100% satisfaction guarantee Immediately available after payment Both online and in PDF No strings attached
Previously searched by you
Summary of Corporate Governance - Corporate Governance; Mechanisms and Systems - Steen Thomsen & Martin Conyon - University of Twente - CHANGEL module$5.02
Add to cart
Summary of the book Corporate Governance: Mechanisms and Systems - Steen Thomsen & Martin Conyon. Originally, the summaries were written for the subject "Corporate Governance" - University of Twente - International Business Administration. The summary contains the following chapters(pages): 1(p.4-9...
Summary Corporate Governance Mechanism and Systems - Steen Thomsen
All for this textbook (2)
Written for
Universiteit Twente (UT)
International Business Administration
Corporate Governance
All documents for this subject (6)
1
review
By: axelpol • 3 year ago
Seller
Follow
Yoerivdmeer
Reviews received
Content preview
Chapter 1: What is corporate governance?
Corporate governance is defined as “The control and direction of companies by ownership, boards,
incentives, company law, and other mechanisms.”
This is however not the sole definition of corporate governance. A key distinction in the definitions is to
what extent the company is seen as accountable to shareholders or to a broader set of stakeholders.
It is important to differentiate between:
1. Corporate governance: the control and direction of managers, excluding business functions such as
marketing, HRM or financial management.
2. Corporate management: the management of those business functions
Managers need to be controlled by some other mechanism than management; a governance
mechanism. This lead to the central problem of corporate governance: the agency problem, which
occurs due to the separation between ownership and management.
The idea of the agency problem is that the agent (managers) act on behalf of the principal (the owner:
shareholders). With the key question to address in how to ensure that managers will manage the
assets/money of the owners well. Though the agency is the central problem of corporate governance, it
is a multidisciplinary subject and deals with more than just that singe problem.
The multiple agency problem: Obviously there are more actors than just the agent and principal in the
real world, there are boards, different types of owners, stakeholders, employees, banks and creditors,
suppliers, customers, the government and even more.
It is also important to know why governance is important. Generally, good management is critical to
economic efficiency, productivity, firm performance and social welfare. Good governance as such is
essential to good economic performance. Governance can be seen as a safety switch to turn of gas
before an accident happens. It is also important to find a governance structure that allows managers and
entrepreneurs to do what they do best but also hold them accountable to investors.
One source for interest in corporate governance is the question on how to make sure that pension
money/savings are put to good use, and there have been many scandals over the years in which they
haven’t been put to good use due to mismanagement or fraud.
The most general view of corporate governance is that it can be seen as concerning with how to devise
governance mechanisms that lead to wealth-creating decisions in businesses. As such, a differentiation
in corporate governance mechanisms at a firm can be a source of advantage.
,Chapter 2: Theories of corporate governance
We already learned about the agency theory, which is applied microeconomics based on the idea that
people response rationally to incentives under asymmetric information. Furthermore, agency theory
cannot explain all human behavior, therefore theories from other disciplines are necessary to be taken
into account. Theories from fields such as psychology, political science and sociology. Therefore this
chapter is not so much about theories of corporate governance, but more about theories which have
applications in corporate governance.
In abstract microeconomic theory, the firm is a black box characterized by a technology and price
maximization, it abstracts from what actually goes on in the firm. All resource allocation is handled by
the rice mechanism, where firms maximize profits by choosing what to produce while taking market
prices for given and not having to expend resources on solving information or incentive problems. Plainly
speaking, in neoclassical economics there are not transaction costs.
The standard assumptions for this model to work are that:
1. There are many firms who compete prices down.
2. There are many buyers with no buying power.
3. There is a centralized exchange.
4. There is full information.
5. There are complete markets.
6. There are no transaction costs.
Under these assumptions it’s possible to show that the price mechanism may lead to a market
equilibrium and that it is efficient in the sense that it will not be possible to find a universally better
resource allocation. It will also not be possible for individual agents to do better by changing their
production or consumption plans.
The price system implies that there is no rationale for other institutions such as governments or
companies. Such institutions must be justified by market failure, which depends on the breach of one or
more of the basic assumptions. With perfectly informed competitors there would be no need for
governance mechanisms.
If it is accepted that not just markets can fail, but also other institutions, the benchmark for comparison
becomes the opportunity costs of using a particular institution. Abstractly speaking, its transaction costs.
The core institutions of concern in corporation governance are legal forms, ownership structure, boards,
incentive systems, information systems and government regulation of those.
In the perfect market model ownership is just a parameter which determines income distribution:
Oij = consumer i’s ownership share of firm j, where ownership shares must sum to 1 for each firm and an
individual consumer can own a share of the firm anywhere between 0 and 1.
