Week 2 Corporate Governance PDF

Week 2 Corporate Governance - This is a system of rules, practices and processes by which a company is directed and controlled - Corporate Governance came into the spotlight in the UK in 1992 with the Cadbury report - A key function of corporate governance is to determine how power is...

Week 2 Corporate Governance - This is a system of rules, practices and processes by which a company is directed and controlled - Corporate Governance came into the spotlight in the UK in 1992 with the Cadbury report - A key function of corporate governance is to determine how power is distributed between different stakeholders with particular emphasizes to: Shareholders who own the company Board of directors who oversee the managers Management who runs the daily operations To ensure that the company runs efficiently - Corporate Governance concerns the way an organisation is formed, structured, and controlled as well as how firms manage themselves, and how their performance is monitored - It refers to the structure of authority within an organisation - Essentially corporate governance involves balancing the interests of a company’s many stakeholders, such as: Shareholders Management Suppliers Financiers Government The Community Stewardship Theory of Corporate Governance: - Managers are stewards of the firm and are only looking after the assets of the company - Managers work to ensure the assets are used appropriately and are in a position to be passed on to their successors Agency Theory: - This argues that managers are agents of shareholders and therefore need to be contracted as such. - Employment contracts should be drawn up to align the interests of managers with that of shareholders. Core Principles of Corporate Governance Rights of Shareholders - The corporate governance framework should protect shareholders, and facilitate their rights in the company. - Companies should generate investment returns for the risk capital put up by the shareholders. Equitable Treatment of Shareholders - All shareholders should be treated equitably (fairly), including those who constitute a minority, individuals and foreign shareholders. - Shareholders should have redress where an individual shareholder or group of shareholders is oppressed by the majority. Stakeholders - A stakeholder is someone, other than a shareholder or creditor, who potentially has a claim on the cash flows of the firm. - The framework should recognize the legal rights of stakeholders and cooperate with them in order to create wealth, employment and sustainable enterprises. Disclosure and transparency: - Companies should make relevant, timely disclosures on matters affecting financial performance, management and ownership of the business. Board of Directors - The board of directors should set the direction of the company and monitor management in order that the company will achieve its objectives. Approaches to Corporate Governance Principles-Based Approach (Adopted in the UK) - This involves establishing a comprehensive set of best practices to which listed companies should adhere. - The company should disclose to its shareholders if it chooses not to abide by one or more of the standards along with the reasons for not doing so. - It may be a condition of membership of the stock exchange that companies strictly follow this ‘comply or explain’ requirement. - The principle of ‘comply or explain’ means that companies must take seriously the general principles of relevant corporate governance codes. Rules-Based Approach (Adopted in the US) - Under this approach, the desired corporate governance standards are enshrined in law and are therefore mandatory. - The best example of this is the US, where the Sarbanes-Oxley Act lays down detailed legal requirements. - Rules-based control is when behaviour is underpinned and prescribed by statute of the country’s legislature. - US-listed companies are required to comply in detail with Sarbox provisions. Forms of Business Organisation Sole Proprietorship - Owned and managed by one person - Very easy to form - Profits taxed as personal income - Unlimited liability - Life of company linked to life of owner - Amount of funding is limited by owner’s personal wealth Partnership - Easy to form - Requires a partnership agreement - Limited and unlimited partners - Partnership is terminated when a partner dies or leaves the firm - Difficult to raise cash - Profits taxed as personal income - Controlled by general partners – sometimes votes are required on major business decisions Limited Corporation - Articles and Memorandum of Incorporation required - Limited liability - Profits taxed at corporate tax rate - Board of directors - Life of company hypothetically unlimited Articles of Incorporation - Name of the corporation - Intended life of the corporation (it may be forever) - Business purpose - Number of shares that the corporation is authorized to issue, with a statement of limitations and rights of different classes of shares - Nature of the rights granted to shareholders - Number of members of the initial board of directors Memorandum of Association - The rules by which the corporation is organised Partnership vs Corporation Liquidity and Marketability - Partnership: Restricted trading - Corporation: Traded easily, sometimes on exchange Voting Rights - Partnership: Partners have control - Corporation: Each share gives a voting right Taxation - Partnership: Profits taxed at personal tax rate - Corporation: Profits taxed at corporate tax rate Forms of Business Organisation Reinvestment and Dividend Payout - Partnership: All profits allocated to partners - Corporation: Total freedom in dividend decisions Liability - Partnership: General Partners