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Lecture Summary for Corporate Governance + Articles

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Summary of lectures for the part of corporate governance and the including articles with detailed description of hypothesis and results!

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  • 30 januari 2025
  • 35
  • 2024/2025
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Corporate Governance
Lectures


Q2 2024/2025


1 (Lecture 5) Introduction to Corporate Governance
1.1 Introduction to Corporate Governance
There are three types of businesses.
• Sole Proprietorship

– Owned and run by one person
– Small but most common
– Unlimited personal liability
• Partnership

– Owned and run by more than one person
– All partners are liable for the firms debt
• Corporation
Corporations and its typical features
A corporation is a legal entity that is separate and distinct from its owners, established under the laws of a state
or country.

• Separation of ownership and control
• Legal rights and responsibilities (legal person) : can sue or be sued, enter into contracts, and are held
accountable for their actions under the law
• Limited liability

• Perpetual existence
• Ownership through shares : shareholders are the owners.




1

,Agency Theory
The separation of ownership and control means that managers are hired by shareholders. A principal is anyone who
hires someone else to do a certain job at their expense. An agent is a person hired to do a certain job in exchange
for an agreed compensation. The principal and agent may have different interests, there is potential risk of agent
acting in his own intrest on the principal’s expense, this is where agency problems arise!




Agency Theory in the Corporate Setting
Shareholders (principals) employ managers (agents) to run the firm in the best interest of the shareholders. However,
some managers act wrong and embezzle shareholders funds.

• Insufficient effort
• Extravagant investments : pet projects and empire building

• Entrenchment strategies : take actions that hurt shareholders to keep or secure their position
• Self-dealing : increase private benefits from running the firm

In the context of corporations, the board of directors is viewed as an essential monitoring device to minimize the
shareholders-manager problem.

Information Asymmetry Theory
There is also the problem of information asymmetry whereby the principal and the agent have access to different
levels of information. In practice, this means that the principal is at a disadvantage because the agent will have
more information. There are two types of information problems.

• Averse Selection
– When one party in a transaction has more information than the other party, this can lead to unfavorable
outcomes for the less-informed party.
– Example: In the second-hand car market, 50% of the cars are good ($10.000) and 50% of the cars are
bad ($5000). As a buyer, what will you offer if you cannot tell the quality of the car? If you are rational,
you will offer $7500. But if you only offer $7500, good quality car sells will leave the market! Meaning
all the cars in the market that are left are bad cars.
• Moral Hazard
– A situation where an economic actor has an incentive to increase its exposure to risk because it does not
bear the full costs of that risk.
– Example: If your house is not insured, you may be careful and take actions to prevent the damage. If
your house is insured, you may behave in riskier ways.

How do we distinguish between the two types of information asymmetry? It depends on the timestamp on the con-
tract. Before contract, we talk about adverse selection. After contract, we talk about moral hazard. For example,
before a manager is hired, it is difficult to judge her ability. After being hired, a manager may make unethical
decisions which can lead to scandals and criminal behavior due to information asymmetry.



2

,Contract Theory
Suppose that the manager and the investors sign a contract that specifies how the manager will use the funds and
also how the investment returns will be divided between the manager and the investors.

• Complete Contract
– If the two sides can write a complete contract that specifies exactly what the manager will do under
each of all possible future contingencies, there will be no room for any conflicts of interest or managerial
discretion.

• Incomplete Contract
– However, it is practically impossible to foresee all future contingencies and write a complete contract.




What is Corporate Governance?
Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting
a return on their investment. Corporate governance refers to the laws, regulation, institutions and corporate prac-
tices that protect shareholders and other investors. Corporate governance refers to a set of relationships between a
company’s board, its shareholders and other stakeholders.

Corporate Governance is NOT about the following.

• Not about management as such, but about the control and direction of managers.
• Not just codes or regulation but also about internal and external mechanisms and introducing a corporate
culture with integrity and ethical behaviour.
• Not a faith or belief, but a field of practice and study


3

, Corporate Governance is crucial for the following.
• Ensure good decision making : good management, good investments ; create checks and balances and prevent
abuse of power.
• Diminish corporate failures and scandals.

• Crucial for corporate performance, economic efficiency and social welfare.
Stakeholder Theory
Stakeholder theory takes into account the interest of a wider group of constituents rather than that of stakeholders.
The term ’stakeholder’ can encompass any individual or group in which the activities of the company have an
impact.




1.2 Mechanisms of Corporate Governance
How does governance work?
Corporate governance mechanisms are the instruments used to motivate and monitor managers. Motivate to align
their own interests with those of other stakeholders. Monitor them to work properly, not to pursue their own
interests.

Major Corporate Governance Mechanisms
• Internal

– Ownership structure, board structure, compensation structure.
• External
– Capital market/analysts, auditors, takeover market, debt market/creditors, product market competition,
labour market, law and regulation.

In addition to these formal mechanisms, there exist informal mechanisms; codes, social norms, reputation and trust.




4

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