In this case it does not matter to overall resource allocation, since firms maximize profits no matter who
owns them and ownership does not influence technology.
,Chapter 3: The mechanisms of corporate governance; An introduction
3.1 INTRODUCTION
Mechanisms of governance:
Informal Governance
Social Norms
Reputation and trust
Codes
Regulation
Company Law
Ownership
Large owners
Shareholder activism
Takeovers
Boards
Incentive Systems (pay)
Stakeholder pressure
Creditors monitoring
Auditors
Analysts
Competition
Up to a point, most corporate governance mechanisms will improve company economic performance.
Beyond this this point, which is difficult to define and varies from mechanism to mechanism and from
firm to firm, the costs start to kick in. From that point increasing use of this governance mechanism will
destroy the value.
3.2 SOCIAL NORMS
At the most basic level corporate governance depends on social norms or what we call morality. To see
that morality plays a role in governance, think of the market for blood. Some people voluntarily give
blood, buy you can also buy it on the professional market or order others to give blood. When people
voluntarily give blood, there is less need for a market or for authority. This substitution between markets
and other institutions led Arrow (1962) to propose that social norms may arise to compensate for
market failure.
Morality is related to ‘stewardship’, or ‘citizenship’ or corporate social responsibility (CSR). To
the extent that managers act morally, as good stewards, there is a tendency for agency problems to
disappear. However, they do not disappear entirely. As a manger, you may feel a moral duty to ben an
equal opportunity employer or help people in need, but your shareholders may not agree. Moreover,
while some managers have high moral standards, others do not, and there are many who would be
willing to compromise on their standards if their incentives were right. This can happen if the rewards
are very high, but it may also happen if they are very low.
Although shareholders cannot usually raise their moral standards of their employees, morality
matters in corporate governance because moral standards differ between nations and may change over
time. Moreover, there may have to be more monitoring in countries where moral standards are low (or
different). Finally, it is possible to influence morality among managers by carefully selecting who is hired
(and fired) and by crafting corporate policies for what is and what is not acceptable behavior.
,3.3 TRUST AND REPUTATION
Informal governance mechanisms like trust and reputation are also important. Mangers who cheat
investors will not find it easy to obtain more money or to get a new job. This means they have an
incentive to protect their reputations. Thus, reputation may be a powerful deterrent to both adverse
selection and moral hazard problems.
Following Kreps (1990) and the ensuing literature, it can be shown formally that reputation can
under certain circumstances help companies overcome in dealing with other market participants. The
standard argument uses the prisoners’ dilemma from game theory in which two players must both
decide whether to cooperate or be opportunistic. For example, the investor may choose to invest in the
company and the manager may take the money and run (opportunism) instead of putting it to good use
in the company (cooperation). Expecting this, the investor may choose not to invest, so the company
goes bankrupt. There are many other situations like it, the worst case opportunistic equilibrium appears
inevitable.
However, the bad spell may be broken in repeated games. If one player decides to play
opportunistic, the other player will not play cooperation in the next round and she will be punished. In
contrast, if she consistently cooperates, she will get a reputation for cooperation, and other players will
be far more likely to cooperate with her. In the same way a company with a reputation for being ethical
will find it much easier to attract finance and do business. In the long run the ethical company will
therefore outcompete its less ethical rival. A good reputation becomes a valuable asset which the
company managers and owners have a self-interest in protecting and investing in. social norms,
corporate culture and business ethics may arise and be sustainable for the same reasons.
Kreps argues that a company needs to be consistent to maintain its reputation. It also needs to
be consistent over time. This may translate into a corporate culture which reinforces patterns of
behavior that may not be profitable in the short run but may sustain the company in the long run.
As Dyck and Zingales (2002) emphasize, the media can influence corporate governance through
the reputation mechanism. Bad corporate governance and bad company performance can lead to media
exposure, which is unpleasant for managers and which may induce them to change their ways.
Personal reputations also matter. Managers have an interest in maintaining a good track record
if they want to advance in their careers. Moreover, a good track record will be helpful to managers who
would like to have post-executive careers as board members when they retire.
It would no doubt be impossible to sustain effective corporate governance without trust, but
reputation is no panacea. It does not work in end-game situations where the game is not continued after
a certain point in time. If a mature company does not need more external finance, it has less of an
incentive to please investors. Moreover, trust and reputation are difficult to sustain in large societies
with impersonal exchange. Finally, reputation is not a fine-tuned instrument.