have unlimited liability - Corporation: Shareholders have limited liability Continuity of Existence - Partnership: Limited life - Corporation: Unlimited life Legal Structure of a corporation Unitary - Board reports to shareholders - Shareholders elect directors at AGM Two-tier - Board reports to supervisory board - Supervisory board elects directors - Supervisory board consists of representatives from banks, government, trade unions, other stakeholders Board of Directors – Single-tier Countries Board of Directors- Two-Tier Countries The Agency Problem and Control of the Corporation Management Goals - The relationship between the managers and the shareholders (owners of the business) is known as Agency Relationships. - Managers want to maximize their own wealth and power - Shareholders want managers to maximize the value of the company Agency Theory Type I - Relationship between managers and shareholders - Such a relationship exists whenever someone (the principal) hired another (the agent) to represent his or her interests. - For example, you might hire someone (an agent) to sell a car you own while you are away at university. Type II - Relationship between majority shareholders and minority investors - Such a relationship exists whenever a company has concentrated ownership structure, which is common in many countries. - When an investor owns a large percentage of a company’s shares, they have ability to remove or install a board of directors through their voting power. Agency Costs - The costs of resolving problematic agency relationships Type I Agency Costs Direct Costs - Corporate expenditure that benefits managers at the expense of shareholders Indirect Costs - Corporate Expenditure to monitor and control manager activities Examples: Private jet, payment of auditors, etc. Type II Agency Costs - Majority shareholder makes one of her firms trade on attractive terms with another of her firms. Known as a Related Party Transaction - Majority shareholder can force the company to declare a large dividend because he needs the cash Do Managers Act in Shareholders’ Interests? Managerial Compensation - Performance-based pay - For example, managers are frequently given the option to buy equity at a bargain price. The more the equity is worth, the more valuable this option is. In fact, options are often used to motivate employees of all types, not just top managers. Control of the Firm - Are shareholders powerful? - They elect the board of directors, who in turn hire and fire managers Shareholder Rights  - Do shareholders have a facility to call managers to account? - Shareholders elect directors, who in turn hire managers to carry out their directives. Proxy Voting - A grant of authority by a shareholder allowing another individual to vote his or her shares - For convenience, much of the voting in large public corporations is actually done by proxy Control of the Corporation Classes of Shares - Some firms have more than one class of ordinary equity. Often the classes are created with unequal voting rights - A primary reason for creating dual or multiple classes of equity has to do with control of the firm. If such shares exist, management of a firm can raise equity capital by issuing non-voting or limited-voting shares while maintaining control. Pre-emptive Rights - A company that wishes to sell equity must first offer it to the existing shareholders before offering it to the general public. The purpose is to give shareholders the opportunity to protect their proportionate ownership in the corporation Dividends - Payments by a corporation to shareholders, made in either cash or shares - The payment of dividends is at the discussion of the board of directors International Corporate Governance Main areas of importance are: - Investor Protection - The Financial System - Control Mechanisms - Firm Corporate Governance Systems Legal Systems Around The World Common law: a body of law derived from judicial decisions of courts and similar tribunals. Civil law: deals with behavior that constitutes an injury to an individual or other private party Religious law: Ethical and moral codes taught by religious traditions. Investor Protection What are the country-level legal rights of shareholders? - Proxy vote by mail is allowed - Votes are not blocked before the annual general meeting - Cumulative voting or proportional representation exists - Oppressed minorities mechanisms exist - Pre-emptive rights exist - There is a minimum percentage to call an extraordinary shareholders’ meeting Many countries have strong regulations but very weak law enforcement To what extent does a government enforce its laws? Two issues to consider: 1. The Efficiency of the Judicial System 2. Is the Rule of Law and Order followed? The Financial System Bank-based Systems - Banks are central to the process of moving funds between demanders and suppliers of capital - More active monitoring - Germany and Japan are examples Market-based Systems - Securities markets are as important and can be significantly more important - External market discipline - US and UK are examples Financial Market Systems Banking Development - Bank Liquid Liabilities/GDP - Bank Assets/GDP - Domestic Bank - Deposits/GDP Market Development - Market Capitalization/GDP - Total Trading Volume/GDP Bringing it all Together - The basis of all good corporate finance decisions is a sound framework of corporate governance. - When a company does not have strong corporate governance, it may make decisions that do not maximize share value. - A firm may choose to invest in projects that maximize managers’ own wealth and not that of shareholders. - Transparency and timely information disclosure are major aspects of good governance.