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International Corporate Governance 1st Edition by Marc Goergen | All Chapters 1-15_ SOLUTIONS & INSTRUCTORS MANUAL
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Financial Management (Book notes + articles), Chapter 1
Defining corporate governance and key theoretical models
1. Introduction
-The focus of this book is on stock-exchange listed firms. These firms are typically in the
form of stock corporations, i.e., they have equity stocks or shares outstanding which trade
on a recognized stock exchange. Stocks or shares are certificates of ownership, and they
also frequently have control rights, i.e. voting rights which enable their holders, the
shareholders, to vote at the annual general shareholders’ meeting (AGM). One of the
important rights that voting shares confer to their holders is the right to appoint the
members of the board of directors. The board of directors is the ultimate governing body
within the corporation. Its role, and in particular the role of the non-executive directors on
the board, is to look after the interests of all the shareholders as well as sometimes those
of other stakeholders such as the corporation’s employees or banks. More precisely, the
non-executives’ role is to monitor the firm’s top management, including the executive
directors which are the other type of directors sitting on the firm’s board.
2.Defining corporate governance
-Shleifer and Vishny’s definition clearly assume that the main objective of the corporation is
to maximize the returns to the shareholders (as well as the debtholders). They justify their
focus by the argument that the investments in the firm by the providers of finance are
typically sunk funds, i.e. funds that the latter are likely to lose if the corporation runs into
trouble. On the contrary, the corporation’s other stakeholders, such as its employees,
suppliers and customers, can easily walk away from the corporation without losing their
investments.
-Providers of finance are said to be residual claimants
-Typically, when the firm is in financial distress, the firm’s assets are insufficient to meet all
the claims it is facing, and the shareholders will lose their initial investment. In contrast, the
other claimants will walk away with all or at least some of their capital.
-There is another view which states that stakeholders are also part of the company,
everything which happens on the company reflects them
-The UK and the USA more equity-based system. Shareholder maximization
-Continental Europe – stakeholder views
-In other words, while directors are expected to take into account the interests of other
stakeholders, they should only do so if this is in the long-term interest of the company, and
ultimately its shareholders, i.e. its owners. Hence, the principle of shareholder primacy is
still pretty much intact in the UK and also the USA. At the same time, Continental Europe
has moved closer to the shareholder-oriented system of corporate governance.
,-A more neutral and less politically charged definition of corporate governance is
that the latter deals with conflicts of interests between:
-the providers of finance and the managers;
- the shareholders and the stakeholders;
-different types of shareholders (mainly the large shareholder and the minority
shareholders);
- the prevention or mitigation of these conflicts of interests.
3. Corporate governance theory
-Principal – agent problems
-While the agent has been asked by the principal to carry out a specific duty, the agent may
not act in the best interest of the principal once the contract between the two parties has
been signed and may prefer to pursue his own interests. This type of danger is what
economists normally refer to as moral hazard. Moral hazard consists of the fact that once a
contract has been signed it may be in the interests of the agent to behave badly or at least
less responsibly, i.e., in ways that may harm the principal while clearly serving the interests
of the agent.
-Ways to mitigate – complete contracts
-A necessary condition for moral hazard to exist and for complete contracts to be an
impossibility is the existence of asymmetric information. Asymmetric information refers to
situations where one party, typically the one that agrees to carry out a certain duty or
agrees to behave in a certain way, i.e., the agent, has more information than the other
party, the principal.
-At first a firm starts off as a small business which is fully owned by its founder, typically an
entrepreneur. At this stage, there are no conflicts of interests within the firm as the
entrepreneur both owns and runs the firms. Hence, if the entrepreneur decides to work
harder, all of the additional revenue generated by this increased effort will go into his own
pockets. This implies that the entrepreneur has the perfect incentives to work hard: all of
the additional revenue generated by working harder will always accrue to him. As the firm
grows, it becomes more and more difficult for the entrepreneur to provide all the capital
needed. At one point the entrepreneur will need to take the firm to the stock market so that
the latter can tap into external capital. Once the firm has raised external capital, the
entrepreneur’s incentives have significantly altered. As the entrepreneur no longer owns all
of the firm’s capital, he may now be less inclined to work hard. In other words, if the
, entrepreneur works harder some of the fruits from his efforts will go to the firm’s new
shareholders. As the firm becomes larger and larger, the separation of ownership and
control is likely to become more pronounced.
-Agency costs are then the sum of the following three components. The first component
consists of the monitoring expenses incurred by the principal. Monitoring not only consists
of the principal observing the agent and keeping a record of the latter’s behavior, but it also
consists of intervening in various ways to constrain the agent’s behavior and to avoid
unwanted actions. The second component is the bonding costs incurred by the agent.
Bonding costs are costs incurred by the agent in order to signal credibly to the principal that
she will act in the interests of the latter. One credible way for the agent to bond herself to
the principal is to invest in the latter’s firm. Finally, the third component is the residual loss.
The residual loss is the loss incurred by the principal due to fact that the agent may not
make decisions that maximize the value of the firm for the former.
4. Agency problems
-Two main types of agency problems: perquisites and empire building
-Perquisites or perks – also called fringe benefits – consist of on-the-job consumption by the
firm’s managers. While the benefits from the perks accrue to the managers, their costs are
borne by the shareholders. Perks can come in lots of different forms. They may consist of
excessively expensive managerial offices, corporate jets, and CEO mansions, all financed by
shareholder funds. Also includes giving jobs to family members. Over the long run, firms
that allow their CEO to use their jets for personal use underperform by 4% which is
significantly more than the cost of the corporate resources the CEO consumes.
-Empire building is also called the free cash flow problem following Michael Jensen’s
influential 1986 paper. Empire building consists of the management pursuing growth rather
than shareholder-value maximisation. While there is a link between the two, growth does
not necessarily generate shareholder value and vice versa. If managers are to act in the
interests of the shareholders, they should only invest in so-called positive net present value
(NPV) projects, i.e. projects whose future expected cash flows exceed their initial
investment outlay. Any cash flow that remains after investing in all available positive-NPV
projects is the so-called free cash flow. Projects with negative NPVs are projects whose
future expected cash flows are lower than the initial investment outlay and hence destroy
rather than create shareholder value. Empire building may come in various forms, but
frequently consists of the management going on a shopping spree and buying up other
firms, sometimes even firms that operate in business sectors that are completely unrelated
to the business sector the management’s firm operates in. Again, empire building can be
seen as the refusal of the company’s management to pay out the free cash flow when there
are no positive NPV projects available.
-Managerial entrenchment, whereby managers shield themselves from hostile takeovers
and internal disciplinary actions, may also be a consequence of the principal–agent problem.
However, managerial entrenchment may also exist in the presence of concentrated family
control whereby top management posts within the family are passed on to the next
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