Corporate Governance
Summary of the Lectures
University of Amsterdam
MSc Finance
2022
,Week 1
1. What is corporate governance?
TRUST
…that your bank will return your money in your account.
…that your financial adviser will give you fair advice.
● What happens when you cannot trust the financial and legal system? The risk is higher; and
fewer transactions are still worth it.
Yet, a constant stream of financial scandals
First Core Issue: The Principal-Agent Problem
● A decision needs to be delegated from a principal to an agent.
● Decision impacts utility of both principal and agent.
● Agent’s interests may differ from those of the principal.
● Situation with incomplete monitoring and/or asymmetric information.
Example with managers: Principal (investor/shareholder/owner) delegates daily operations to a
manager. Private benefits for managers hurt payouts to owners. Incomplete monitoring of daily
activities and asymmetric information.
● How to ensure that agent takes action that is in best interest of principal?
● Key problem: separation of ownership and control with asymmetric information and
incomplete monitoring
● Solution: creating the right incentives (“sticks and carrots”) plus a web of internal and
external checks and balances
Second Core Issue: Ethics meets governance and finance
Boatright (2014) makes a strong case that governance and ethics cannot be separated from one
another.
● Things that are considered “good governance” (e.g., strong executive incentive pay) may lead
to pushing the envelope too far into legally unchartered territory and result in actions that are
ex-post ruled illegal.
Legal gray areas frequent, particularly in finance
● In a market transaction, when does withholding some negative information about the asset
become a willful misrepresentation and thus deception/fraud?
● Frequently, market players in finance with dual roles:
○ Insider trades by managers based on material inside information illegal . But when a
short seller does the same, not illegal. Difference is fiduciary duty.
○ If you buy a stock on the exchange, the market maker may fill your order. The market
maker is not only a facilitator of your transactions, but may also be the counterparty
that sells to you while having inside information (sees the full trading book!).
Shareholder vs. Stakeholder perspective
● Shareholder perspective: an organization’s primary obligation is to maximize shareholder
value. Shareholders have both cash flow rights and control rights.
● Stakeholder perspective: an organization has moral obligations towards all stakeholders (not
just shareholders but also employees, municipalities, society, …). Stakeholders ought to
receive control rights.
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,Stakeholder or Shareholder approach?
Many economists argue that there are some problems with the stakeholder approach:
● Control rights for stakeholders may discourage financing and make financing more expensive.
● No agreement what those social obligations might be (so, how much). (Competition may have
firms enter a “race to the bottom”.)
● Success of managers becomes immeasurable.
● Managers currently with fiduciary duty to shareholders. Would need to change to fiduciary
duty to stakeholders – but they have competing interests; how to codify?
Instead
● Put all social obligations into laws (rather than let managers decide).
● Since shareholders are “residual claimants” (i.e., they only receive any profits after all legal
claims are paid), maximizing shareholder value also takes care of all legal claims.
Proponents of the stakeholder approach argue:
● Sole focus of profit maximization can lead to exploitation of workers and negative
externalities (e.g. pollution). Laws alone unlikely be the solution in places where laws are de
facto not enforced.
● Many contracts incomplete or implicit
Suggested solutions:
● control rights to stakeholders
● more laws and better enforcement
● social responsible investing (SRI):
Keynote address by Diane Denis (required reading):
1. Shareholder wealth maximization and stakeholder approach are not necessarily in conflict
with one another.
a. Companies compete not just for financial capital, but are also for human capital and
for customers and -> even in pure rationale shareholder perspective, it can pay to take
care of one’s employees, customers, suppliers (greater motivation, productivity,
customer loyalty, investments in joint supply-chain relationships, …)
2. In some areas, there is however the need for the government to limit the application of
shareholder wealth maximization.
a. Externalities and market frictions: anti-trust, pollution, corporate wrong-doing.
b. However, recognizing the limits of governmental one-size-fits-all regulation crucial!
(E.g., forbid carbon emissions at all costs? Or better use a market approach that puts a
price on carbon emission?)
Dutch Corporate Governance Code
“The management board and the supervisory board have overall responsibility for weighing up these
interests, generally with a view to ensuring the continuity of the enterprise, while the company
endeavors to create long-term shareholder value.”
Control rights in the Netherlands
Control rights is what matters: the board of director is where the power lies inside a company.
● Typically 2-tier boards: separation into management and supervisory board. Supervisory
board with 1/3 employee representatives.
● 1-tier boards possible: large firms can opt for a 1-tier board (but very few do, e.g., Unilever).
