Summary Corporate Governance (EBE 2022)
Lecture 1
Paper: Jensen & Meckling: "Theory of the Firm: managerial behaviour, agency costs and
ownership structure" (1976)
Agency relationship
=a contract under which the principal engages the agent to perform some service on their
behalf which involves delegating some decision making authority to the agent. If both
maximize utility, the agent will not always act in favour of the principal. (opportunistic behaviour)
• Principal can try to monitor the agent, but this comes at a cost
• Principal can set up pay structure for the agent dependent on effort
• Agents often act as if they work in the best interest of the principal
Agency costs
• Costs that happen because of asymmetry between principal and agent, resulting in
opportunistic behaviour. This exists of:
o monitoring costs,
o bonding expenditures by agent,
o residual loss.
Separation of ownership and control
• Suppose: a manager owns all of the company, he will act in the best interest of the firm
• If: a manager only owns half of the company, the utility maximizing choice will involve
choices that are only in his own interest (buying more luxurious than optimal goods).
• This opportunism by the manager is reflected in the share price
• Shareholders are willing to spend on monitoring effort (or good decision-making)
Contractual relations
• Companies are legal fictions that serve as a nexus of contractual relations
o That's the essence of the firm, the firm is not an individual.
• Agency costs and monitoring exist for all contracts
Conclusion, behaviour of the firm:
Contractual relations are the essence of the firm. A firm is not an individual. The ‘behaviour’
of the firm, can better be said to be market behaviour which is has a complex equilibrium of
many contracts. Markets are no individuals, so are organizations not.
Clip 1/4
Quote from Jensen & Meckling 1976
“As the owner-manager’s fraction of the equity falls, his fractional claim to the outcomes
falls and this will tend him to encourage him to appropriate larger amounts of the corporate
resources in the form of perquisites.”
Example: VOC
First share emission, first time split between management and ownership
Huge information asymmetry. The captain could take away spices.
Why is corporate governance (ownership and control split) required?
Owners cannot be managers
No time
No expertise
Rick Titulaer EBE year 2, SM2 23-05-2022
,Clip 2/4
Keys to corporate governance
• Divergent interests
Agency theory
The manager will sooner buy a sports car when the costs are shared between him and the
stakeholders. The marginal costs (for the manager) are equal to the marginal benefits to the
manager.
Agency relationship
A contract under which one or more persons are asked to perform service on their behalf,
in which the agent has decision making authority.
Agency problem
Two parties are utility maximisers, so the agent will not always act in the interest of the
principal.
Managers are myopic
Managers aim short term to reach benchmarks, which is away from long term interest.
Managers are risk averse
Taking risk might be a better company decision. However, managers don’t want to be
possibly criticised.
Agency costs
=The loss of wealth if the owner does not run the business himself
- Monitoring costs
- Bonding costs
- Residual loss
Jensen & Meckling
Organizations are legal fictions / nexus of contracts between individuals
The organization is not an individual entity
Clip 3/4
Stewardship theory
=Directors should serve shareholders
Criticism
Normative theory, what should be instead of what is reality.
Resource dependency theory
• Companies benefit from the personal link that the managers have
• Linchpin between the company and the resources it needs
• Directors are boundary-expanding nodes
• Boards are structurally needed
Transaction costs theory
• (Coase) Looks at the cost/benefit side of corporate governance
• Audit only if it reduces agency costs
Definitions of corporate governance
1.The process how companies are directed and controlled
2.How finance-suppliers assure themselves getting a return on investment
3.Relationships between parties are optimized singularly
4.How corporation handles rights and wishes of stakeholders
5.Balancing economic and social goals, and individual and communal goals
Rick Titulaer EBE year 2, SM2 23-05-2022
,Clip 4/4
Function of the board
“The corporate governance framework should ensure the strategic guidance of the
company, the effective monitoring of management by the board, and the board’s
accountability of the company and the shareholders”
For all 4 functions it is essential to get a good
CEO and communicate with the CEO.
