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CORPORATE GOVERNANCE
Corporate governance is:
• Multifaceted, e.g., it can be analyzed from different disciplinary or country perspectives.
• Ever-evolving issue as periodical waves of scandals and frauds promote the evolution of best practices.
• Identified with controls and check-and-balances, but must also promote entrepreneurship and value
creation.
Historical period What happened?
Mid of 19 century - Birth of limited responsibility company
Beginning of 20 century - Listing of companies in New York and London
First decades of the 20th century - USA: Separation between ownership and control in public companies,
debate on company’s purpose
1960 - Development of managerial theories
- Market for corporate control as key governance mechanism
1970 - USA: empirical research on board of directors, bankruptcy of some
large companies, intervention of the NYSE and the SEC
- Europe: commercial law harmonization (V directive)
- World: corporate social responsibility
1980 - World: corporate scandals associated with illegal practices
- USA: loss of competitiveness of the system, LBO and hostile takeovers,
increasing wealth of CEO’s, corporate restructuring
1990 - East Europe: transitions from planned to market economies
- World: privatization and liberalizations of many industries, increasing
role of institutional investors, codes of many best practices, financial
markets integration, takeover cross-borders.
Beginning of 21st century - World: rise and fall of the new economy, corporate scandals, financial
crisis…
Mid of 19th century
• Birth of the “limited responsibility company”
o The first big issue, which started the debate in “corporate governance”, was the possibility to create
limited responsibilities companies. At the beginning of the 19th century, all shareholders were
“unlimited. The situation changes in the mid-19th century, when the legal system allows entrepreneurs
to create legal entities with their own personalities, i.e., companies:
- with legal rights and responsibilities that were previously attributed only to individuals, and that
are distinct and independent from those of shareholders who temporarily own their shares;
- allowing shareholders limited liability for company’s debts, and so making much easier to acquire
the financial resources needed to fuel the growth of their firms.
If you have a “limited responsibility company”, if the company goes bankruptcy, a shareholder
loses only the value of its investment.
Why is this so important?
, There is also an impact in terms of corporate governance of corporations.
- People will be more likely to invest money in companies.
- In fact, if there was a “unlimited responsibility” you would invest only in their own company,
where they can have the management, otherwise it would be too risky in case of a big loss.
- This basically means, that having “limited responsibility companies” gives the possibility to have
large companies (otherwise we would have only had small shops).
- This was considered to be really an important innovation (to some also more than the wheel).
- However, the big effect of this innovation was visible only at the beginning of 20 century when
some companies “go public”.
Beginning of 20 century
• Birth of the modern public company
- At the beginning of the 20th century, some US and UK companies go public and list their shares on
the capital market. This is the birth of the modern public company, characterized by the separation
between shareholders, who confer the share capital, and managers, who run the company.
- In 1932, there was a book written by two scholars, Berle and Means entitled “Modern corporations’
private property”, in which they show that the ownership structure of the largest US companies is
highly fragmented at the end of the 1920s: the first shareholder in each of this company owned 1% or
less. It means that shareholders are not anymore in control of their corporations.
What does this mean? If controlling shareholders own only about the 1% of a company, there is a
phenomena called “separation between ownership and control”.
NB:
This is really American, in Italy, still today, the major shareholders own
around 40% of the total.
• The debate on HBR between two prominent US scholars on the “purpose of the firm”.
- Adolph Berle argues that companies should produce profits for their shareholders.
- Merrick Dodd argues that companies are economic institutions with both social and economic
purposes.
- In 1953, a New Jersey Supreme Court decision (i.e., the A.P. Smith Manufacturing Company v.
Barlow case) established that companies can make philanthropic donations.
NB:
Despite this case, the shareholder primacy became the dominant view in the
following decades.
60’s
• Development of the managerial theory of the firm
- The separation between ownership and control favors the development of the managerial theory of the
firm, arguing that large listed companies are run by top managers who want to satisfy their interests
(e.g., higher compensation, power, status).
- The managerial discretion to pursue their own goals is not unlimited, as managers must ensure a
certain level of profit and an acceptable dividend policy, to finance the future growth and to preserve
company’s financial solidity.
- The market for corporate control – i.e., the market allocating the control of a company to the people or
companies who attribute the greatest value to it – can discipline top managers and limit their
opportunism.
, 70’s
• USA: empirical researches on boards, failure of some important companies, active regulation by NYSE
and SEC
- In the US and UK, both empirical studies and the failure of large companies prompt regulators to call
for greater directors’ independence and to encourage boards to introduce audit committees.
- In the USA the Board of Directors were more and more under the control of the top
management.
- Under ideal situation there is the Top Manager (CEO) that receives power to take decisions,
is a “decision maker” and clearly, he knows everything about the company.