In this case, employees can appoint 1/3 non-executive directors on board (while majority of
directors and chairman must come from the outside).
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,2. Why do we need corporate governance?
If investors need to worry, capital becomes more expensive.
● Debt: yields increase
● Equity: lower share price when new shares are issued
● Then, at higher financing cost:
○ some projects not feasible any longer -> less economic growth
○ higher costs of production higher price and lower sales -> loss of consumer welfare
● Firms become dependent on internal sources of finance: slower growth
● Internal sources dependent on business cycles: more volatile growth
Overall welfare loss for society
Governance Failures: Example 1
Vereenigde Oostindische Compagnie (VOC)
● Corporate charter stated that company/project would live for 20 years; then be liquidated with
a final dividend to all owners/stockholders.
● 1622: Management unilaterally decides to ignore corporate charter, to continue to operate
indefinitely and not pay out any final dividend.
● Why did the Dutch government not intervene? State benefited hugely from the colonies
started by the VOC
● But on the road to success, governance-wise:
○ The first case of management ignoring the company charter to dissolve.
○ First case of shareholder activism (1609). (Activist wins board representation.)
Governance Failures: Example 2
Dennis Kozlowski (CEO, Tyco)
● Excessive lifestyle on shareholders’ dime -> The “Tyco Roman Orgy” » 4-day long
extravagant birthday party for Kozlowski’s wife on Italian island; >$1m paid by shareholders
and $19m apartment with $11m worth of interior
● Jailed 2005 for 8-25 yrs for stealing $170m from investors
● Where was the board? composed of friends and insiders (subordinates). Some “independent”
directors received private perks or private business contracts with Tyco.
Governance Failures: Example 3
Richard Scrushy (CEO, HealthSouth Corp)
● 1999-2002: Scrushy (CEO) and Owens (CFO) overstate earnings by $1.4 billion to meet
analyst expectations.
● 2002: Scrushy sells 94% of his stocks weeks before massive earnings restatement. Scrushy
gets fired; firm close to bankruptcy; fires 9000 workers
● Where was the system of checks and balances?
○ Board: Compensation committee met once in 2001.
○ Auditor (Ernst & Young): CFO previous employee of Ernst & Young. Besides audit
work ($1.2m), CEO hired Ernst & Young for consulting activities ($2.5m).
○ Analysts: UBS had “strong buy” until shortly before restatements while earning $7m
in investment banking fees from HealthSouth
-> Definitely not all management “evil” and not all events illegal but anecdotal evidence points to
frequent governance issues.
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,3. Players and Corporate Conflicts of Interest
Corporate Governance Players
Corporate Conflicts of Interest
Conflicts of interest between different players:
● Shareholders prefer more risk while bondholders prefer less.
● Auditors and rating agencies need independence but are hired by firms.
● Analysts need independence but need access to firms’ management.
But also within classes of players:
● Large investors vs. small investors:
○ Large investors may engage in tunneling out money to related businesses.
○ Small investors may prefer more risk-taking (due to greater diversification).
● Directors:
○ Inside directors: subordinates want to keep their job and relationships.
○ Family directors: worried about risk (too little diversified/reputation)
○ Independent directors: may worry more about reputation than performance
Many of those conflicts are unavoidable. How to best manage them?
The first and second agency problem
Conflicts of interest generate agency costs that lead to a reduction or breakdown of external financing
and welfare loss if not dealt with. In lectures, we are mostly concerned with:
● The conflict of interest between shareholders and managers -> first agency problem
● The conflict of interest between different groups of shareholders -> second agency problem
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,Can’t we just deal with corporate governance once and be done?
1. Innovation and unintended consequences
a. New regulation, business processes or financial innovation with side effects.
b. Example 1: Compensation consultancies (CC): Huge exec pay in 1990s -> CCs get
empowered -> CCs get captured by CEOs via other consulting contracts -> new SEC
regulation in 2006 requires new disclosure -> CCs split up firms into separate entities
to avoid the disclosures.
c. Example 2: Contingent convertible bonds (CoCos): New financial product in which
bonds convert (upon some trigger event) into equity -> Good for society as bank
equity get replenished during distress (= automatic bail-in of creditors). -> Harnessing
the monitoring of creditors to help restrict risk-shifting/gambling-for-resurrection. ->
But if debt acts like equity, will it lead to fire sales and increase systemic risk in bond
markets?
