Summary Corporate Governance
MSc Finance – Block 2
Vera Scholten
GENERAL NOTE: We mostly look at the US since a) it is the largest market for public firms (1/3 of
world capitalization); b) many non-US firms are cross-listed in the US and have to adhere to US laws;
c) financial markets move towards US institutions d) US has greatest data availability.
Also note that there are summaries of lecture 1/2 in the beginning of the lecture slides 2/3.
Lecture 1 Introduction to CG
CG is very important - 2/3 of companies say they would avoid badly governed firms + up to 40%
premium would be paid for well-governed firms. Bad corporate governance drives a wedge between
potential firm value and realized firm value – the premium is an estimate for the size of this wedge.
This shows investor value.
CG can be both internal (within the firm) and external (laws & enforcement), direct (policies,
government) and indirect (media decreasing IA = more efficient markets).
What is Corporate Governance? → Core issue 1 = Principal-agent problem
A decision needs to be delegated from a principal to an agent, which impacts utility of both principal
and agent. However, the agent’s interests may differ from those of the principal. There is incomplete
monitoring and/or asymmetric information. (e.g. doctor prescribing unnecessary treatment, cab rides). For
finance specifically, shareholders (principal) delegates operations of their equity to a manager
(agent). →How to ensure that agent takes action that is in best interest of principal? How to make sure
that managers don’t steal or waste money/tech/ideas/clients, grant excessive pay, take execive risk, shirk, falsify records,
empire building, insider trading, entrench themselves?
Central problem: separation of ownership&control with info asymmetry and incomplete monitoring.
Solution: creating the right incentives (“sticks and carrots”) plus a web of internal and external
checks and balances (= corporate governance mechanisms)
→ Core-issue 2: Ethics meets governance and finance
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. If it's allowed by the letter of
the law, is it always okay to do it? Does fiduciary duty of directors to their shareholders compel them
to take any profit‐maximizing action if it is legal by the letter of the law? Examples:
− Checks clearing later than amount is credited to your account (is temporary free loan). Illegal!
− Redlining = discriminatory positioning of your branches. Illegal!
− Tax avoidance/tax evasion. Amazon agreement with Luxemburg = legal
Definitions in CG
− Shareholder perspective - maximize SH value. SH have CF rights and control rights.
− Stakeholder perspective - moral obligations to all stakeholders (employees, society, suppliers etc.).
Stakeholders ought to have control rights. Firms are responsible for the environment, taxes etc.
(CSR) and employees should be on the board.
Economists argue there are some problems with the stakeholder approach:
▪ Control rights for stakeholders may discourage financing and make financing more expensive.
▪ No agreement on what social obligations might be.
▪ The success of a manager becomes immeasurable. Unlike profits, workers and environment
performance are hard to measure and might decrease profits, causing manager punishment.
▪ Managers currently have a fiduciary duty to SH. If stakeholders incl. interests might compete.
▪ SH often already have the least protection among stakeholders.
, Instead they argue to 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 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 laws are not enforced.
▪ Contracts can be incomplete or implicit → abuse of human capital/firing older employees
Suggested solutions: control rights to stakeholders, more laws and socially responsible investing.
**Keynote Address by Diane Dennis
Aim: eliminating misunderstandings about SH and StH approaches/ discussing implications.
Point 1: SH wealth max and stakeholder approach are not necessarily in conflict with one another e.g.
it can pay to take care of employees by increased motivation/productivity. You need to maximize LR value.
Point 2: in some areas there is however the need for government to limit the application of SH
wealth max. to mitigate externalities and market frictions. However, no one-size-fits-all policies and
only intervene when market solutions do not exist.
Dutch CG Code: §3 contains principles/best practises that regulate relations between boards and
SH, not company and employees. In §7 it is stated that a company is a LT alliance between various
parties. Stakeholders = people who influence or are influenced by the company. The boards have
overall responsibility for weighing up these interests together with LT SH value.
Control right: typically 2-tier board (management + supervisory). 1-tier is possible if employees can
appoint directors.
Why do we need CG?
Policy view: If investors need to worry, capital becomes more expensive (debt interest rate ↑ due to
risk + share price ↓ due to uncertainty). At higher financing costs some projects are not feasible
anymore (economic growth ↓) and production is more costly (product price ↑ and consumer W↓)
Firms become dependent on internal sources of finance (slower growth) which depends on business
cycles (more volatility) = overall welfare loss for society.
Governance failure examples: VOC (1 stock/LLC in the world), Dennis Kozlowski (CEO of Tyco,
dependent board) and Richard Schrushy (CEO of HealthCorp). See slides/notes.
CG issues are frequent: evidence from Corporate Events showing bankruptcies, financial
restatements, class action lawsuits, corruption, stock option backdating, earnings management and
insider trading – see slides /notes.
, Conflicts of interest between players… (1st AP) …but also within classes of players (2nd AP)
− Shareholders prefer more risk while − Large investors (tunnel out money) vs.
bondholders prefer less. small investors (more risk-taking)
− Employees/unions prefer stable − Inside directors (subordinates) vs. family
employment & higher wages while directors (worry about risk) vs.
shareholders are concerned about independent directors (worry about
returns. reputation more than performance)
− Auditors should be independent but are
hired by the firm.
− Analysts should be independent but need
access to firms’ managements
Many of those conflicts of interest are unavoidable and generate agency costs that lead to a
reduction or breakdown of external financing and welfare loss if not dealt with.
Corporate governance is dynamic / constantly changing
▪ Businesses become increasingly complex due to greater competition, changing financial
innovation (SF, hedging etc.) and changing business processes. It is unclear how new regulation and
players interact with the existing situation (e.g. comp. consultancy & contingent convertible = trigger bonds)
▪ Analysis of what works best is not straightforward.
▪ All actions taken by players are endogenous to all other players’ actions and their conflicts of
interests → the institutions that are used to manage them are also endogenously chosen.
▪ Often, one can only observe issues when things have already gone wrong (“off‐equilibrium play”)
→Changes in CG regulation often preceded by scandals and a decline in public confidence into
capital markets. Scandals provide the political impetus to find a “fix” to the problem.
▪ Herding among the innovators = just a few innovators of a new business practice (e.g., mortgage
backed securities), while many others just watch. If “nothing” happens, they copy the business
process. The same applies to those that monitor! Few monitors initially while others start
copying the same way in monitoring as long as nothing occurs. Herding implies that a web of
monitors is not independent; the overall failure rate increases.
Anti-Takeover Provisions → CG innovation that has developed “a life of its own”
What: Provisions, often in corporate bylaws, that makes it harder to acquire a firm (or a majority of
its stocks) without the consent of the target firm’s board.
Original Intent/Purpose: to make firm intentionally unattractive for a takeover from a hostile bidder
= a bid that is not endorsed by the board of target firm.
Benefits: complicates a hostile takeover. Force negotiation + greater bargaining power. Allows the
board to extract higher premium/concessions. Prevents exploitation of momentary weakness.
Examples:
➢ 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 pre‐defined threshold, every
shareholder (except the bidder!), receives the option to purchase additional shares at 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 full board in a single shareholder meeting so to force
board to accept a bid. Supermajority of votes (often 66%) required for certain shareholder votes.
Costs: directors are more immune to activists, block holders and market for corporate control =
greater potential for agency costs. Additionally, SH are deprived of DM and profits. Finally, some
ATPs lead to perverse managerial incentives (e.g. intentional trigger of severance package/acquisition)
