Corporate Governance PDF

Chapter 1 – An introduction to the corporate governance 1.1 Introduction to the corporate governance Corporate Governance is a set of rules and procedures in the decision-making process of a company at the highest level. The highest level includes the board of directors (BoD) and the corporate admi...

Chapter 1 – An introduction to the corporate governance 1.1 Introduction to the corporate governance Corporate Governance is a set of rules and procedures in the decision-making process of a company at the highest level. The highest level includes the board of directors (BoD) and the corporate administration. In business management, accountability is not sufficient, but it is fundamental to set and distribute responsibilities all over the organization and to identify the expectations that must be reached. Meeting the expectations does not refer to the internal actors, such as managers or employees, but also to the external actors, as shareholders and stakeholders. In fact, the listed companies produce a non-financial reporting, a section of the FS that can be used by the stakeholders to check if their interests have been satisfied. 1.2 Different definitions of Corporate Governance Most common definition of CG: the activity of "management" and "control" carried out by the owners of property rights and by the persons they designate to be their representatives in the top management, and especially on the board of directors. Different definition of corporate governance can be identified, according to the past literature. These definitions differ on the variety of the interests considered in the process and on the number of structures and mechanism involved in managing and controlling the company. The first dimension is the interests that must be pursued, can concern the shareholders’ interests or the stakeholders’ interest. Definitions of corporate governance to understand the difference between these two perspectives: Shleifer and Vishny, in 1996, stated that the CG deals with the ways in which investors assure themselves of getting a return on their investments. Sheridan and Kendall, in 1992, affirmed that “In essence, good corporate governance consists of a system of structuring, operating and controlling a company such as to achieve the following (few vs many): o Fulfill the long-term strategic goal of the owners, o Consider and care for the interests of employees, past, present and future, o Take account of the needs of the environment and the local community, o Work to maintain excellent relations with both customers and suppliers, o Maintain proper compliance with the legal and regulatory requirements under which the company is carrying out its activities”. The second variable is the presence or absence of multiple structures and mechanism for the corporate governance. Some definitions consider the Board of Director the only body responsible for facing and solving corporate governance problems, while for others there is a various and complex set of structures with the aim of protecting the different interests. Definitions effective to understand the difference between these two perspectives: 1  The Cadbury Committee, in 1992, affirmed that the only corporate body responsible for the governance is the Board of Directors. Among the responsibilities recognized we remember to set the strategic view, to supervise the management, to report information to the shareholders and to respect the laws. On the other hand, the only responsibility of the shareholders is to appoint the member of the BoD (boards of directors only); Blair, in 1995, stated that the corporate governance structures cannot be summarized in the BoD, but is fundamental to take into account also the legal, cultural and institutional bodies, such as law, financial institutions or compensation systems. By crossing these two dimensions, we obtain a matrix into which we can place the different definitions of corporate governance. On the first quadrant we have the “narrow view” of corporate governance, while on the fourth quadrant we have the “broad view” of corporate governance. First quadrant: The Narrow view In the first quadrant, we have the narrow view of the corporate governance. This is the classic definition and states that the only interests to follow are the shareholders’ ones and that the Board of Directors is the only body responsible for managing and controlling the company. The relationship between the other stakeholders and the company is left to the market, which is considered efficient and able to manage this factor. According to this view, only three actors are involved: 1. Shareholders, that provide equity capital and appoint the BoD members 2. Directors, that must verify that the managers are working in their interests 3. Managers, that have to manage the company trying to achieve the goals identified by the Board of Directors. This perspective, coming from the Anglo-Saxon approach, lead to the following problems: The agency problem; The governance problem, related to the public companies; The origins of bad governance. 2 Second quadrant The second quadrant considers the stakeholders’ interest as worthy of protection. However, the Board of Directors remain the only mechanism of corporate governance. Third quadrant The third quadrant takes into considerations only the shareholders’ interests but includes internal and external mechanisms of corporate governance. In this case, the corporate governance is made of the Board of Directors and all the other legal, cultural and institutional element, such as corporation law, compensation system and internal information and control system. Fourth quadrant: The Broad view The fourth quadrant identifies the broad view of CG. The interests pursued are the stakeholders’ ones and the corporate governance develops in several structures. Also the shareholders’ meeting becomes a fundamental place to respect the different interests. In the broad view, the corporate governance does not only focus on the shareholders’ and stakeholders’ interests, but also on the balance between the interests of large and small shareholders. The broad view considers new bodies, such as national commissions, auditing firms, regulatory authorities and, in particular in the highly regulated sectors, trade unions and consumer associations. 1.3 Corporate governance in large, listed companies (PCs) Let’s consider the traditional Anglo-Saxon approach of corporate governance. The problem of this definition is translated into the configuration of the Board of Directors in the large listed companies, with fragmented shareholding. In the typical approach, the BoD is responsible for carrying out the strategic leadership function, and representing the overlap between the small but powerful group of people who lead the company and a huge but helpless group of shareholders. So, the governance power is a duty of the Board of Directors. The governance problem in the large companies is related to the BoD, because there is a high probability that directors’ interests are not aligned to the shareholders’ ones. The misbehavior of the directors can lead to two scenarios: The opportunistic behavior can remain hidden, namely, the directors act in a opportunistic way, affecting the profitability and the growth of the company, but without being discovered, because of the lack of financial or legal consequences; The opportunistic behavior leads to legal consequences, such as bankruptcy. The main goal of the corporate governance literature is to take into consideration these problems and identify the structure, mechanism and rules that can avoid misbehaviors and guarantee the pursuit of shareholders’ interests. Board of directors should have 2 main responsibilities: 1. Create value for the company, setting the main direction and making the right choices 3  2. Try to anticipate future problems that can affect the entity’s performance. 1.4 The origins of public companies At the beginning the companies were owned and managed by the same person or family. However, because of the company’s need for growth and for a more professionalized management, the public companies were born, to guarantee the separation between ownership and control. PC = a listed company without any major controlling shareholders because of the highly fragmented ownership structure, so hold by the public (a company can be identified as public also if there is a major shareholder, but he is an investment fund or other financial institution with no interest in changing the way the company is structured and governed). In the PCs, shareholders have no interest in voting the directors, because they can’t control or influence the company life. This phenomenon is called “to vote with their feet”, so the situation in which the shareholders vote the directors appointed by the previous BoD, because they do not have interest in the management of the company. The PC’s setting favored situations characterized by “omnipotent boards” in 60/70s in the US: The board members were appointed by the board itself (shareholders’ passivity), The shareholders meeting was just a formality, Board members were also top managers of the company (inside directors), There was a high temptation to act in a self-interested way, rather than in the interest of the large number of small shareholders. 1.5 The agency theory The main objective of the CG literature is to identify the best structure, mechanism and rules that guarantee the pursuit of shareholders’ interests. Many of the classical studies of corporate governance identify the best structure using the agency theory. The agency relationship can be defined as a contract under which a person (the principal) delegates another person (the agent) to fulfil a task which implies a power, for the agent itself, to take decisions in name of the principal. The relationship between shareholders and directors, so the management, is an agency relationship; the purpose is thus to minimize the agency costs. When both the agent and the principal try to maximize their utility, it is probable that the agent will not follow the principal’s interests. A good governance structure should secure the lower possible agency costs. The agency costs can be computed with the following formula: 𝐴𝑔𝑒𝑛𝑐𝑦 𝑐𝑜𝑠𝑡 = 𝑀𝑜𝑛𝑖𝑡𝑜𝑟𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 + 𝐺𝑢𝑎𝑟𝑎𝑛𝑡𝑒𝑒𝑠 𝑐𝑜𝑠𝑡 + 𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝐿𝑜𝑠𝑠𝑒𝑠 In this context, the role of the Board of Directors is fundamental. The BoD must be able to balance the relationship between the shareholders and managers. The situation described can be seen as the basic scheme of the agency theory. 4 1.6 The first variant of the agency problem The Board of Directors is the body responsible for the control of the management, but also for governing the company and it is called to carry out a series of action to support the management in making the most important decisions. This make unrealistic for the board to be totally independent from management because it would be less effective. The conclusion of this process is that the board is made of a mix of internal executive, such as CEO, and external and independent actors. It is relevant to understand the "optimal" degree of overlap or of separation between the governing and controlling body and the executive body; this is necessary to avoid the risk of a domain being established by management (as happens in the past). This level change among the different countries, according to the more concentrated ownership of their national companies. 