Corporate Governance, Risk & Internal Control (EPG_A_CG)
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Summary Corporate Governance
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Course
Corporate Governance, Risk & Internal Control (EPG_A_CG)
Institution
Vrije Universiteit Amsterdam (VU)
Book
Corporate Governance
This document contains a summary of all the material covered during the lectures. This exam is an open-book exam that uses 2 books:
- Corporate governance. Principles and Issues, by D Nordberg.
- Corporate Governance, 5th edition. Streng, Sadal, by Kints and Kater
It also contains a summary o...
Corporate Governance, Risk & Internal Control (EPG_A_CG)
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Lecture 1 - Introduction (part 1)
Leerdoelen van het vak
Dit vak heeft als doel bij te dragen aan het begrip van studenten van de volgende zaken:
- Het belang, begrip en relaties tussen Corporate Governance, Internal Control en Risk Management.
- Rollen en verantwoordelijkheden van de verschillende stakeholders bij private en publieke organisaties.
- Inhoud van belangrijke CG codes en belangrijke verschillen en overeenkomsten tussen deze codes.
- Beperkingen van de Corporate Governance codes in relatie tot het borgen van adequaat management.
- De manier waarop Risk Management kan worden geïmplementeerd in het Internal control systeem.
- Het belang van betrouwbare informatiesystemen in het Internal control systeem.
Agenda
Main subject: info that is available to all
stakeholders within an organization.
Example Toshiba
Toshiba inflates their profit figures
Vragen voor dit vak:
- Wat is management? Wat doet het management?
- Waarom doet het management zaken zoals ze het doen?
- Wie managet de manager?
- En waarom verlopen zaken niet zoals beoogd?
Manage & Supervise: seperation of ownership and control (Article 1 - Fama & Jensen 1983)
Separation effective and ‘agency costs’ are limited
➢ Shareholders focus on: resource utilization and structuring of contracts. They will also be able to monitor
the performance of decision agents and implementation of rewards.
➢ The management of the company should focus on ratification; the choice of the decision initiatives. They
should be responsible for the implementation; the execution of ratified decisions.
,If you are managing a company, you have to go through a couple of stages as a manager:
1. Initiation: generation of proposals for resource utilization and structuring contracts.
➢ How to use the resources that are available?
2. Ratification: choice of the decision initiatives to be implemented.
3. Implementation: execution of ratified decisions.
4. Monitoring: measurement of the performance of decision agent and implementation of rewards.
➢ Accounting and control comes in here (how well are things going?)
“It is usually in the interest of everybody that the firm continues to exist as an entity.”
Responsible Corporate Governance is aimed at securing the continuity of the firm -> Why?
- Shareholders get their share of the profit
- Customers get products or services
- Suppliers have their customers
- Employees keep their job
- Management receives their bonuses
- Society receives taxes
Lots of people get something out of an organization, that’s why it’s important that it performs well.
• Objective of Corporate Governance: realising long term shareholder value whilst taking into account
interests of other stakeholders (balance between stakeholders).
• In other words: finding the position in the feasibility space that is acceptable to all stakeholders…
The feasibility space
- X1 represents a set of activities acceptable both to
shareholders and employees, but not to customers or the
government (high prices)
- X2 represents a set acceptable to all but shareholders (high
wage, low price)
- Only Xf is feasible for satisfying all stakeholders.
4 types of stakeholders that all want something out of the organization. The feasibility space is the only part
where all stakeholders are satisfied. CG focuses on finding the feasibility space.
The size of the feasibility space
- The feasible region is shown as being relatively small. This is almost by definition the case: if the feasible
region increases, the groups will adjust their demands in such a way that is relatively small again. Every
party tries to pull it to their best interests.
- For example, if the company’s profits are very high, and the shareholders require a fixed amount of
dividend, the feasible region increases. But as a reaction, share-holders may want a higher dividend pay-
out, or the customers want lower product prices as probably the competition will increase in this
profitable market. Then the feasible region shrinks again.
Why Corporate Governance (Article 2 - Ueng)?
Finding the feasibility space (long-term) is the aim of Corporate Governance. Also according to Ueng
companies with good CG policies are more likely to have better financial performance.
➢ In his study that included 3.068 firms found that: ‘when firms have a better rating on the board structure,
compensation policy, takeover defense strategy, accounting practice, and a formal governance policy,
firms are more likely to perform better than their counterparts without such quality governance policies.‘
➢ Stakeholders and shareholders want to know if the company does their best of meet their interests. There
are 2 critical backbones that should support good Corporate Governance.