2. Analysis of what works is not straightforward
a. Actions by market players and market institutions are endogenous. Hence, often, one
can only observe issues when things have already gone wrong (“off-equilibrium
play”).
b. Changes in corporate governance regulation are often preceded by scandals and a
decline in public confidence into capital markets. Scandals then provide the political
impetus to find a “fix” to the problem and to re-establish confidence in capital
markets.
c. So new regulation is often only “backward looking” to avoid a repeat of a similar
crisis.
3. Herding among the innovators and monitors
a. Often just a few innovators of a new business practice, while others watch. If
“nothing” happens, they copy it.
b. The same applies to monitors! Few monitor initially; other monitors copy the method
to monitor as long as nothing happens.
c. The correlated behavior and copying of actions replaces each monitor’s own analysis.
Herding implies that a web of monitors is not independent and the overall failure rate
increases. (Demski, JEP 2003)
Anti-Takeover Provisions
An example of a corporate governance innovation that has developed “a life of its own”:
Anti-Takeover Provisions (ATP)
● Provisions, often in corporate bylaws, that make it harder to acquire a firm (or a majority of
its stocks) without the consent of the target firm’s board.
● Original intent was to make a firm intentionally unattractive (!) for a takeover from a hostile
bidder
○ Hostile bid: a bid that is not endorsed by the board of the target firm; e.g. a bidder
makes a public announcement to buy all shares at a premium “x” to the current price
(which prompts some shareholders to sell their shares directly to the bidder).
Why would we want to make a firm intentionally unattractive? Empire Building?
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,Benefits of anti-takeover provisions (ATP)
Complicates a hostile takeover:
● Forces a negotiation with the target’s board and provides greater bargaining power and time
for the target’s board during these negotiations, which may allow the board to extract a higher
premium or other concessions. In contrast, approaching small investors one-by-one (a
“divide-andconquer” strategy) can leave investors as a whole worse off.
● Hostile investors cannot exploit momentary weakness.
Costs from anti-takeover provisions (ATP)
● Directors and managers are more immune against disciplining from:
○ pressure by shareholders, activists
○ the market of corporate control
○ and thus a greater potential for agency costs from shirking, excessive perks and
compensation increases.
● Shareholders deprived from their own decision-making and from potentially selling with a big
premium. (Or, a management buyout could force low selling prices upon investors.)
● Some ATPs may lead to perverse managerial incentives:
○ Anti-takeover provisions for the sake of “entrenching” oneself
○ Intentionally trying to depress share price in order to attract a hostile bid which then
triggers a golden parachute for the managers.
○ Accepting a lower premium during board negotiations in exchange for private
benefits from the bidder (continued employment as director or manager in the
bidder’s firm; higher severance package; early vesting of stock options)
Examples of anti-takeover provisions (ATP)
Scorched earth defense
● Firm contractually commits to costly policies if hostile takeover was to occur:
○ selling its “crown jewel” assets; or repaying all debt at once.
○ Providing very generous severance packages to executives (golden
parachute/handshake)
Shareholder rights plan (Poison pill)
● In the event that one shareholder (bidder) crosses a predefined threshold, every shareholder
(except the bidder!), receives the option to purchase additional shares at a steep discount.
○ Dilutes stake of the bidder; increases the costs for a hostile takeover.
Staggered boards and Supermajority voting
● Directors are appointed for 3 years; every proxy season, only 1/3 of all director seats are up
for election. Hostile bidder cannot replace the full board in a single shareholder meeting so to
force the board to accept a bid.
● Supermajority of votes (often 66%) required for certain shareholder votes.
Very effective provisions; hostile bids are rare today.
What could be the downsides/costs of ATPs?
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,Dutch example
A hostile bid for KPN from Mexican billionaire Carlos Slim (who owns America Movil)
● Aug 2013: Offers to buy 70% of shares
● Oct 2013: KPN board uses Stichting (Dutch version of a poison pill. Most Dutch companies
have such Stichtings in their bylaws) to block hostile bid
● Stichting exercises call option for newly issued shares, receiving 50.1% of voting rights
● America Movil withdraws its bid soon after (with about $1 billion in losses)
● Jan 2014: Stichting returns shares.
Corporate Governance Mechanisms
Internal Mechanisms:
● Monitoring by the Board
● Executive Compensation
● Internal Procedures/Audits
External Mechanisms:
● Ownership Concentration
● Shareholder activism
● Market for Corporate Control
● Supervision by Regulators
● Disciplining by Debt Markets
● Product Market Competition
● Analysts, Ratings, Proxy Voting
● Managerial Labor Market
● Media
Week 2
Review last class
What is corporate governance? It is the set of mechanisms that tries to ensure that:
● suppliers of finance receive back their investment plus a return (narrow view).
