrated and complicated. The potential incentives for executives. auditors, boards, banks, and so on, to misbehave are intertwined. By focusing on one part of the system, readers might not fully under- stand how the governance system can break down. Consider the diagram of cor porate participants in Figure 1.2. The arrows show the relationships between the groups Note that these relationships are interconnected. For example. analysts talk to management to gauge the prospects of the firm. Managers want to paint a rosy picture so that analysts Will recommend a “buy” rating and the stock price will rise. However+ this situation may also cause ana- lysts to predict a high profit forecast for the company, and the managers may struggle to meet the high forecast. If the business activities of the firm do not fl {It-IAPTER 1 THE Summer or EoRPoaenons merit the high profit forecast, managers might then pressure their accounting department to help. In some cases, consultants are hired who reconunend aggres— sive accounting techniques to help show increased profits. . The public auditors for the firm may have had a long and fruitful relationship with the company, auditing the books for many years. The auditors are proud to have a prestigious corporation as a client and do not want to end this relation- ship; consequently they may not press too hard on limiting aggressive accounting methods This circumstance holds true especially if the consultants who recom- mended diose methods are from the auditors own amounting and auditing firm. Why are managers so obsessed with pushing hard for smooth and increasing profits? Why are they obsessed with gaining analyst favor? It is because a board [which is largely picked by the managers} awards them stock options and stock incentives If managers can increase the price of the stock, then they can cash in their options and stock and become rich- Regulators also monitor managers’ behavior. However, regulators often have experience as partners in consulting firms, auditing firms, or law firms that are an integral part of the system. By participating in the corporate sysmm, regu~ lators know how it works. Unfortunately, they might also have their own conflicts of interest. ——— INTERNATIONAL MONITORING Other capitalist countries use the types of monitoring and incentives used in the United States to atign the interests of executives and shareholders. However, important differences do occur. In many countries. lacs. regulation, and enforce- ment are considerably more lax than in die United States For example, Japan's W'-IT -**-m1T'—"-"': - Ir.- CHAPTER 1 THE STItLtti'I'IJRE or [earnestness - 9 version of the SEC is the Securities and Exchange Surveillance Commission (SESC).Tl1c SESC has only one‘tenth the number of SEC employees, and the SEC is already considered to be grossly understaffed.S The SESC does not even have the power to file civil suits or bring administrative action against market participants The securities regulator in Taiwan, the Securities and Futures Commission, also does not have the authority to conduct investigations; instead. they must rely on local prosecutors who have little experience wad: the market and with accounting fraud. In addition, in 21111 in Italy, the charge of false accounting was reduced to a mere misdemeanor. The tale of Gennany‘s Gerhard Schmid, the former CEO of MohilCom. is telling. As CECI, in ZDIII, Schmid transferred EMS million [$69.5 million] in new MchiICom stock to a shell company his wife controlled. The German regulatory group, the German Financial Supervisory Authority, said that the actions did not fall under their jurisdiction. Consequently, there was no investigation, even though Schmid broke German law by not informing other executives or the board. The tirm‘s board of directors did find out about the transfer and investi- gated. In June 2002, the board fired Schmid and demanded the return of the money. In most countries, the laws, regulators, and enforcement are so weak that corporate fraud conviction is unlikely. a Sunlalnttv The corporate form of business allows firms that need capital to obtain it and expand, thereby helping the economyJ'ttis form also allows people with money to provide those funds and profit from having ownership in business The disadvantage of public corporations lies in the relation between owner— ship and control. Managers who control the firm can take advantage of the investors who own the fum.To inhibit poor managerial behavior, sharehold— ers try to align the executives‘ interests with their own interests through incentive programs involving stock and stock options In addition, the corpus rate system has several different groups of people that monitor managers. Unfortunately, both alignment incentives and monitoring groups have prob- lems. "Ihe corporate system has interrelated incentives that combine to cre~ ate an environment where people can act unethieaIty.'Ihe following chapters discuss each aspect of the incentive and monitor systetn. Qu Esrtnns I. How can executive compensation tinn comes about and why it leads to align manager interests with share— problems holder interests? 4. Compare and contrast the participants 2. Name and describe the different in the LES. corporate governance sys- groups that monitor a firm. tent with those in other countries. 3. Describe the separation of ownership and control. Explain how that separa- "I _CHAPTER 1 THE STRUCI'IJRE oF CDRFDRAHDNS EHDHIJTES I. William J. Magginson, Corporate Foams: Theory {Reading MA: Addimfl-Wfifluy, 199?}. p. 40. . Ibid. _ See, for exampie. Stuart Gillan and Laura Sharks. “A Survey of Shareholder Activism: Muljvation and Empirical Evldonm" Contempomry Finance Digm 2,11o. 3 [1993}:10—34: Cynthia Campbell, Stuart Gillan, and Cathy Niden.“Current Perspoctives on Shareholder Proposals: Lassons from the 1997 Proxy Season," Financnt Management 28, no. 1 {1%}:89—98; and Gordon and Pound. “Information. Ownership Structure. and Shoreholde: Voting: Efidcuoe fronl Shmhfllder— Sponsored Corporate Governanoe Proposals.“ Jam-m! offing-me 4?, no. 2 {mama—113. 4. Larry.r Magid. “Many Would Loso in Hewlett-Packard. Compaq Merger," Lo: Angelic: Timex, www.forryswrflcomfflrfldflfl'synihp mgenhm: Mike Elgan and Susan B. Sher, “Gloves Are Off in Merger Fight,” HP Worm 5. no. 21 wwminrerexflrgfhp worldnnvo’hp wZflZe’ filmfllrmf. 5. Almar Latou: and Kevin Delaney, “Outside the 115.. Exocutivcs Face Littlo Legal Peril," The Wolf Erma: Journoifiugust 16,2[I121 Al. ...
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This note was uploaded on 04/06/2010 for the course LAPS ADMS 1000 taught by Professor Lastry during the Winter '10 term at York University.

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the_structure_of_corporations - THE SlRllflllRl 0i...

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