Lecture
Unitary board
=needs to make decisions as well as supervise
All executive director Majority executive Majority non- All non-executive director
board director board executive director board
board
Two Tier boards
=There is a supervisory board, and
an executive board
2003-2008-2016 Dutch Corporate Governance Code
• Comply or explain → Adhere to rules, or give a good reason why you don't adhere
Rick Titulaer EBE year 2, SM2 23-05-2022
, Lecture 2
Paper: Adams, Hermalin & Weisbach, "The role of boards of directors in corporate
governance" (2010)
Role of BoD
• Running and controlling the organization
Boards are 'endogenous'
• The structure of the board is shaped by company-specific factors inside.
Not too small board
• Less diversification
Not too large board
• Teams problem → If a member's share falls, he or she is likely to supply less effort
What is the difference between outside and inside directors?
• outside directors → directors not in management board
o Are supposed to be independent from the company. Work elsewhere.
• inside directors → directors in management board
o Work fulltime in the company
Unknown CEO vs promoting a current employee
• An internal hire is a better known commodity
• External hires could be a greater option, and is more valuable.
• The external hire performs better if he is monitored more intensively
• outside (independent) directors are more likely to fire a bad performing CEO.
• A diligent (='betrokken') board pick up signals the best, and therefore value uncertainty less
bad than a not diligent board.
• More monitoring leads to more CEO dismissal, this happens sooner when a CEO is
unknown.
What does it mean that many corporate governance choices are jointly endogenous with
company characteristics?
• Board structure is a result of internal factors, which differ per company and environment.
This makes it difficult to use statistics to research board structure.
• The company's performance interacts with optimal board structure. If a company performs
well, this is the result of a mixture of board structure and the company itself, which
interact. Factors like the size of the company influence both the performance and the
optimal board size.
Rating a board
• Inside/outside ratio
• Ethnicities
• Genders
• Board size
• Age
Incentives for directors
• Direct compensation
• Reputation
Rick Titulaer EBE year 2, SM2 23-05-2022
Lecture 1
Paper: Jensen & Meckling: "Theory of the Firm: managerial behaviour, agency costs and
ownership structure" (1976)
Agency relationship
=a contract under which the principal engages the agent to perform some service on their
behalf which involves delegating some decision making authority to the agent. If both
maximize utility, the agent will not always act in favour of the principal. (opportunistic behaviour)
• Principal can try to monitor the agent, but this comes at a cost
• Principal can set up pay structure for the agent dependent on effort
• Agents often act as if they work in the best interest of the principal
Agency costs
• Costs that happen because of asymmetry between principal and agent, resulting in
opportunistic behaviour. This exists of:
o monitoring costs,
o bonding expenditures by agent,
o residual loss.
Separation of ownership and control
• Suppose: a manager owns all of the company, he will act in the best interest of the firm
• If: a manager only owns half of the company, the utility maximizing choice will involve
choices that are only in his own interest (buying more luxurious than optimal goods).
• This opportunism by the manager is reflected in the share price
• Shareholders are willing to spend on monitoring effort (or good decision-making)
Contractual relations
• Companies are legal fictions that serve as a nexus of contractual relations
o That's the essence of the firm, the firm is not an individual.
• Agency costs and monitoring exist for all contracts
Conclusion, behaviour of the firm:
Contractual relations are the essence of the firm. A firm is not an individual. The ‘behaviour’
of the firm, can better be said to be market behaviour which is has a complex equilibrium of
many contracts. Markets are no individuals, so are organizations not.
Clip 1/4
Quote from Jensen & Meckling 1976
“As the owner-manager’s fraction of the equity falls, his fractional claim to the outcomes
falls and this will tend him to encourage him to appropriate larger amounts of the corporate
resources in the form of perquisites.”
Example: VOC
First share emission, first time split between management and ownership
Huge information asymmetry. The captain could take away spices.
Why is corporate governance (ownership and control split) required?
