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Summary Corporate Governance
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Summary Corporate Governance
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Week 1Session 1A ‘How are firms directed and controlled? ‘
Corporate governance attracts a lot of attention from
both; academics, financial press, as well as other
participant.
There are a lot of topics covered under the ‘umbrella’ of
corporate governance. The bigger the word, the more
important it is in corporate governance.
Quick overview of the most important fundamentals (key
players) of corporate governance: Umbrella of corporate governance
o Shareholders/Stakeholders: First the focus was on the shareholders, but the last decade the
attention became more and more to the stakeholders prospecting. The stakeholders
prospecting has more interest for employees, suppliers, the environment and the society.
o Board of directors: is the link between the top managers and the stakeholders. One of the
prime tasks of the board is to make sure the top managers are focused on achieving the right
objectives and goals.
o Executive officer: it is important to know what the pay is he or she will get, and where this is
based on.
o Agency problems: If the shareholders own the firm and another person (like the CEO) makes
decisions on behalf of the shareholders. It is possible that the other person focuses on
achieving personnel interest goals rater than focusing on creating value for the shareholders.
You can solve agency problems by organize the top managers pay in contract, by
including specific elements and targets. This way shareholders can make sure that the
top managers focus on achieving the firms objectives.
There are different definitions for corporate governance. There is no definition that is ‘the right
one’. It is important to realize that different conditions require a different compos of corporate
governance. Every firm is unique, so you have to take a look at the different circumstances to decide
which compos of corporate governance fits at the company.
1. “Corporate governance deals with the ways in which suppliers of finance to corporations
assure themselves of getting a return on their investment” (Shleifer & Vishny, 1997)
This definition suggest that corporate governance is the design of mechanism by
executive compensation the way board are structured, to address the material self
interested behavior and to promote shareholder value into companies. It also indicates
that interest of other providers of finance are equal important
2. “[Corporate governance deals with the] procedures and processes according to which an
organisation is directed and controlled. The corporate governance structure specifies the
distribution of rights and responsibilities among the different participants in the organisation
– such as the board, managers, shareholders and other stakeholders – and lays down the
rules and procedures for decision-making.” (OECD, 2005)
This definition is used a lot in European countries (also the Netherlands), Scandinavia and
Asia. The definition does not only involve shareholders, but also the stakeholders. The
systems of corporate governance requires the design of a combination of mechanism
and processes.
3. “[Corporate governance] is defined as the exercise of ethical and effective leadership by the
governing body towards the achievement of the following governance outcomes: (1) ethical
, culture, (2) good performance, (3) effective control, and (4) legitimacy.” (King IV Report,
2016).
This definition gives guidelines, for firms listed in South-Africa, about how to achieve
corporate governance. At this definition it is about more than just the financial
performance. Not only in profits, but also in terms of people and planet. It is about
creating long-term value rather that short-term profit.
Key player of corporate governance, and the Setting in which they operate:
Key players: (left)
- Shareholders: they basically own the firm. The key element in corporate governance is that
shareholders have dedicated decision making power to the tot management teams.
Shareholders may expect that the decisions made by the top management teams will help to
achieve the firms goals, and that the decisions create value in a short and long term.
- Top management teams: forensic chief executive officer, chief financial officer and chief
operating officer. They make decisions about what investments to do, whether or not to hire
new employees, and how much to spend on research and development.
Shareholders do not always have the time, information or expertise to check whether the decisions
the top management team has made are always achieving the firms goals. To reduce the risk of ‘self
serving behavior’ by the top managers, it is important that the firm has a proper corporate
governance mechanism (check and balances) emplaced. Check and balances: include executive pay
arrangements, stimulate managers to creating value, monitoring by the board of directors and the
provision of reliable information checked by an auditor.
Middle:
- (Other) Stakeholders: reputational agents, are also important. They provide additional check
and balances, to monitor decision made by the top management.
- Reputational agents: the main task of the auditor is to verify whether the financial
information, prepared by the top management team, is true and a fair value of the firm’s
financial situation in according with the financial reporting standards.
Setting: (right)
- Social norms: the focus on people and the planet apart from the profit.
- Standard laws: laws and rules, codes of corporate governance, and corporate law
- Financial sector: debit (banks, equity (new shares)
- Markets: competition, corporate control
,Session 1B ‘fundamentals of Agency theory’
Agency Theory is the most dominant theory used in the field of corporate governance! It exists of a
lot of theories. The theory is there to reduce agency problems.
Agency relationship: an legal agreement between 2 parties. When one party (the principals (the
shareholders)) delicate the decision making to another party (the agent). The agent
can be a person or an entity, and must be authorised by the principal before they can act on the
principals behalf.