1.7 The second variant of the agency problem A second variant of the basic agency scheme shows an overlap also between the shareholders the BoD and the Management. This happens more often in the family-owned companies. On one hand, this overlap indicates the convergence of the interests between management and ownership. On the other hand, it highlights the negative aspects of the family involvement in the business. Moreover, this scheme can generate the principal-principal problem, and so the situation where there is an important shareholder that influences the other bodies and does not allow the pursuing of small minority shareholders’ interests. 5 There can also be a problem in the Board of Directors, between independents and ownership representatives. This generates the problem of the controllers, namely the independent directors, that have to control the controlled people. Finally, the coexistence of owners’ managers and external managers can affect the identification of an harmonious governance of the company (demonstrated that the presence of family and non-family managers can affect company’s performances and emphasize the internal conflicts). 1.8 The origins of bad governance The corporate governance literature gives us a list of deep origins of the bad governance. General origins: Human nature, Different risk preferences of directors and managers. Different individuals can adopt very different behavior, Limited rationality of the individuals, that determines condition of information asymmetry between the actors involved, which makes impossible to define complete contracts. Among the specific origins of bad governance, there are the followings: The separation between ownership and management, that leads to the temptation of directors and managers to pursue the personal objectives, Leverage effect of “private benefits/public costs” and the vicious circle (in big companies is easy to fool little investors who will receive small amount of money. That small amount of money per share is very big in general, so incentive for the manger to misbehave), Imperfect markets, The weakness of formal and bureaucratic controls. 6 1.9 Possible examples of managerial misbehaviors and bad governance Both directors and top managers may privilege their interests which manifest in different possible misbehaviors against the shareholders’ interests: Less clear area (these are not illegal actions, so it’s not wrong in absolute terms, it depends from company to company): o Privilege risky growth on profitability —> empire building o Privilege riskless strategies —> reduce to the minimum the personal commitment and relax (shirking) o Excessive focus on short term results and low commitment on long term performance Legally prohibited: o Enhance personal wealth through improper practices —> overcompensation, excessive benefits, false in B/S etc. o Building up barriers against hostile takeovers —> golden parachutes, poison pills, pyramidal groups etc. o Transfer of benefits to other persons (nepotism) o Insider trading 1.10 Possible solutions to the Corporate Governance problem In the traditional perspective, adopted so far, values mechanisms can mitigate the tendency of top management to pursue its own interests. These mechanisms can be classified into three different categories: 1. Making markets efficient The first mechanism is related to the financial theory, namely the efficiency of the markets. The markets used as regulators can be divided into four main types. The first type of market is the Product markets. The hypothesis underlying "real" markets is that the company exists to produce goods and services considered satisfactory, and that therefore those companies that demonstrate the ability to interpret the needs of their consumers survive, thus generating value for the company itself and for its shareholders The second type of market is the Financial markets. The hypothesis under the financial market is that the equity performance of a company represents the best possible measure of the value created for the shareholders (moreover, this would align the interests between the managers and the investors, that would be interested in the equity value) The third market is the market for Corporate Control, that can be used to acquire the ownership of a company that is not able to generate value through the management. It can happen in a friendly or hostile way. Hostile ways: the battle for proxies, when a shareholder tries to gather enough shareholder proxies to present a different list of directors in the board, and the hostile takeover, when a shareholder buys all the stock of the company to replace all the management of the firm. 7 The last market is the Managerial market. According to the theory of economic rationality, it is very difficult that managers will carry out some misbehaviors because it could affect the future employment opportunities. However, the markets have not reached the expectations. Failure of financial markets can be related to: The strong dependence of the equity values from the crisis periods, even if the company is a well-managed entity, The difficulty to use the capital markets to collect risk capital because of the lack of trust. 2. Define and impose structures, rules and mechanisms Given that the markets are not always efficient there is the need to identify the structure, the rules and the mechanism of the Board of Directors, that is the main governance body in every firm. For governance bodies: - Scope and responsibilities: make the basic decisions for the company (definition of what to produce or provide, size of the production, diversification, general policies regarding the organizational structure etc…). Selecting, encouraging and evaluating top management (through the selection of CEOs, definition of responsibilities etc…) - Composition of the board: number and characteristics of the directors, structures of the board, such as the presence of the independent directors and the division of power. - Operating mechanisms: providing information to directors, frequency and manners of meetings etc. For control mechanisms: every company, in the corporate governance structure, should consider both internal control system and external controls. The internal control system is based on the law of the country the firm operates. There can be identified three main internal control systems: The two-tier system, typical of German tradition, that divides the governance bodies into the management board and the supervisory board, appointed by the shareholders; The one tier-system, typical of English tradition, that assigns the management of the board to a single body, namely the Board of Directors; The ordinary system, typical of the Italian tradition, that requires a management board and a control body. The system of external control is the one that refers to the independent auditors and external bodies, such as the national supervisory authority, that improve the governance of the firm. 3. Favoring certain capital structures It has been proved that the quality of the shareholders structure affects the Board of Directors quality and efficiency. There can be identified two main kinds of ownership structure, that are public companies and concentrated ownership. 8 The public companies seem to be able to guarantee the possibility to grow in size in an easier way and to ensure a better and clearer separation of power and roles. However, these companies have more problem in avoiding the misalignment of interests. On the other hand, the concentrated ownership, controlled by a blockholder, can eliminate the agency problem and appears to be more resilient during crisis periods. However, the presence of a blockholder increases ambiguity in the governance because there is an overlap of roles and responsibilities and can lead to conflicts between majority and minority shareholders. The blockholders are shareholders large enough to have an incentive to monitor the managers. However, not all the blockholders can be considered good shareholders. Typically, the blockholders that can help to avoid the agency problem are the institutional investors, such as pension funds, that have become more active in the management of the companies. 1.11 Incentives and fiduciary duties In addition to the possible solution given before, two ways to solve the corporate governance problem are the use of incentives and the presence of fiduciary duties. About the incentives, using ex-post incentives can damage the business performance because allows the managerial opportunism. On the other hand, the use of ex-ante incentives can help to eliminate the misalignment of interests between investors and managers and directors: - Stock incentives (but they create enormous opportunities for self-dealing) - Leveraging on reputation that directors and managers have to defend on (capital market and job market for top managers) → very weak Moving to the fiduciary duties, the identification of legal responsibilities can improve the efficiency of the governance. The fiduciary duties could regard the loyalty and the duty of care, that is the duty to act in an informed way and to inform the directors about the management. Fiduciary duties, together with legal sanctions, are a good substitute for financial incentives and contribute to align directors’ and shareholders’ interests. 1.12 Financial debt The use of financial debt can change the management incentives due to the different time distribution of the cash flows. Equity → no contractual obligation to pay dividends and to reimburse equity. Financial debt → reimbursement plan and regular payment of interests, can reduce FCF and the related managerial discretion to deviate funds. However, it also implies the creation of conflicts of interests between creditors and shareholders. In fact, there can be asset substitution, that is the situation when the shareholders increase the risk of the investments because the positive results are mostly earned by them, while the negative ones by the creditors. Moreover, the presence of a high quantity of debt can make the company unable to invest in new opportunities. 9 1.13 The legal protection Concentration of ownership is the response to the lack of legal protection for shareholders. In particular: In countries where there is a strong shareholders protection, such as the one with Common Low and German Civil law, the most used ownership structure is the public company. In the countries where there is a weak shareholders protection, such as the French Civil Law, the most used ownership structure is the concentrated ownership. This happens because the shareholders are interested in controlling the management and avoid misalignments of interests, because of the weak legal protection. 