Owners cannot be managers
No time
No expertise
Rick Titulaer EBE year 2, SM2 23-05-2022
,Clip 2/4
Keys to corporate governance
• Divergent interests
Agency theory
The manager will sooner buy a sports car when the costs are shared between him and the
stakeholders. The marginal costs (for the manager) are equal to the marginal benefits to the
manager.
Agency relationship
A contract under which one or more persons are asked to perform service on their behalf,
in which the agent has decision making authority.
Agency problem
Two parties are utility maximisers, so the agent will not always act in the interest of the
principal.
Managers are myopic
Managers aim short term to reach benchmarks, which is away from long term interest.
Managers are risk averse
Taking risk might be a better company decision. However, managers don’t want to be
possibly criticised.
Agency costs
=The loss of wealth if the owner does not run the business himself
- Monitoring costs
- Bonding costs
- Residual loss
Jensen & Meckling
Organizations are legal fictions / nexus of contracts between individuals
The organization is not an individual entity
Clip 3/4
Stewardship theory
=Directors should serve shareholders
Criticism
Normative theory, what should be instead of what is reality.
Resource dependency theory
• Companies benefit from the personal link that the managers have
• Linchpin between the company and the resources it needs
• Directors are boundary-expanding nodes
• Boards are structurally needed
Transaction costs theory
• (Coase) Looks at the cost/benefit side of corporate governance
• Audit only if it reduces agency costs
Definitions of corporate governance
1.The process how companies are directed and controlled
2.How finance-suppliers assure themselves getting a return on investment
3.Relationships between parties are optimized singularly
4.How corporation handles rights and wishes of stakeholders
5.Balancing economic and social goals, and individual and communal goals
Rick Titulaer EBE year 2, SM2 23-05-2022
,Clip 4/4
Function of the board
“The corporate governance framework should ensure the strategic guidance of the
company, the effective monitoring of management by the board, and the board’s
accountability of the company and the shareholders”
For all 4 functions it is essential to get a good
CEO and communicate with the CEO.
Lecture
Unitary board
=needs to make decisions as well as supervise
All executive director Majority executive Majority non- All non-executive director
board director board executive director board
board
Two Tier boards
=There is a supervisory board, and
an executive board
2003-2008-2016 Dutch Corporate Governance Code
• Comply or explain → Adhere to rules, or give a good reason why you don't adhere
Rick Titulaer EBE year 2, SM2 23-05-2022
, Lecture 2
Paper: Adams, Hermalin & Weisbach, "The role of boards of directors in corporate
governance" (2010)
Role of BoD
• Running and controlling the organization
Boards are 'endogenous'
• The structure of the board is shaped by company-specific factors inside.
Not too small board
• Less diversification
Not too large board
• Teams problem → If a member's share falls, he or she is likely to supply less effort
What is the difference between outside and inside directors?
• outside directors → directors not in management board
o Are supposed to be independent from the company. Work elsewhere.
• inside directors → directors in management board
o Work fulltime in the company
Unknown CEO vs promoting a current employee
• An internal hire is a better known commodity
• External hires could be a greater option, and is more valuable.
• The external hire performs better if he is monitored more intensively
• outside (independent) directors are more likely to fire a bad performing CEO.
• A diligent (='betrokken') board pick up signals the best, and therefore value uncertainty less
bad than a not diligent board.
• More monitoring leads to more CEO dismissal, this happens sooner when a CEO is
unknown.
What does it mean that many corporate governance choices are jointly endogenous with
company characteristics?
• Board structure is a result of internal factors, which differ per company and environment.
This makes it difficult to use statistics to research board structure.
• The company's performance interacts with optimal board structure. If a company performs
well, this is the result of a mixture of board structure and the company itself, which
interact. Factors like the size of the company influence both the performance and the
optimal board size.
Rating a board
• Inside/outside ratio
• Ethnicities
• Genders
• Board size
• Age
Incentives for directors
• Direct compensation
• Reputation
Rick Titulaer EBE year 2, SM2 23-05-2022