Agency problems: Owners of a company are the shareholders (principals). Especially in larger
companies the shareholders will have managers (agents) who act on their behalf. These managers
will have to reach the company’s goals. Beside the firms goals the managers also have their own
‘Shopping list’ about what they want to reach. When the managers follow their own goals, they
don’t always make (enough) profit for the shareholders.
Managers may have preference and goals that are not the same as the shareholders, these managers
may take decisions that are not fully beneficial to the shareholders
To reduce these agency problems, the shareholders have to control the actions of the manager
through contracts in which the goals are set. These key contract is the labor contract of the agent
and must contain the following:
- How the agent should handle to make profit for the shareholders, so they cannot aim their
own goals and profits
- How to get the agents motivated
- How the agents will be compensated for their job
Beside the key contract with the agent, the firm has many other contract with suppliers, employees
and the board of directors.
‘’Decision-making authority from the principal to the agent = agency theory’’
Note: it is possible that a shareholder is also an agent. This happens when the person controls the
firm, but is not the only person with shares in the company. For example: when there are many
small outside investors who each own a small part of the firm
Situation where ownership and control are separated are likely to lead to problems. The agency
theory highlight several reasons why agency problems arise:
o Differences in goals and/or preferences, while at the same time all actors behave rationally;
people are rational actors who maximize their own utility. Agent are incline to adduct self
service behaviors to pursuit their interest at the expense of the principle.
o Agency relationships face two conditions;
Information asymmetry: when the agents actions are not directly observable to the
principle
Uncertainty: when the outcome of agents actions is affected by an event beyond the
control
Shareholders cannot observe top managers behaviors or efforts and hands cannot tide action
to specific outcomes. Beside that shareholders cannot directly access information about the
firms operations.
o ‘complete contracts’ are not possible; you cannot include every circumstance that may arise
in a contract. You never know what could happen (crisis). Beside that managers need
, freedom to make decisions quickly if this is necessary without permission of the
shareholders.
To form an opinion about the managers and de decisions these managers make, shareholders have
to use information they get from annual reports, earning announcements and of what the financial
press says. But this information is highly distilled, not complete and subject to many politician by the
managers. So for the shareholders it is difficult/impossible to judge the managers actions and to see
if all of these action are creating value to the shareholders.
There are two basic forms of agency problems:
- Adverse selection (ex ante); hidden information. Are the result of pre contractual
information asymmetry, and arise when one party owns information that the other party
doesn’t have before the conclusion of a deal; ‘lemons problem’. Lemons (bad quality) pushes
the good quality products out of the market (campervan). Buyers are unable to see the
differences between good or bad quality if they don’t have all of the information. In
corporate governance this happens when CEO’s misrepresent their ability to perform tasks in
order to increase their wealth and others expenses
- Moral hazard (ex post): hidden behavior. Are the result of post contractual opportunistic
behavior and arise because not all of the managers actions can be observed. Examples:
Decision-making: announcement of acquisitions on average do not lead to a positive
reaction on the stock market of buy influences. In this situation only the shareholders
of the targeted firm benefit, the shareholders of the buying firm won’t. So why do
managers make these investments? Because managers prefer to help of a large
company, this give them more status and probably a higher pay.
Perks: these includes various non primary benefits like; having a nice office, Leisure
consumption (playing golf at a golf course), use of corporate jets.
The corporate governance mechanisms (checks and balances) can solve the agency problems. There
are different mechanisms, but there is no one size fits all. The designing of the ‘right’ checks and
balances is like solving a puzzle. The effect of a governance mechanisms are influenced by;
- the firms conditions
- the characteristic of the environment in which the firm operates
- characteristics of other governance mechanisms that are used. Corporate governance
mechanisms do not work independently of each other.
To minimize agency problems firms should design corporate governance mechanisms which will
limited managers to aim their own personnel interest at the expense of the shareholder and
stimulate to focus goals. Corporate governance mechanisms can be classified in two different ways:
o Distinguishes between Internal and external governance mechanisms;
- External; markets, laws, regulations and external subject controlling or at least
monitoring the firms behavior, role of the media
- Internal; firms bodies or governant actors, role of the board of directors, pay of CEO
o Distinguishes between monitoring and alignment mechanisms
- Monitoring mechanisms are aimed at guiding or controlling behaviors and decisions
- Alignment mechanisms are aimed at intent to advising or stimulating the behaviors
and decisions
Examples
Internal, monitoring by ‘board’: the board of directors is the main mechanisms for monitoring top managers;
nominating and operating the CEO, refining and improving of decisions, and controlling appliance with law
and regulations
Internal, alignment of CEO; shareholders can discipline top managers by designing compensation systems
that link the CEO’s compensations to company’s performance.
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