10 Chapter 1.a – Shareholders’ vs Stakeholders’ view of the firm: the “Corporate Purpose” 1a.1 The assumptions of the shareholders view The shareholders’ view is based on some implicit assumptions: - The maximization of shareholders’ value leads to the maximization of the corporate value - Financial markets are efficient - The maximization of shareholders’ value disciplines top managers - Stock incentive plans push managers to maximize shareholders’ value - The market for corporate control disciplines top managers 1a.2 Shareholders view The firm can be seen as a nexus of contracts (implicit and explicit) regulating rights and responsibilities of each stakeholder. To obtain positive and persistent performance, companies should create a set of contracts to attract key resources, and to motivate stakeholders which supply those resources to behave honestly. The key mechanism in this view is that of “ownership rights”. Ownership is a complex concept consists of two elements: The right to appropriate the returns from an asset (residual income rights) The right to control the asset (residual control rights) Residual control rights should be allocated to shareholders and the firm should maximize the shareholders’ value. Residual control rights should be allocated to shareholders because they: Receive residual income Can be easily expropriated by top managers → Residual control rights allow shareholders to decide on very important matters, such as dividend policy, capital increase, corporate by-laws, election of board members etc… The allocation of ownership rights is a powerful governance mechanism, however it does not solve completely the cognitive and motivation problems in case of multiple stakeholders at risk → the controlling stakeholder can expropriate other stakeholders’ specific investments by exploiting gaps in contracts. Despite this limitation, given the incompleteness of contracts and the inefficiencies of the judicial system and of the market alternatives, the allocation of ownership rights plays an important role in mitigating the costs involved in the relationship between stakeholders → Who should control a corporation if we want to maximize the profitability that it survives and prospers in the long run? 1a.3 Ownership, control and theories of the firm According to classical finance studies “corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment”. This definition assumes a “property conception” of the corporation (corp as a 11 “nexus of contracts”) according to which assets of the corporation are property of shareholders, and managers and boards are viewed as agents of shareholders. A competing view assumes a “social entity conception” of the corporation → the “suppliers of finance” (shareholders and creditor) must be rewarded properly, but the corporation has others purposes of equal dignity. 12 Enron case (The smartest guy in the room) Business Enron was a commodity company (trading energy) Key mechanism of fraud The mechanism of fraud was based on the creation of a new business model in the energy system and on different accounting frauds. The company's objective was to alter the existing business level by manipulating the prices of the goods sold. In addition, the fraudulent mechanism relied on the CEO's creation of a new fraudulent accounting method to artificially inflate and improve the company's financial and income situation. The main connection point with Theranos is the presence of misbehavior by top managers. Key actors The main actors were the founder, Kenneth Lay, and the CEO, Jeffrey Skilling. The founder of the company was responsible for having implemented an opportunistic trading strategy and having supported the CEO's ideas within the company. Also, Skilling had conceived the fraudulent accounting method that enabled the company to deceive investors and the markets. Role of Board of Directors The Enron Board of Directors consisted of many individuals who showed little concern for the company's activities. Decision-making was primarily the responsibility of the CEO, with other directors often uninformed about the CEO's actions. Role of the extended system In this scenario, a multitude of both internal and external individuals, such as the other company managers, were aware of the events. Moreover, the sector deregulation and the relationship between the company and the other directors of the remaining sector companies allowed the firm to carry out the opportunistic behavior. The outside people were not able to understand the accounting policies of the firm, because of the high complexity. The only person that discovered the fraud was a journalist. Key message of the case The main responsible was the founder, because, even if he wasn’t the architect of the fraud, he selected Skilling as the CEO of the company and didn’t use any mechanism to control his managerial action. In fact, fundamental governance principle is the role of the Board, responsible for appointing and overseeing top management and establishing the organization's ethos and values. However, also the CEO was responsible, because he created the strategy to increase in an illegal way the net income. When evaluating governance, it's crucial to examine the values emanating from the top, specifically from the CEO and, notably, from the founder. Theranos (The Dropout) Business Theranos was a company active in the medical instrument market. Key mechanism of fraud The fraud mechanism at Theranos was built on lies. The founder and CEO of the company had promised the launch of a medical device capable of conducting hundreds of blood tests quickly and with a small amount of blood. However, this device was never actually created and tested. The CEO concealed this falsehood by using existing machines to perform the intended blood tests. The main connection point with Enron is the presence of misbehavior by top managers. 13 Key actors The key actor was the founder and CEO of the company Elizabet Holmes, that was able to raise a large amount of capital by different investors without being able to commercialize the patented machine. Role of Board of Directors The BoD of Theranos has also been the victim of deception. Elizabet chose among its members successful people of politics, the army, diplomacy, in order to manipulate the market. However, they had no experience in the medical field so they could not accurately assess management’s statements. Role of the extended system The private investors were not able to understand the technology sold by the company. Moreover, there were no comprehensive studies conducted on the company's product, and the CEO employed various tactics to cover the problems, such as using already existing machines instead of the product of the company to carry out the blood tests. Key message of the case The main responsible was the founder. Fundamental governance principle is the role of the Board, responsible for appointing and overseeing top management and establishing the organization's ethos and values. This case shows that a lack of proper supervision and accountability at management but first and foremost at the BoD, can lead to serious inefficiencies and losses in the company. 14 Chapter 2 – The Board of Directors The Unilever case study Unilever is one of the largest consumer goods companies in the world. The controlling shareholders are the two listed companies Unilever Holland and Unilever UK. The two companies shareholders have the same directors and use the same accounting principles. Starting from 2000, the corporate governance of Unilever reflects the regulations of the two countries. Specifically, in Britain the companies had non-executive directors in the board, that were not allowed in the Netherlands, where there was a supervisory board. To comply with the different needs, Unilever introduced the advisory directors, namely independent directors that carry out the functions of the supervisory board members and the non-executive directors. However, these were not allowed to use the right of vote. During the first years of the new millennium, the analyst started to criticize the quality of the corporate governance of the firm. In particular, the company seemed to not respect the code of governance published in 1992 in Great Britain. The first criticism was about the absence of the CEO and the presence of the executive chairmen in the board with executive duties. This feature was a symbol of bad governance practice because there was no separation between the executive power and the ownership. This overlap between power and responsibilities didn’t allow a balance in the board. Moreover, the board was accompanied by a large list of committees, mainly composed of executive directors. There was no space for control for the independent directors and the power of identifying the strategic plans and priorities belonged only to the executive directors. Finally, the mechanism of the advisory directors did not allow the firm to provide an effective control by the board. Those ones, in fact, were not legitimated to vote, so all the responsibilities were held by the non- independent directors. In 2003, the board was made of 8 executive members and 12 advisory directors with no right to vote. Moreover, there was not the CEO. Once the analyst discovered the bad governance practices of the firm, Unilever started to modify the composition of the board. From 2003 to 2008 the board passed from 20 members to 14 members. The reduction of the members was done to simplify the decision making process. Moreover, while in the 2003 the executive members were 8 and the non-executive ones were 12, in 2008 the executive members became 3, while the non-executive were 11, among which some appointed by minorities. Those changings improved the governance policies and the quality of the board, with the assumption that when the composition of the Board changes, also the quality of the governance policies modifies. 4 pillars of governance: Check the Board Size Split chairman and CEO role → why investors are bery strict on it: the CEO is in charge of other executive (he can remove them), the chariman is the leader of the board of directors and he can remove the CEO. The chairman appoints the agenda of the board. The charmain is the checkerbalance of the CEO. → check possible relation of chairman and CEO. Today the chairman is often an indipendent from the company Indipendent directors of the board Set up committees to handle specific issues ➔ The role of the board is to hire, fire and compansate the CEO (control) → we have to check that the board is in condition to do that 15  ➔ Today u would never find board commettees with executive memebers → they r usually just with indipendent memers ➔ Importance of the self-evaluation process 2.1 Why the Board of Directors is so important The role of the Board of directors is fundamental in the corporate system of a company. It represents the interface between the shareholders and the managers. In theory, the BOD is the most important group of people that help the company to reach the success and holds the entire responsibility of the entity they control. The BoD: - Is composed by competent and expert professionals, - Deal with critical strategic and governance issues, - Is away from the day-to-day activity of the firm. In practice, the Board of Directors wasn’t fulfilling the responsibilities it had. The meeting were 4 or 5 times a year, just to certify the partial results achieved and the information shared to the board by the managers was biased and incomplete. Moreover, still today, there is some uncertainty about the roles the board should fulfil. 