,Backbone of good CG (Transparency)
Transparency is the backbone of good corporate governance and requires a sophisticated system of
accounting. Such system should:
• Allow investors to assess the magnitude and timing of future cash flows to be generated by a business
• Encourage efficient operations and maximization of results
• Provide an early warning of problems in meeting objectives of the firm
• Lead to quick corrective action whenever things go bad
Backbone of good CG (Integrity)
- Integrity forms the backbone of good corporate governance and requires “doing the right things”
- A “check in the box” approach to good corporate governance will not inspire a true sense of
ethical obligation. It could merely lead to an array of inhibiting “politically correct ”dictates.”
Gatekeepers and watchdogs (Nordberg)
Houden organisaties in de gaten (controle) en letten op transparantie en integriteit.
➢ Supervisors - oversight bodies - auditors - analysts/ investment bankers - credit
rating agencies - remuneration advisors - lawyers - press
Most importantly, every member of the chain must commit to collaborating with all
others. This chain is only as strong as its weakest link.
Corporate Governance
▪ Not so long ago (1997):
➢ “Corporate governance deals with the way in which suppliers of finance to corporations assure
themselves of getting a return on their investment”
➢ Note that this definition does not mention the “continuity of the firm”. It does mention “return on
investment” for the “suppliers of finance”. Apart from these investors, it does not refer to any other
stakeholder in the corporation.
▪ Now -> Find the feasible region determined by stakeholders (not only for shareholders as in the past).
The challenges of CG:
• Long term versus short term
value creation
• Stakeholder value versus
shareholders value (see next)
Overview of all kind of stakeholders
that all play a role within an
organization.
(1) Customers (to buy or not to buy)
- No firm can exist without its Customers.
- Their formal influence may be limited, their informal influence (especially when exercising their option not
to buy from the firm) is big.
- In the literature on CG, this group is less visible than several of the other groups of stakeholders.
,(2) Shareholders
- Shareholders of listed corporations have taken the chance to participate in the profits of the firm without
taking responsibility for the operations.
- They have limited liability and therefore limited involvement in the company’s affairs.
- That involvement includes the right to elect directors and the fiduciary obligation of directors and
management to protect their interests.
- The group of shareholders ranges from private persons that have only have a few shares in a corporation,
to institutions such as pension funds that own a significant portion of the shares. Apart from the
difference in size, the goal of each shareholder for owning the shares can be very diverse.
- Ownership is typically dispersed in the UK and US. The OECD study shows a shift in dispersed ownership in
the US and UK: the largest 20 institutional owners hold more than 30% of the capital in listed companies.
Most corporations are controlled by large shareholders in continental Europe, Asia, and Latin America.
The separation of ownership and control (shareholders value)
- The shareholder has the exclusive control of the stock itself;
- But as a condition for the shareholder’s limited liability, the shareholder gives up the right to control use
of the corporate’s property by others. That right is delegated to the management of the corporation;
- It is one of the benefits of the corporate organization to the investor: he can entrust his money to people
who have expertise and time he does not;
- Shareholders have voting, information and approval rights.
- The Theory is that Corporations are managed by officers, under a system of checks and balances provided
by the board of directors and the shareholders.
(3) Employees
- Often referred to by senior management as “the most important asset of our company”.
- They are compensated for the time and skills they devote to the firm. They have various faces: they can be
organized in a union, they can have a significant amount of shares, and in several countries they are
represented in the Board of Directors as well.
(4) Society, Suppliers, Creditors
- The group that we refer to as the Society is composed of a large amount of sub-groups that include the
Government, which sets formal rules and regulations, and organizations such as the local variant of the
SEC who can be very specific on the requirements with respect to disclosure for listed companies.
- Suppliers and other Creditors have an interest in 1. that their current invoices are being paid and 2. that
they can deliver to and invest in the firm in the future as well. Creditors play an important role in a
number of governance systems and can serve as external monitors over corporate performance.
(5) Directors
- The Directors of the firm face the challenging task of balancing the wishes of all stakeholders.
- They officially act on behalf of the shareholders. But they won’t just do what the shareholders want:
➢ First of all, keeping stock is a different profession than managing a business.