- The Board Members, however, cannot easily control the CEO.
- It is difficult to control the CEO do to the fact that there is a gap of information, which cannot
be so much narrowed, between him and the Board Members.
- Most of the people that are in the Board do another job, while the CEO is committed every
day with the company and the business.
- In the 70’s this gap of information was even worse: The Directors thought not to be
responsible, so that if, for example, there was a fraud in the company, it was the top
management fault.
✓ Things change when the Court, in the USA, for the first time said that: “if there is a fraud, and you
are a board member, you are responsible” and Board Members had to show they did everything
to prevent this fraud.
✓ If you are a Board Member you are responsible for any issue concerning the company, and you
have to show the court you did something to prevent the issue. There are legal responsibilities
for directors.
✓ Specifically, were introduced more:
a. “non-executive directors”: these are non-executive directors of the company)
b. “Audit Committee”: this is a group of directors that meets separately and are responsible for
the whole control of the company (control of risk, control of compliance, control of norms).
Is a kind of way to reinforce control on top management.
Europe: commercial law harmonization (V Directive)
- In Europe, in the 70’s we discussed about the V Directive, that has never been approved.
According to this directive, companies needed to change their model of corporate governance for
the Board of Directors. The traditional model was the “One Tier Model”:
1. “Shareholders” nominate the “Board of Directors” and the “Statutory Auditor”.
2. “Statutory Auditor”: should keep an eye and vigilate the BOD about compliance with law,
regulation, and accounting principles (if there are no external auditors).
3. “Board of Directors” is responsible for taking decisions and controlling.
This directive instead proposed a “Two Tier Model” or “German model”:
1. “Shareholders” and “Employees”: nominate the “Supervisory Board”
2. “Supervisory board”: they nominate the “Management board”.
3. “Management board”: is responsible for taking decisions and controlling.
- In this model, the Board of Directors is divided in two parts.
- The main problem was the “codetermination”: this principle establishes that the “Supervisory
Board” members are elected by both the shareholders and also employees could have a voice in
the governance.
- This is a big issue: employees are very important for the company in terms of profitability, lead
the company every day…
- In this sense, however, employees have to be close to the long-term goals of the company.
, - At the end the directive never passed, because in Europe several countries were against the
employee representation in the board. The only countries who uses this model are: Germany,
Austria, Scandinavian countries.
World: Corporate Social Responsibility (CSR)
- In the main industrialized countries, there is a call to broaden Corporate Social Responsibilities (CSR) to
include - beyond shareholders, employees, suppliers, customers, and financial institutions – also the State
and the community at large.
- There are two different views about corporate governance:
1. “Company should maximize profit, create value for shareholders”:
- One of the main supporter of this theory was Milton Friedman, who published an article in
1971 on the New York Times.
- If everything is so well protected by markets, the objective of a manager becomes to
maximize profit and shareholders value. In this sense, no company has a moral
responsibility, or corporate social responsibility. (ex: don’t care about unemployment, of the
pollution…).
2. “Companies should also consider other interests over the shareholders one”
- This dominant view has been challenged in 1930s;
- Some main supporters are Berle and Dodd: companies should consider other interests over
the shareholders one, for example companies can do philanthropy (give money to N.G.O. or
associations, to protect the environment, to sustain unemployment…)
- This debate then exploded again in the 70’s in the USA, because people started thinking
companies were too powerful, too rich, and they had also to consider the externalities
(positive or negative) they create for the people around them.
- In the 70’s there was a revolt of the population: against society, the consumism, the power of
the companies.
- Now this debate is coming back also in these years.
- What is relevant is that if before this second position was sustained by normal stakeholders,
today this issue is coming back by CEOs and Mutual Funds.
80s
In the early 1980s, the Reagan and the Thatcher administrations pursue a liberal economic policy that reaffirms
the shareholders’ supremacy, and promotes the liberalization of previously regulated sectors.
• World: Corporate scandals
- At the end of the 1980s, in industrialized countries, the debate on CG is fueled by some financial
scandals affecting large corporations. Corporate scandals are linked to corporate governance:
every time there is a scandal, people want more protection of their needs, of their investments,
higher money for top management and directors.
- Unfortunately, is impossible to avoid corporate scandals in the future this is because companies
are made of people (if people are greed, they are smart, pay people…).
- In the Anglo-American countries, and in particular in the US, the debate is stimulated by several
phenomena like:
o Loss of competiveness of the US economic system compared to the German Japanese
system:
In the 80’s there was a new feed of corporate governance called “comparative corporate
governance”. Americans at that time understood that their economic model, their corporate
governance model could have some issues and it was showed that the German or the
Japanese model could be a better model because of some variables (es: the employee
protections and so on).
o The high number of mergers and acquisitions (M&A)