2.2 The international corporate governance codes The uncertainty about the board of director practices has been solved by the codification of principles and rules of functioning of the board. CG codes are sets of principles, rules, and best practices, aimed at making the board a corporate body of effective control and guidance for the company. It is a tool by European stock exchanges to ensure greater transparency and fairness in the application and respect of the principles of good governance, and to encourage the spread of some practices which, up to the mid-1990s, existed exclusively in the Anglo-Saxon context. The regulation is partially made up of laws, but a fundamental role has been and is played by the “Codes of Self-Regulation” adopted by companies listed on the various stock exchanges. The CG Codes: - Are a reference model (“best practices”) of organizational and functional nature, - Are substantially similar across countries, - Are based on the thesis that protecting the interests of shareholders reduces agency costs and, consequently, the cost of risk capital, - Listed companies are required to communicate to shareholders and the Stock Exchange the reasons that have led them not to comply with the recommendations contained in the Code (so called “comply or explain” principle). The proliferation of codes started with the publishment of the Cadbury report in 1992 in the UK. In the following years, there was a proliferation of codes, based on the English one. The European codes show some similarities when the countries belong to the same law system, such as the Civil law. Differences are identified between those countries that adopt 16 a one level corporate governance system (one-tier system), and a two level corporate governance system (two-tier system). 2.3 The 2018 edition of the UK Corporate Governance Code This code applies to periods beginning after January 2019. The new English God has been revised with the goal of simplifying as much as possible. There was an increase in the emphasis on the relationship between companies, shareholders and stakeholders. The new code has five sections: 1. Board leadership and purpose, 2. Division of responsibilities, 3. Composition and evaluation of the board, 4. Audit, risk and internal control, 5. Remuneration. 2.4 Board tasks The Board of Directors (BoD) is the central body in the corporate governance system of a company and represents the interface between those who provide financial resources (shareholders) and those who use those resources to create value. It is entrusted with the primarily responsibility for controlling the management on behalf of the multitude of small shareholders who are unable to directly and efficiently exercise the property rights they hold. Literature and codes of corporate governance state that the board has three main tasks: 1. Control - Evaluation of the results achieved by the company (income, competitive, and social performance) - Verification of the validity of the decisions taken by the top managers of the company - Control of compliance with the rules and regulations in force - Verification of the effectiveness of internal reporting - Evaluation of the main corporate players, in particular, the CEO. 2. Strategic task From a managerial perspective, the board of directors should also play a role of service, which enhances the contribution of the directors to the strategic decision-making process and to guidance of the company. The directors are expected: - To define the mission and the vision of the company and - To contribute to its development and approve strategic plans. The strategies and business plans are drawn up by the Top management, led by the CEO, who submit them to the Board for critical evaluation conducted from the perspective of shareholders and stakeholders. However, the presence of independent directors in the standard board can make more difficult for the board to commonly identify the vision of the company. 3. Networking 17 Directors contribute to the development of corporate reputation and prestige and manage the relationship with shareholders and other stakeholders → when choosing the directors, the company has to consider prestige, links etc. of the directors. All these three tasks are equally important and have to be balanced. INPUTS OF A BOARD ANALYSIS!!!!! 2.5 Board composition The main goal of the evaluation of the characteristics of the board is to analyze the quality of the application of the code and not the application of the code itself. The recommendations for the creation of an effective board are based on the composition, structure and functioning of the board. With regards to the composition, the aspects analyzed both by English and international codes are the size of the board, the types of directors and the diversity among them. The size of the board Ideally a BoD is composed of 8-15 people, with high skills and sufficient time and energy available to make effective contributions, willing to take responsibilities and risks involved. The number of members of the board of directors depends on several circumstances, including the sides of the company, its ownership, structure, the demand for independence, and the variety of directors, and sometimes even the sector in which the company operates. In general, it can be argued that a too small BoD sacrifice variety in ideas and debate in favor of easier coordination and streamlined decision-making. On the other hand, Too large boards generates information redundancy, reduced decision-making capacity and board free-riding (qualcuno all’interno non farà un cazzo). → you need a number that is large enough to have all the competences you need (financial, legal, risk management, remuneration + others specific to the industry: sustainability, organization, performance measurement, cyber risk ecc…) Types of directors The main categories identified by the CG codes are: The chairman, a member who leads the board and is responsible for the overall effectiveness of the company. The chair is fundamental in creating the conditions for board effectiveness, ensuring that the board has effective decision-making process, The CEO, that is a director who received extensive powers from the board on all the aspects of the management of the company. The CEO is responsible for proposing company strategy and for its success (possible to have multiple), Internal or executive directors, members of the board of directors with executive functions in the company. These directors bring specific skills to board the discussions. It is not possible to establish an optimal relationship between internal and external directors (should be no more than 3), External or non-executive directors, members of the board without management functions in the company. Non-executive directors enrich discussions 18  with skills formed outside the company. The contribution of these directors is particular benefit when the interests of executives and shareholders of the company do not coincide, The independent directors, directors who meet the requirements of Independence. They are professionals who “do not entertain, nor have recently entertained, even indirectly, with the issuer or with persons linked to the issuer, relationship such as to influence their autonomy of judgment”. The BoD assesses the independence of the non-executive director immediately after appointment as well as during the course of the term of office when circumstances relevant to independence arise and, in any case, at least once a year. They must be able to play an effective leadership and control role over the CEO and the executives directors, avoiding that they pursue objectives to the detriment of all owners and the generality of stakeholders. Diversity of directors Diversity of the directors can be understood as involving various dimensions. - Mix of skills and knowledge. Diversity in the boardroom can have a positive effect on the quality of decision-making by reducing the risk of groupthink. - Demographic terms, such as differences in age, gender, and nationality. In this sense, one of the most topical aspects is the presence of women. Gender diversity has the benefit of increasing the quality and intensity of the debate and the climate and internal cohesion among the directors. - Professional background. Professional experience is the antecedent of certain behaviors, skills and discussion style. 2.6 Board structure The attention is about the separation of the roles of chairman and CEO, the appointment of a senior independent director and especially the establishment of committees within the board of directors. CEO Duality The separation of the roles of chairman and CEO is one of the most widespread recommendations in the governance codes of all countries. The overlap between chairman and CEO leads to an excessive concentration of power in the hands of the same person, limiting the independence of the board of directors from the top management of the company. The two positions require different skills and abilities, and the chairman position needs time, so the CEO will not be able to respect all dimensions given to the chairman. However, there are some voices in favor of a joint structure. The overlap of the chairman and CEO is someway an opportunity to express clear leadership. In countries such as US and France, the CEO-duality it is widespread. Lead independent director When is the position of chairman and CEO could not be separated, the solution is to identify a lead independent director. The senior independent director is an independent director 19 who is assigned particular tasks, including chairing meetings of external advisers, assessing the CEO and discussing aspects of the operation of the board with the chairman himself. However, this situation could lead to the birth of conflict between the independent director and the CEO of the company. Board committees The most important issue of the board structure is represented by the opportunity to set up committees to facilitate the operation of the board on the specific issues. Typically, the committees are led by independent directors. The committees have to analyze the matter, but the power to decide belongs to the board. In fact, the responsibility is defined as collegial in the board of directors. It is considered appropriate to establish at least four committees, that are the control, risk, audit committee; remuneration committee; nomination committee; sustainability committee. - The audit committee monitors the work of the executives and the proper functioning of the board. The internal control committee is usually responsible for all examinations to ensure the independent and effectiveness of the functioning of internal and external auditing system (at least 3 independents). - The remuneration committee is entrusted with defining the remuneration policies for the managing directors. Remuneration policies and practices should be designed to support the company strategy and promote long-term sustainable success (at least 3 independents + chairman not chair the committee). - The nomination committee is responsible for the process of selecting new directors. The UK corporate governance code requires that all directors should be subject to annual re- election. Typically, the committees are led by independent directors. The Board of Directors defines the tasks of the committees and determines their composition, giving priority to the competence and experience of their members 2.7 Board working style It is appropriate to reflect on the “soft” characteristics of the functioning of the board, such as the characteristics of its meeting, the provision of information to the directors and the decision-making process. Board meetings’ characteristics Starting from the number of annual board meeting, it is difficult to establish benchmarks that identify the effective number. However, the board of directors should meet at least 6 times a year, and the meetings should not be short and ineffective (—> board should meet at least 6 times (listed 8) a year with a duration on average of 1/2 day). Also, the physical environment is important. The environment of the board meeting should be able to engage all the directors and involve all of them in the discussion. It is best to meet in presence, because online meetings can be characterized by a low interaction and commitment. Board information 20 The information made available to the directors is an important feature. As far as quality is concerned, the information should be both concise and comprehensive, so that board members can easily understand the information before each meeting. 