Introduction to Corporate Governance PDF

Module 1 Introduction to Corporate Governance Key concepts Learning objectives After studying this section, you should • Understand different definitions of corporate governance • Understand how the separation of ownership and control creates the agency problem in firms • Know the various ways to...

Module 1 Introduction to Corporate Governance Key concepts Learning objectives After studying this section, you should • Understand different definitions of corporate governance • Understand how the separation of ownership and control creates the agency problem in firms • Know the various ways to solve the agency problem • Understand the main elements of corporate governance practices in listed firms 2 Forms of business ownership There are four general types of business ownership: Sole proprietorship Partnership Limited Liability Company = Private Company Corporation = Listed Company = Public Company Business owner Single owner Partners Members Shareholders Owner’s liability Unlimited Unlimited Limited Limited Easy access to capital market? No No No Yes Is management and ownership separate? No No Sometimes Yes 3 Pros and cons of listed companies • Pros ˗ Easy access to capital markets ˗ Infinite life unless go bankrupt or merged by others ˗ Owners have limited liability ˗ Liquid corporate ownership • Cons ˗ Cost structure of running a corporation is higher than simpler forms ˗ Corporations suffer from potentially serious governance problems, which creates a need for corporate governance. We will get back to this issues a bit later… 4 Different definitions of corporate governance • Definitions of corporate governance vary according to the perspective ˗ Operational ▪ “Corporate governance is the process by which companies are directed and controlled” (OECD, 1999) ˗ Relationship ▪ “The relationship among various participants in determining the direction and performance of corporations. The primary participants are the shareholders, the management, and the board of directors” (Monks and Minow, 2001) ▪ “The corporate governance structure specifies the distribution of rights and responsibilities among the different participants in the organization—such as the board, managers, shareholders, and other stakeholders—and lays down the rules and procedures for decision-making” (OECD, 2002) ˗ Stakeholder ▪ “Corporate governance is the process by which corporations are made responsive to the rights and wishes of stakeholders” (Demb and Neubauer, 1992) 5 Different definitions of corporate governance • Definitions of corporate governance vary according to the perspective of the user ˗ Financial economics ▪ “Corporate governance deals with the way suppliers of finance assure themselves of getting a return on their investment” (Shleifer and Vishny, 1997) ˗ Societal ▪ “The whole set of legal, cultural, and institutional arrangements that determine what (public) corporations can do, who controls them. How that control is exercised, and how the risks and return from the activities they undertake are allocated.” (Blair, 1995) ˗ Overall ▪ “Corporate governance is the exercise of power over a corporate entities” (Clarke, 2004) 6 Agency problem • Adam 7Smith (1776): “The directors of companies, being managers of other people’s money than their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private co-partnery frequently watch over their own” • Adam Smith’s notion was the first thought of what later became known as the agency problem • Berle and Means (1932) defined how corporate structures create a need for corporate governance • They pointed out that firms were becoming so large that the ownership and control was separated • Stockholders own the firm and managers control the firm → Self-interested managers have an opportunity to take actions that benefit themselves, with the cost of these actions paid by owners (the agency problem) Agency problem • Agency problem (also called as the principal-agency problem) represents the conflict of interest between the principal and the agent. In corporations Principal = Shareholders Agent = Management • Related agent problems ˗ Shareholders controlling board members ˗ Board members (= directors) controlling management • In public companies today, agency relationships can involve strings of agency relations ˗ For instance, an individual owner might invest his funds through a financial adviser, which invests in a mutual fund or investment trust ˗ Hence, there are multiple agency relations from an individual owner to the CEO of the company 8 Agency problem • The agency problem arises, whenever the owner of wealth (the principal) contracts with someone else (the agent) to manage his affairs • In simple contracts there may be just one principal and one agent • In a limited-liability company, there are many principals (shareholders) and their agents (directors) • As the number and diversity of shareholders increases their interests are seldom homogeneous • Therefore, the governance of the firm is structured as follows: 1. Shareholders are the owners of the firm 2. Shareholders elect members to the board to act as their agents in supervising the firm 3. Boards appoint managers to actually run the firm on a day-to-day basis Agency costs • Shareholders bear the cost of the self-interested actions taken by the management • Examples of the agency costs include ˗ Insufficient effort on building shareholder value ˗ Excess executive compensation ˗ Manipulating financial results to increase bonus or stock price ˗ Excessive risk taking to increase short-term results and bonus ˗ Failure to groom successors so management is “indispensible” ˗ Pursuing uneconomic acquisitions to “Empire building” ˗ Rejecting hostile takeover to protect job 10 How can shareholders influence managers? • Shareholders do not directly hire/fire managers – so they cannot vote to replace them • Shareholders can influence managers indirectly through the board of directors • Changing board members can be difficult as management controls the process and some inactive shareholders will go along with whatever management wants • Some “active” shareholders are large enough to try and influence management or change the board, but they are often met with defeat 11 Two solutions to agency problem 1. Incentives (carrots…) ˗ Aligning executive incentives with shareholder desires ▪ Executives become the owners of the firm ▪ “Give them stocks, restricted stocks or stock options” 2. Monitoring (a stick…) ˗ Setting up mechanisms for monitoring managers’ behavior ▪ Inside monitors ▪ Outside monitors 12 Some evidence on incentives: CEO compensation mix for the S&P 1500 Firms in the US in 2020 Source: WillisTowerWatson, 2021 13 Some evidence on incentives: CEO compensation mix for the S&P 1500 Firms by sector Source: WillisTowerWatson, 2021 14 Some evidence on incentives: CEO compensation mix for the biggest firms (Sales > USD 10 billion) globally Source: WillisTowerWatson, 2021 15 BIG picture of MONITORING A Future evolution of corporate governance • Some key issues remain ˗ Should the CEO ever also be chairman of the board? ˗ Should a retiring CEO go on as chairman? ˗ Can outside directors be genuinely independent? ˗ Should shareholders be able to nominate directors? ˗ Should institutional investors exercise more power? ˗ Are external auditors really independent? ˗ How should directors’ remuneration be determined? ˗ How should new complex, dynamic, and often global corporate entities be governed? ˗ Are governance processes around the world converging? ˗ Are rules for governance of listed companies appropriate to family companies, small firms, partnerships, or not-for-profit entities? Bibliography • Blair, M. M. (1995). “Rethinking assumptions behind corporate governance”, Challenge, 38(6), pp. 12-17. • Demb, A., & Neubauer, F. F. (1992), “The corporate board: Confronting the paradoxes”, Long Range Planning, 25(3), pp. 9-20. • Shleifer, A., & Vishny, R. W. (1997), “A survey of corporate governance”, The Journal of Finance, 52(2), pp. 737-783. 18