3.4 COMPANY LAW
Legal protection of shareholders rights is clearly very important. Moreover, the law obligates companies
to many practices which protect the interests of investors. The law stipulates duties for officers and
directors in the corporation. Directors have a duty of loyalty (to shareholders) and a duty of care (to
actively line up to their responsibility). Shareholders may use the court system and sue the company if
they feel that the company is being mismanaged. Knowing this keeps managers on their toes. The law
also protects the interests of other stakeholders, like creditors and employees.
Corporate governance would not be possible without some enforcement of property rights, and
it certainly helps shareholders control managers. But it is not a perfect mechanism. Sometimes managers
break the law. And shareholders may not be satisfied with a mangers just because he abides by the law.
Too many rules and large penalties would lead to a loss of flexibility and risk aversion, which would make
it difficult to do business.
, Governance rules and standards are valuable to investors and therefore also to issuers, because
they reduce their cost of capital, but they come at a cost. There are direct costs, which include listing
fees, fees for auditors and lawyers, liability and insurance costs etc. Indirect costs would include costs of
disclosure to competitors, loss of flexibility with regard to board structure, opportunity cost of
management time, box checking and bureaucratic procedures. Most of these costs will be fixed, while
the variable cost of trading shares will be negligible.
It is difficult to determine the optimal level of regulation with any degree of precision because
regulation is so multifaceted. Theoretically, it can be argued that the optimal level of investor protection
for listed companies is greater than zero since stock exchanges use regulation to lower the costs of
exchange. It is equally plausible that there are limits to the optimal complexity of regulation and that
more regulation will at some point have a negative effect.
3.5 LARGE OWNERS
The vast majority of all companies are owned by one or two shareholders who also manage the
company. It is not difficult to understand why. Owner-management aligns the interests of owners and
managers. It is their own money so they have every incentive to manage it well. In other words, it is a
solution to the moral hazard problem. Owner-management also addresses the adverse selection
problem.
The most effective solution to shareholder problems is a shareholder agreement, which
regulates governance and exit, and is signed when the company is founded, before the trouble starts.
But it is well known that most partnerships do not have such clauses, because they are considered to be
irrelevant at the beginning of the partnership which has to be founded on trust in any case. As a result, a
lot of value is being destroyed across the world when unlisted companies break up. An effective solution
would be to build in a generic shareholder agreement as default clauses in the standard corporate form
which shareholders could then deviate from if they wanted.
Even for listed companies, a blockholder can be a solution to a corporate governance problem
because she has both the incentives and the power to influence what happens in the company. Large
owners may therefore act as watchdogs on behalf of minority investors who can free ride on their
efforts.
Large owners are not a perfect solution. First, as a rule they will be more risk averse than other
investors because they have invested so much in this particular firm, and this will influence corporate
strategy. Secondly, there is a risk that they may exploit the minority investors, particularly in countries
with low investor protection. Large owners may also have idiosyncratic preferences which do not
maximize shareholder value.
The effects of large ownership on corporate governance and performance depends critically on
owner identity. A financial investor with a clear preference for shareholder value might be expected to
exercise ownership in a way that is aligned with the interests of minority investors. In contrast, a
government owner will usually have objectives which differ very much from shareholder value
maximization.
3.6 SHAREHOLDER ACTIVISM
In the absence of a large owner, shareholders are much weaker, but it is not true that they have no
power at all. They can turn up at annual meetings, they can criticize the management, and they can vote
against it. Even if they lose a vote, the pressure can be unpleasant for the managers and it may damage
their reputation. So mangers have incentives to keep them happy.
Moreover, small shareholders may sell their shares. This will tend to lower share prices and
increase the costs of capital for the corporation. Corporate bondholders may sell out, too. Shareholder
pressure is obviously not less imperfect than all the other mechanisms.
The benefits of buying summaries with Stuvia:
Guaranteed quality through customer reviews
Stuvia customers have reviewed more than 700,000 summaries. This how you know that you are buying the best documents.
Quick and easy check-out
You can quickly pay through EFT, credit card or Stuvia-credit for the summaries. There is no membership needed.
Focus on what matters
Your fellow students write the study notes themselves, which is why the documents are always reliable and up-to-date. This ensures you quickly get to the core!
Frequently asked questions
What do I get when I buy this document?
You get a PDF, available immediately after your purchase. The purchased document is accessible anytime, anywhere and indefinitely through your profile.
Satisfaction guarantee: how does it work?
Our satisfaction guarantee ensures that you always find a study document that suits you well. You fill out a form, and our customer service team takes care of the rest.
Who am I buying this summary from?
Stuvia is a marketplace, so you are not buying this document from us, but from seller Yoerivdmeer. Stuvia facilitates payment to the seller.
Will I be stuck with a subscription?
No, you only buy this summary for $5.02. You're not tied to anything after your purchase.