1. Information shared must be comprehensive of all the financial and strategic features. 2. Information must be timely, so the documents shared must be based on information useful to make a decision about the topic discussed in the meeting. 3. The Board must activate mechanisms to prevent its members (and company managers) from misusing confidential information and “price-sensitive” information!!! The Board adopts appropriate procedures to manage possible situations of conflict of interest for directors; the director concerned must declare the existence of the conflict of interest and abstain from the related decisions. Board decision-making style The board decision-making style represents the most relevant aspect of the process. This dimension can be examined along various characteristics. - Evaluate the democratic nature of the debate, which depends on the corporate culture and the attitude of executives and owners towards an open confrontation. - The decision-making style is influenced by the leadership style of the chairman. - !!! The human component appears to be in the end the most relevant aspect in building an effective board. This points to the following guidelines for the development of an effective "culture" within a modern board of directors: Create a climate of trust, Stimulate a culture of “open dissent”, Use a “fluid” range of roles, Ensure individual accountability, Evaluate the performance of the board of directors. The board processes can be divided into 5 main groups, according to the openness and democratic nature of the discussion: The passive board, where CEO holds power and directors have limited accountability. The certifying board, where the directors are considered accountable for the management of the business and the quality of the CEO. The engaged board, where the CEO act as a partner and the directors are fundamental to provide advice on the key issues and actively define the responsibilities. The intervening board. This model is common in a crisis, because in this case the directors make decisions about the company. The operating board. In this case, the board makes key decisions that management then implement. This is common in early-stage start up where there is a lack of managerial experience. The passive board is the kind of board controlled by the CEO, while the operating board is the kind of board that controls the CEO. The best kind of board should be identified in the middle. 21 2.8 The Board evaluation The practice of evaluating the board is fundamental to reach objectives, such as instilling discipline among members, increasing the overall efficiency of the board, ensuring continuous monitoring of processes, and increasing external accountability. The UK government code recommends: - An annual evaluation of the board in general, considering its composition, diversity, and working style, - An individual evaluation, that should consider the director contributes given. The assessment could be in the form of self-evaluation or made by external people. The self-assessment requires a lot of effort in terms of time, agreement on its goal and honesty from each director. However, the self-assessment is inappropriate when the board wants an objective view of the individual’s performance. Obstacles to its adoption: - Habit of companies to carry out vertical evaluations, - The unwillingness of directors to be evaluate, - The risk of collusion in case of peer-to-peer evaluation 22 Internal control system – PWC guests The internal control system is the process, effected by the Board of Directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of objectives relating to operations, reporting and compliance. The control system concerns different functions, such as internal auditing or risk management. Moreover, it provides a reasonable and not a certain assurance, because the system is carried out by people. The main goals of the internal control systems are: Effectiveness and efficiency of operations; Reliability on both internal and external reporting; Compliance with laws and regulations. The Integrated Framework for Internal Control System In the 1992, the original Framework was published. The framework provided guidance to the establishing, monitoring, evaluating and reporting on internal control system. In 2013, an updated version to ease the use and application was introduced. In particular, the new version: - Considered changes in business and operating environments; - Articulated principles and clarifying requirements for effective internal control; - Encouraged users to apply internal control to additional objectives. What has not changed were the three main objectives of the internal control, so the efficiency in operations, reliability of reporting and compliance with law. However, there was the introduction of 5 components, that must be respected to achieve the goals. The 5 components identified were enriched with the creation of 17 principles. The fundamental components are: 1. Control environment The 5 principles connected to this component were: o Demonstrates commitment to integrity and ethical values o Exercises oversight responsibility o Establishes structure, authority and responsibility o Demonstrates commitment to competence o Enforces accountability 2. Risk assessment → budgeting /sensitivity & scenario a analysis / risk management The 4 principles connected to this component were: o Specifies suitable objectives o Identifies and analyzes risk o Assesses fraud risk o Identifies and analyzes significant change 3. Control activities →actions/activities The 3 principles connected to this component were: o Selects and develops control activities o Selects and develops general controls over technology o Deploys through policies and procedures 4. Information and Communication The 3 principles connected to this component were: o Uses relevant information o Communicates internally o Communicates externally 5. Monitoring activities The 2 principles connected to this component were: o Conducts ongoing and/or separate evaluations o Evaluates and communicates deficiencies 23 Moreover, every component and every principle could be applied at different level in the firm, in particular: Entity level Division level Operating unit level Function level. So, the internal control system features can be seen as a cube. Examples of instruments for each component of the Internal control system 1. Control environment This component sets the tone for the organization's internal control system. It encompasses the overall culture, values, and ethical climate within the organization. A strong control environment is characterized by a commitment to integrity, ethics, and accountability at all levels of the organization. The main instruments to be used to create a control environment are: Code of ethics; Employees surveys to gauge the perception of the organization’s ethical culture and identity; Remuneration and incentive plans; Disciplinary system. 2. Risk assessment This component involves identifying and assessing the risks that could affect the achievement of an organization's objectives. It includes evaluating internal and external factors that may impact the organization and determining the potential risks associated with these factors. The main instruments to be used to assess the risk are: Creation of key risk indicators, to monitor and track specific risks; Budgeting instruments at each level of the organization; Identification of the objectives to ensure the pursue of the goals identified. 3. Control activities Control activities are the policies, procedures, and practices put in place to mitigate identified risks. These can include both preventive and detective controls, such as segregation of duties, approvals and authorizations, and reconciliation procedures. The main instruments to be used to control and mitigate the risk are: IT instruments and software that automate the control activities and reduce manual errors; Outsource to third parties of the riskier activities; Identification and application of an operating procedures. 24  4. Information and communication This component involves the flow of relevant information within the organization. Effective communication ensures that all personnel are aware of their roles and responsibilities related to internal control. It also involves the timely and accurate dissemination of information needed for decision-making. The main instruments to be used to improve the flow of relevant information for the risk control are: Employee training, to educate them about internal control policies and procedures; Financial and non-financial information; Communication policies. 5. Monitoring Monitoring is the ongoing assessment of the effectiveness of an organization's internal control system. It includes regular evaluations, testing, and reviews to ensure that controls are functioning as intended. Any deficiencies or weaknesses identified through monitoring should be addressed and corrected. The main instruments to be used to monitor the effectiveness of the control activities are: Presence of independent auditors; Analysis of the KPIs previously identified; Exception internal reports that highlight deviation from the established control standards. The effective internal control system The framework for the Internal control system states that an effective internal control system requires that: Each of the 5 components and the relevant principles are present and functioning. The components can be considered present and functioning if each relevant principles is determined to be present and functioning. Moreover, the relevent principles can be considered relevant and functioning if persuasive evidence exists that controls are selected, developed and deployed to affect them; The 5 components are operating together in an integrated manner. In particular, components are operating together and are present and functioning when them are present and functioning. The three lines of defense in the organizations In every company, it is possible to identify 3 separate groups or lines of defense that are necessary for effective management of risks and controls, so: First line is composed of the management controls and internal controls measures; Second line is composed of the Risk management and compliance. The second line of defense consists of specialized functions and roles that support and oversee the first line of defense; Third line is composed of Internal Audit. The third line of defense is the independent assurance function within the organization. Internal audit is responsible for providing objective assessments of the effectiveness of an organization's risk management, internal control, and governance processes. 