➢ Second, it is not always easy to determine what the “best interest” for shareholders is. If the
executive directors do not listen well enough to the firm’s employees (or simply pay them low wages
so they can pay out more dividends), an unmotivated work force (or even a work force on strike) may
endanger the shareholders’ value. If the Directors raise the prices of the products, and therefore the
profit on each product, this may at first be seen as beneficial to the shareholders. However,
customers won’t like that and if they stop buying the product for that reason, the shareholder is hit.
- The task of the Directors may be viewed as maintaining the activities of the organization within the
feasible region determined by the intersecting acceptable sets of the stakeholders.
- In principle, there exist 2 kinds of Directors: (1) non-executive Directors (2) executive Directors. The former
supervise the latter, and in many countries they form a separate group called the Supervisory Board.
- In many countries, the Executive and the Supervisory Board form together really one Board, the so-call
one-tier system. In other countries these two boards are separated, which is called the two-tier system.
,5.1 Non-executive directors
- In essence the Supervisory Board has to ensure that two conditions are fulfilled.
➢ First, they should be certain that the Executive Directors are really acting in the interest of the
shareholders. It is not easy to accomplish because “in the interest of” cannot be straightforwardly
translated into actions.
➢ Second, they should be certain that the Executive Directors are capable in running the company.
Above all, they do so by the mechanism of hiring & firing, decisions that usually have to be endorsed
by the shareholders. Finding a new CEO is for many supervisory boards a long and tedious process,
but in many respects it is the most important task they have.
- In addition, supervisors should also regularly ask how things are going.
5.2 Executive directors
- According to the Dutch CG Code, the Executive and the Supervisory Board have to serve the interests of
the company and its stakeholders and are accountable for this to the general meeting of shareholders.
The shareholders are, in principle, free to put their own interests first.
- The governance paradigm (Vaassen) provides a clear way to show how the Executive Board operates.
The Governance Paradigm brings together control systems and information systems
How does management control the controlled system? By
using an information system.
Information system helps managers to come up with the
right decisions and help them implement the right control
actions.
The 4 important characteristics of the Governance Paradigm
1. Information and, more specifically, the information system is key to governing a system.
2. There is a continuous interaction between the environment and the system.
3. The subjective choice of the system boundaries determines what info is considered external/internal.
4. There is a control system (manager) that attempts to control the behaviour of a controlled system (a
subordinate) on the basis of often imperfect information.
There are two generic modes of reaction:
• Feedforward mechanisms
• Feedback mechanisms
Note that for External Governance, the Control System itself
is the Controlled System ->
Key role of information systems
▪ Info is key in the functioning of a CG system. We identify 2 types of information systems:
➢ External data
➢ Data within the company:
➢ Feedforward loop
➢ Feedback loop: If the control actions are started based on the info that is gathered after an action
of the controlled system, this is called a feedback loop.
▪ The terms ‘Planning & Control’ can be seen as almost synonymous to ‘feedforward & feedback”.
, Governance and Control are two strongly related concepts
▪ To put it simply: By means of governing a business, the executive directors attempt to control it.
▪ From a rather traditional and narrow perspective:
➢ Governance and control entails giving task assignments and holding workers accountable for
fulfilment of their task.
➢ The processes that take place are delegation and accountability. If power and responsibilities are
delegated, the need for control arises.
▪ In the broader sense: Control encompasses all those activities aimed at having organization members
cooperate to reach the organizational goals.
CG consists of External Governance and Internal Governance
The Shareholders nominate their agents (the Executive Board)
to manage the organization. In return, these agents have to
justify their actions and decisions on a regular basis.
The principal-agent problem
- Separation of ownership and the management of
the company leads to issues.
- Due to a lack of direct control by the owners,
other mechanisms of control are required.
Codes of Conducts have been developed to improve governance
▪ Scandals have led to laws:
➢ Executives can be held personally accountable for their actions + can be punished if they break a law.
➢ By law organizations are obliged to comply with the codes of conduct;
➢ Strong requirements on Internal Control.
▪ Tendency is a demand for more rigorous supervision and regulations (focus on influencing behaviour)
▪ Stakeholders require transparency with respect to:
➢ The quality and the integrity of the executives;
➢ The general approach to risk management: CG is the organization's strategic response to Risk.
Law as governance
Corporate Governance Codes & Laws
- Factbook OECD: 47 jurisdictions investigated
- Law: India, US (and China)
- Rest: 83% countries have ‘apply or explain’ / 11% mixed system
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