● management is responsive to all stakeholders (broad view).
Recall: Debate on what should be the objective of a company (shareholder vs stakeholder capitalism)
What are the underlying issues corporate governance deals with?
● the separation of ownership and control
● the principal agent problem
○ Principal delegates an action to an agent
○ Payoffs/utilities are not aligned
○ Asymmetric information and/or incomplete monitoring
What can happen under separation of ownership and control?
● Managers can steal: money, clients, technology, business secrets.
● Managers can waste investors’ money (empire building, perks, excessive compensation)
● Managers can take too little or too much risk (enjoying the quiet life; gambling for
resurrection)
● Managers can undertake projects that are not in the interest of shareholders:
○ Projects that increases manager’s level of entrenchment
○ Projects that carry litigation risk and potential penalties
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, ● Managers can derive private benefits at the cost of shareholders
○ Falsify profits/earnings for personal benefits (for bonuses)
○ Projects that advance his/her career (e.g., management buyout)
○ Use insider knowledge to opportunistically trade
○ Engage in self-dealing, tunneling or accepting bribes.
● Examples
○ CEO disappearing with cash in German-listed company; Dutch East Indian Company;
Tyco; HealthSouth Corp; accounting scandals 1999-2002; systematic large-scale
evidence from bankruptcies, class action suits, opportunistic insider trading, stock
option backdating
○ Country-level institutions: Corporate raiding in Russia; IPO rigging in the U.S.
10-40% premium for good corporate governance (country-dependent)
● Internal corporate governance.: charters, bylaws, ATPs
● External corporate governance.: rule of law, enforceability, corruption
Should society care about corporate governance?
● If investors worry, raising finance becomes more expensive
○ Issuing equity: lower stock return -> price one is willing to pay for new CF right
decreases
○ Issuing debt: higher bankruptcy risk -> yield increases
● Then at higher financing cost
○ some projects not NPV-positive any longer: less economic growth
○ firms more dependent on internal sources of finance: slower economic growth
○ internal sources dependent on business cycles: more volatile economic growth
○ higher prices, lower sales: loss of consumer welfare
● If risk of expropriation, then
○ firms may not want to invest/grow as much: less economic growth
○ firms might buy protection from powerful people: corruption & worse institutional
quality
What to do?
● Conflicts ubiquitous: between as well as within same types of market participants
● Conflicts unavoidable: many (not all) conflicts stem from zero-sum context
● Conflicts evolving: financial innovations, herding among monitors, new rules create new
issues.
Design best-possible institutions to minimize conflicts; keep monitoring and refining them not just
through regulation but also by supporting markets to come up with their own solutions!
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, The Separation of Ownership and Control
Conflict 1: Shareholders vs. Management
● Shareholder’s cash flow rights determine ownership
● But managers with actual control in running the day-to-day operations of firm
How can ownership and control differ here?
● Management typically without any significant ownership stake
○ Due to operational control it holds power in excess of its ownership level
○ In contrast to private firms in which managers are 100% owners.
● Management may engage in policies that increase its control
○ Adopting anti-takeover provisions; befriending the board; influencing the director
nomination process; taking on “entrenching projects” harder to oust management
● Atomistic shareholder base
○ Incentives to free-ride on others’ monitoring efforts.
○ Collective-action problem of monitoring.
● Disinterested/passive/arms-length investors
○ Due to investors nature (ETFs), cost structure (low-cost mutual funds), missing
monitoring expertise, or due to legal considerations
Example: China’s opening to foreign investors -> China never publicly approved the VIE workaround
but only silently agreed to it! What if China’s regulators suddenly state that all VIE contracts are
(obviously) mimicking actual ownership which is forbidden and declare them void?
Conflict 2: Shareholders vs. Shareholders
● Ownership depends on cash flow rights
● Control depends on voting rights of shares
How can ownership and control differ here?
● 20% vote stake is usually sufficient to secure control of a company (many shares don’t vote)
● Multiple classes of shares with different voting rights:
○ Preferred shares: almost guaranteed dividends (dividends with higher priority than
those of common stock) but without any voting rights.
○ Class A/B/C shares with different voting rights.
○ Ex: Ford: Ford family owns 4% of cash flow rights, but 40% of voting rights
Example: in 2017 Zuckerberg owns 15% of cash flow rights but has 54% of voting rights (thanks to
having Class B shares with each 10 votes)
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