25 Chapter 3 – Ownership structure, corporate governance and corporate strategy 3.1 The models of capitalism and governance systems The different governance systems reflect the different models of capitalism. According to Weimer and Pape (1999) a governance system is: “more or less country-specific framework of legal, institutional and cultural factors shaping the patterns of influence that stakeholders exert on a managerial decision-making.” Along a number of variables, the main different systems of corporate governance are: 1. Anglo-Saxon model - UK, USA, Canada and Australia. - The Anglo-Saxon model is a market-oriented model, where the main investors are represented by families and institutional investors. The reason why the Anglo-Saxon model is based on the market is that the financial markets are strongly developed and transparent, so able to monitor directors and managers to favor good behaviors. - The corporate ownership structure is the public company, where there is a high presence of institutional investors and hostile takeovers are relatively simple. 2. Germanic model - Germany, the Netherlands, Switzerland, and Japan. - Financial markets are less important, smaller and less transparent than the Anglo- Saxon model. For this reason, the most used ownership structure is the industrial groups or coalitions. In this kind of model, the role of the banks in the ownership structure is way more important than in the Anglo-Saxon one. - In the Germanic models, the main investors are other companies, institutional investors and banks. 3. Latin model - Italy, France, Spain and Greece. - The role of the financial market is limited, so there are no large listed companies. The most used kind of ownership structure is the family capitalism and the pyramidal group. Also the State as a shareholder plays a pivotal role in the economy. - The role of the banks is quite irrelevant. However, due to the undeveloped financial markets, the bank debt is the main financial source used by the companies. - The reasons why the Latin model is not based on the financial markets is related to the less efficient law system, that does not allow a proper defense of the shareholders’ rights. Given that, the presence of more concentrated ownership structures allows a safer control on the business. 26 3.2 Control enhancing mechanisms (CEMs) There are different mechanisms to increase the control mechanism: o Deviation from the proportionality principle of voting (one-share-one-vote), o Shareholder’s’ agreements, o Pyramidal groups and stock pyramiding effect, o Combination of previous mechanism. 3.3 Ownership, Governance and Strategy (OGS) model Corporate strategies, ownership structures and governance choices are characterized by strong interdependencies. In particular, these relationships depend on the context of the conditions, that can refer to the competitive context and to the institutional context. The ownership-governance and strategy (OGS) is a model that highlights the centrality of ownership structure, which is also strongly connected to the level of efficiency of the financial markets, and to the characteristics of the capitalist model in which the company operates. The choices in the OGS model are influenced by the following context conditions: Past performance. The health of a company is fundamental in the identification of the choices. In fact, companies that are living crisis should revise the strategy, Values, interests and resources of the current owners. If a company highlights the family’s values, there will be and higher probability that the family will participate in governance over the management of the company itself, Pressures/opportunities from the competitive environment. If a company can grow in the international markets, it will be probable that there will be the need to find new resources, so increasing the number of shareholders, Pressures/opportunities offered by the institutional context. Several variables, such as regulation, political model, stakeholders’ representation, judiciary system, can favor the proliferation of certain types of businesses and strategies over others, Constraints/opportunities offered by other context conditions, such as the available technology. 3.4 The first variant for the public companies While the OGS conceptual model states that the ownership defines the governance, that appoints executive, with which the strategy is defined, there can be two main variants. The first one is the public company model. In the public companies, it seems to have a weak role the ownership. This leads to the location of the total responsibilities for the strategic choices to the governance and the management bodies. So, in this case, the board of directors and the top management are very powerful, while the ownership is weak and passive. 27 So, in this case, there must be the application of some solutions to increase the power of the ownership in the identification of the strategy. 3.5 The second variant for the controlling shareholders The second variant of the OGS model refers to the case of concentrated ownership. The presence of controlling shareholder will have two types of consequences. 1. It is expected that the company governance bodies will be designed according to the needs, wishes and vision of the owner. The same applies to the top management, 2. The concentration of ownership suggests that the controlling shareholders have a direct impact on the strategic choices. The effects of the controlling shareholders depend also on the characteristics of the shareholder itself: An Institutional Investor tends to operate with a greater propensity to risk, with strategic choices oriented to the long-term and the creation of value for minority shareholders. Bank controlled companies will be more likely to pursue expansionary strategies. However, it is improbable that this kind of firms will try to diversify their activities. Family controlled companies will be more risk adverse, and this will translate into a lower propensity toward acquisitions, but also into a higher degree of diversification, State companies are characterized by goals and consequent strategies for reducing prices, increasing employment, and generating a positive externalities through the company’s operations. In the case of concentrated ownership, the main goal is to increase the independence and power of the Board of Directors and Top management. 3.6 Corporate strategy and ownership structures It is likely that there is an optimal relationship between ownership structure, and the strategic choices of companies. Strong controlling shareholder, with available cash and without external constraints - Available to make relevant investments in the m/l term, - Favorable to risky but promising corporate strategic choices (change in the business model, acquisitions etc…), - Supportive of strong R&D investments, - May accept pro-tempore low dividends to support organic growth. Controlling shareholder with relevant debts - Demand high dividends (to pay the debt), 28 - Scarcely oriented to investments, growth and risks’ assumption, - Contrary to capital increases, - Favorable to cash-generating activities. Public controlling shareholder with available cash - Support long-term (and often low risk) investments, - Contrary to large restructurings and dismissals, - Available to buy firms in crisis (also unrelated businesses), - Available to give to non-owner stakeholders (employees, customers, suppliers, local communities etc…). Financial and active non-controlling shareholders - Contrary to corporate diversifications (financial investors diversify risks by themselves) - Contrary to cross-shareholdings and business groups - If necessary, they are supportive of heavy restructurings. 3.6 The importance of ESG commitment The recent behavior of Blackrock (an asset management group), which voted against in the shareholders’ meetings of 53 listed companies due to their insufficient commitment to environmental sustainability, testifies to the great and growing importance of the ESG commitment on the part of companies. The ESG commitment of companies is becoming crucial in their governance strategies. ESG presence is now a criteria of investment choices, so it’s crucial to attract and retain capital. The ESG commitment of a firm, has a direct and significant impact on the company’s growth in long term. To evaluate the ESG commitment of a company there are some KPIs: 3.9 The ESG investment strategies Companies and investors can follow different ESG strategies: Exclusion: the company doesn’t invest or operate in unethical or unsustainable business, so there is exclusion of entire countries or sector or some partner companies, Engagement and voting: shareholders are active in involving and influencing the board of the company to embark ESG initiatives, 29  ESG integration: in this case the board make sure that there is a systematic inclusion of ESG criteria in financial analysis and operating choices, Norms-based screening: investing only on companies that adhere to international standards and norms, such as respect for the environment and human rights, Best in class: investment in companies selected because they have reached the highest ESG values in their sectors, Sustainability themed investments: companies select asset related to ESG in different operating areas, such as renewable energy, waste management, energy efficiency and sustainable transport, Impact Investing: company operates, and shareholders invest, only in activities and business opportunities aimed to solve some specific social or environmental problems. The adoption of ESG logic is spreading all over investment choices made by investments fund, retail and institutional investors; but also in governance and strategy choices made by the board of companies (especially the most large and international ones). It’s also increasing the tendency to create and ESG reporting to share among all stakeholders, in particular the public and the institutions. 30 Chapter 4 – Designing Governance for effective decision- making in family firms The Family Firm Institute estimates shows that family businesses generate from 70 % to 90% of the world’s GDP. In this kind of companies, the concentration of ownership is way higher than in the public companies → the concentration increases as the size of the business decreases. Family companies represent the most used ownership structure in the first stage of every company and can be considered a fundamental structure for the evolution and growth of the firm itself. Definition: a family business is a business where the absolute majority of the voting rights is in the hand of multiple members of the same family and at least one of this members sits on the Board or held a managerial position. 4.1 The key characteristics of the family companies During the XX century family companies were considered ineffective, because of the lower growth rate, but during the financial crisis, family corporations were discovered to be more resilient than the public ones. The key core characteristics of the family companies are: Family companies are frugal, both in good times and bad one. Family companies do not invest more than they earn. Family companies carry low debt. Family companies acquire fewer and smaller companies. Family companies are more diversified. Family companies are more internationalized, through exports. Family companies can retain talent better than their competitors. 4.2 The conceptual scheme of the family companies The family-controlled companies are the companies where there is the highest overlap between ownership, management and control. More precisely, the owners, in the majority of cases, sits in the Board of Directors, usually as executive directors. Moreover, the family members usually have some operating and managerial role in the company. The strong overlap between these three bodies can lead to some positive and negative aspects: - The strong overlap ensures that there will not be a misalignment of interests between the principal and the agent, reducing the cost of agency. - The strong overlap does not ensure the possibility, for the Board of Directors, to carry out its role in a free and proper way. 31 4.3 The importance of the governance Also in the family controlled companies the good governance practices play a fundamental role. It is possible to identify three main situation in which governance has a fundamental role: 1. When the family company grows and succeeds, while operating in a highly competitive and fast-changing environment, the governance is fundamental, because there is the need for: - A stronger decision-making process, - A stronger corporate structure, - An increase in the reputation to allow international alliances. 2. Where there are tensions and conflict between the family members. In this case, the goal of the governance is to: - Activate mechanisms that oversee tensions between managers and members, - Ensure that the entrepreneur and managers' energies will not be fully absorbed by interpersonal tensions. 3. When there are some changes in the ownership structure, such as the entrance of new family members, external shareholders or financial investors, or when the owners get older and there is the need for a general transition. The Board of Directors plays different roles in the management of the relationship between family and business. Among these roles there are: The role of moderator. In case there is only one person that owns the majority of the equity capital, a well-structured Board of Directors can be very useful as a counterweight to the entrepreneur, The participatory role. A well-functioning board of directors can represent a mean for allowing family members to maintain good knowledge of the business, The role of auditor. The BoD can allow its members to monitor the work of the CEO, The role of facilitator. A well-functioning BoD can be very useful in situations of interpersonal tensions between owners. The role of governance. 4.4 The peculiarities of family-owned companies The literature agrees on some common traits among family businesses, such as: The personal relationship and the mutual knowledge are considered primary with respect to the business relationships, Concentration (on average 3 members in Italy for firms up to 500 employees) and long-term stability, There is a high overlap between management, governance, and ownership, so a high level of participation by the family owners in the other two bodies, There is the coexistence of economic and non-economic objectives, There is a high attachment to the local area of origin of the family, The presence of financial and emotional barriers to the exit, also because of the difficulty in finding partners acceptable to the family owners, While small and medium companies appear to be opposed to the business diversification, the big family companies seem to be open to the diversification. 32 4.5 Positive and negative aspects of the family-owned firms Among the positive aspects there are: The “patient capital” of the family, that privileges long term objectives and returns compared to the short term, The strong emotional involvement of the owners, managers and company’s employees, A corporate culture that promotes the identification of all stakeholders in the enterprise, reducing the "turnover" (both at the top or elsewhere), promoting stability goals, “Social capital” accumulation as a moral resource for the enterprise, The capability to produce “unique” resources, Leadership continuity, greater “resilience” in difficult period, and faster decision-making. There are negative aspects among the characteristics of the family-controlled companies, that can increase the risk of failure. Among these factors there are: The nepotism phenomena and the probable distorted selection of management, Companies apply a conservative approach and are risk adverse, which avoid innovation in favor of safeguarding accumulated assets and family privileges, The family will appropriate company resources to satisfy its desires, The effort of managing the family emotions and conflict can distract the attention from the business issues, There is a high risk in the generational turnover. → !!! Thesis “The courage to chose”: family business owners choose for succession: 1/3 first born, 1/3 outside CEO, 1/3 second/later born. In terms of performance, we have 3-2-1 in order (because the first born is the obvious choice, while the second/later born choice means that the owner decide (!!!) that it is the best for the company) → very tough choice is the better because you choose the best and not the natural pathway !!! As we can understand from the results the best option, run terms of performance, is to choose a family member (if you choose a member internally, they will be better motivated to manage the company (how can an external member lead another person’s company??)) 4.6 The family ownership in different theoretical frameworks - Agency theory. According to this theory, the company is guided by family executives, take advantages of lower agency costs because owners and managers’ interests are aligned. This situation reduces information asymmetry and the consequent risks of opportunistic behavior by the management. - Stewardship theory. According to this research, the family members attachment to the business is seen as a positive factor for the success of the business, on the hypothesis that there is a cooperative behavior within the organization along the family members and the non-family members. These two studies on the family owned companies have found that the optimal conditions to benefit from the agency and stewardship advantages are one of the firm is small, and the ownership is highly concentrated. Under these circumstances, companies with the family CEOs will achieve greater performance, due to the deeper knowledge of the business, and the alignment of the interests. 33 4.7 The family business transition through the Governance In the first phase of the lifecycle, the family businesses are owned by a single entrepreneur. In this phase, the best governance tool is the Board of Directors. The BoD is the governance starting point for all the different companies. The absence of this body can lead to some problems and inefficiencies in the decision-making process. During the subsequent growth of the company, and the entrance of new members in the company, it is useful to define some ownership agreement on the way the company has to be managed. After the entrepreneurial phase, there will be the entrance of the second generation of the owner in the ownership structure. During this phase, it could be useful to organize and carry out some family meetings, during which the family members will have to define the strategies to apply in the company. If the second generation is made of a high number of members, it is better to establish the family agreements, so contracts in which identifying the purpose and principles that must be followed by the family members. Moving forward, the next phase if the introduction of new family branches in the ownership structure of the company. During this phase, it fundamental to create: Family committee, that is a smaller group within a family business that focuses on the goals of the family in the administration of the company; Family foundation, so a different legal entity that has the legal form of a foundation that is responsible for the identification and respect of the code of conduct and objectives of the family in the administration of the business. The final phase is the one during which the firm becomes a family business. In this case, it is fundamental the presence of a family office, namely an entity responsible for managing the family financials’ affairs. At this point, there is a total separation between the ownership and control. 4.8 The generational transition Among governance problems of a family firm, especially in more “traditional” firms, one of the most relevant is the generational transition. The generational transition is a natural event of the life cycle of a family company, that cannot be seen as a substitution of a person with another. 34 Research have shown that the transition between generations is an opportunity to rethink and review the ownership, the governance, the organizational and strategic enterprise's structures. In some circumstances, the general transition can take place in a traumatic way, such as the unexpected unavailability of the entrepreneur or unsolvable conflict between family members about the transition. The succession of the founder entrepreneur shows specific issues in the following cases: The founder-entrepreneur is a charismatic figure, and the company is completely identified in the founder. The business formula is modelled on the founder and has never been tested in his absence. There is a lack of experience in managing generational transitions. The case of generational transition with multiple successors raises the problem of leader’s choice. In this case, the possible approaches are - To hire a non-family leader or - To choose among the family members, according to an objective evaluation or - Recognizing the firstborn as the heir of the generational transition. The condition for success in the generational transition shown by the theory and the practice are: ▪ Distinguish the business from the family, ▪ Respect and use the governance tools, ▪ Define the shared rules for the transition, ▪ Plan the objectives and the process to reach them in the long run, ▪ Involve third parties in the transition. 4.9 The governance structural design for family firms To summarize, the optimal governance structure for family firms is made of: 1. Family board, so an external body that is responsible for the identification of the objectives and code of conduct of the family members in the management of the company. The family board is also responsible for training the future members in the administration of the firm; 2. Shareholders’ meetings, that have a fundamental informative role. During this meetings the family representatives have to share to the other shareholders the goals and the strategy identified by the family; 3. Holding Board of Directors; 4. Operating Board of directors, that is made of family and non-family members; 5. Top management team, that must be made of family and non-family members, to guarantee a proper balance. It could be useful to set a management committee. 4.10 The Importance of outsider in the family businesses The outsiders can be divided in the following groups: Family members not involved in the business, Affiliated non-family members, so outsider experts that are in some way related to the family. Some examples of this directors are the family accountant or lawyer, 35  Independent non-family directors, so external directors that do not have any kind of relationship with the family. The main advantages of the presence of outside directors can be divided into control, strategic and relationship management improvements: 1. Strategic improvements The main advantages from a strategic point of view are: External directors bring experience and skills that are critical in order to integrate company’s knowledge, External directors improve the quality of the decision-making process, External directors promote better relationships with the other stakeholders, External directors strengthen the image and the enterprise’s network. 2. Control improvements The main advantages from a control point of view are: External directors stimulate a sense of discipline and responsibility, External directors facilitate the introduction of more sophisticated reporting tools, It is possible to monitor possible conflicts of interests, External directors protect the interests of the shareholders. 3. Relationship management improvements The main advantages from a relationship management point of view are: External directors help in planning the generational succession, External directors can ensure the training of the successors, There is a less emotional and a higher professional management of the tensions between the family members. 36 Chapter 5 – The origins of Corporate Governance 5.1 Corporate Governance and the democracy The debate about the corporate democracy was born in the US. The equivalence of one head one vote from the political conception of the democracy struggled in the real economy with the differences existing among citizens. In the first half of the XIX century, the firms controlled by a stockholder or by the members of the Board, encouraged the small shareholders to join the company with some information about the voting rights. However, all these restrictions and discussions about the different forms to reduce the power of the biggest shareholders became obsolete after 1860s. The huge economic development post-Civil War produced a situation where the legislation was always late, compared to the original initiative of the new big corporations. The boom of some capital intensive business, such as the railway and the chemical sectors, pushed many States to provide special conditions for the incorporation of the companies. In 1890s, the Congress approved the Sherman Act, known as the first antitrust law. However, the concentration of economic power was not the only aspect of this period. A second set of issues was connected to the needs of additional capitals from the listed companies. This situation led to the potential conflict between the major shareholders and managers. Finally, a third issue was connected to the separation of ownership and management. The growth of some sectors, such as the railway and the chemical one, increased the complexity and difficulty in managing the big companies. So, there was the need for hiring professional managers. 5.2 The impact of the Great Crash (1929) Until 1929, managers controlled huge powers and the shareholders remained passive as dividends were regularly distributed. The one-share-one-vote rule was widespread, and companies started to introduce multiple and non-voting shares. The crisis of 1929 changed the situation. The insufficient amount of information and the lack of transparency in the decision process evidenced the risk for the minorities. In 1931 the professor Adolph Berle highlighted the huge power reached by the big corporations, comparing them to States. The professor stated that all the power of the corporations and of the managers should have been used only for the benefit of the shareholders. However, the professor recognized the possibility of a misalignment in the interests among the shareholders and the managers. Merrick Dodd, a Harvard professor, argued that the business is a private property only from a theoretical point of view, and society must demand that the business should be carried out to safeguard the interests of all those who deal with it, such as employees. → In 1934 the Security and Exchange Commission (SEC) was introduced. These new rules improved the transparency in the markets and the amount of information shared with the investors. However, the Board of Directors became less independent. 37  5.3 The post-World War II period and the shareholders’ value principle The debates started again only in the early 1970s in the US, because of the LBO period. The way to control the managers can be split in three different categories: 1. Market for corporate control. It is the market for acquisitions and mergers (external/exogenous mechanism), but the market sometimes is not efficient (ex. Italian market for corporate control is working very badly) —> managers are judged by shareholders through performances → in States as Italy you can’t use it because of the limited dimensions of the market (only 270 companies listed) 2. Corporate Governance rules. Very clear in telling what managers can/can't do in order to be legally compliant (internal mechanism, as they work inside the company, eg. committees) 3. Lenders and institutional investors for debt. The leading US and UK companies, differently from the European ones, are supportive of a stakeholders-oriented approach. The heart of this approach is the market, which is the real controller of the managers. To be efficient markets need rules, among which the equality among shareholders, according to the principle “one-share-one-vote”(first pillar). The European model is not based on the shareholders democracy, in Europe, many companies use the control enhancing mechanisms, such as the pyramids, shareholding agreements and multiple voting shares. The second pillar of the US and UK approach (stakeholder oriented approach) is the primacy of shareholders, against the growth, community, and stakeholders. According to this vision, the shareholder is the only one that has the right to get the residual after the satisfaction of the other performance obligations of the business → the purpose of the company is to create value for the shareholders. 5.4 The conglomerates phenomena and the value discount In the US, in 1970s, companies were destroying value because of a strategy of non-related diversification undertaken by the largest US companies. The reasons for this nonrelated diversification were many: o The countercyclical strategies of top management, willing to keep high ROA and ROE (at the corporate level) in a phase of structural stagnation and competitive challenges (crisis, but managers want to keep indices high —> now companies are doing that again… o The prevailing remuneration strategy of the top management privileging both returns and “size” (market share) o The development of management techniques of purely financial nature (returns) enforced by the instruments forged by consulting companies (e.g. BCG relative market share matrix The main problem with the conglomerates is that, even if in the short term there is a high return, in the long-term will be difficult to manage all these diversified businesses. Conglomeration strategies are in general justified by risk-diversification in situations of institutional/normative voids and market failures. Also, can effectively promote a better internal allocation of financial resources. 38 However, their management can be problematic, resulting in a corporate value inferior to that which can derive from a corporate break-up. On average, the so-called conglomerate discount amounts to about one third of the theoretical corporate value, namely the value of the business breaking-up the divisions. 5.5 The revolution of the 1980s and the LBO (leveraged-buyouts) period As a consequence of the conglomerate discount, between the late 1970s and above all during the 1980s, the number of LBO started to increase involving large market caps. - The basic principle is that a target company, undervalued by the market but with some potential value and assets, can be taken over by a hostile bidder. - The bidder was endowed by financial resources (debt, bonds, equity) in part granted by the assets and cash-flow of the target. - The financial resources issued by the LBO company were rated as junk bonds and the collateral of the loan were the assets of the targeted company. → Perfect targets of LBOs were conglomerates discounted by the market but with good assets, quite acceptable cash flows and with a medium-low level of indebtedness. The philosophy of the LBOs of the conglomerates was to maximize the value of the business after the breakup of the companies. To be efficient, the LBO requires: An efficient market for corporate control, The maximization of the value for the shareholders, An efficient management of the companies after the takeover and the break-up, Effective instruments to promote the alignment of interests of managers and shareholders, such as the stock options, The LBOs season also shows the relevance of institutional investors, and in particular of pension funds, among the main providers of financial resources for the bidders. Given that the LBOs needed a large number of financial resources, the LBOs seasons coincided with the increase of the institutional investors, in particular the pensions funds, in the ownership structure of the companies. 39  5.6 The 1990s and the globalization process During the 1990s institutional investors became global thanks to the ongoing integration process of the World economy which took place after the Fall of the Berlin Wall. Besides the US., in which they became a dominant force, the privatization processes in OECD countries have made institutional investors key players in the state privatization process. The effect of the increasing dominance of institutional investors was a rise in the demand for better governance practices → during the whole decade, Governments started to reform the financial markets, promoting transparency and accountability. The main example of the increasing demand for corporate governance was the Cadbury report. In 1990s, after many company’s collapses and scandals, the market was losing trust in the management of listed companies and there was a need for an imminent reform. In 1992 the Cadbury committee published its report, which can be considered the first code of good corporate governance practices. The main points concerned the introduction of independent directors, creation of an audit committee, definition of responsibilities, birth of a nomination committee and remuneration committee. Starting from 1992, all the UK listed companies had to respect this code. After the Cadbury report, other initiatives took place in other countries. In some cases, like other Anglo-Saxon countries (Canada or Australia), many similar recommendations were adopted. In others, like France, there was a more dialectic relationship. The US have been for decades the front-runner for the corporate governance discussion, did not introduce any real code for many years. Until 2000, the American companies were only requested to respect to the company law of the state. 5.7 The 2000s scandals and the financial crisis The Enron scandal in 2001 induced the Congress to reinforce the legislation about the corporate governance for the listed companies. The main changing was related to the role of independent directors and the stress about the presence of the audit committee. After 2008, the demand for an improvement in the corporate governance increased. The US financial crisis inquiry commission was extremely severe in its judgement about the rating agencies, identifying them as the key enablers of the financial meltdown. Also, the European commission entered in the discussion. In the Green paper, publishe