Corporate Governance - Lecture 1 Notes
Introduction to Corporate Governance
What is a Corporation
A corporation is a legal entity that is separate and distinct from its owners, providing them with limited liability while enabling the organization to own property, enter into contracts, and conduct business in its own name.
Sole Proprietorship: Owner = firm; unlimited personal liability.
Partnership: All partners are liable for the debt, unlimited liability.
Limited Liability Companies:
Firm as a legal entity with contractual rights and obligations.
Limited liabilities.
Separate ownership and control.
Joint-stock.
The course focuses on limited liability firms.
What is Corporate Governance?
Describes the processes, structures, and mechanisms that influence the control and direction of corporations (Encyclopedia of Business and Professional Ethics, Springer International Publishing AG, 2018).
Involves a set of relationships between a company's management, its board, its shareholders, and other stakeholders (OECD 2015).
Provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined (OECD 2015).
Provides the assurance that managers give the capital providers their money back (Shleifer and Vishny 1997).
Governance structure is the mechanism for decision making about the residual control rights (Hart 1995).
Involves many disciplines – economics, accounting, finance, law, management, politics, psychology, etc.
Why Does Corporate Governance Matter?
Corporate governance quality affects:
Firm Value: Example: In the 90s, Russian firms were worth 1% of their western equivalents (Shleifer and Vishny 1997).
Shareholder Rights: The average voting premium was 45.5% in Israel and 82% in Italy (Shleifer and Vishny 1997).
Impacts whether management invests in positive NPV projects.
Influences investor willingness to invest if they don’t get adequate returns.
Corporate Governance as a Global Challenge
Impacts the development and health of a country’s capital markets and economy.
Contributes to governance and economic well-being.
Addresses how international organizations are governed.
Helps prevent the next global financial crisis.
Contributes to governance and political well-being.
Identifies common characteristics of successful corporations.
Helps win and maintain trust from investors.
Relevant to governance of multinational corporations.
Key Theories
Corporate Governance Theories
Agency theory
Transaction cost economics
Stakeholder theory
Stewardship theory
Resource dependence theory
Institutional theory
Agency Theory
Separation of ownership and control: Managers (agents) control the firm, while shareholders (principals) own it.
Focuses on whether investors will get their money back, when, and how much, and if managers will act in the investors' best interests.
Investors (capital providers) Manager (controls the firm)
Principal and Agent Relationship
Examples:
Citizens (principal) — politicians (agent) — political science.
Patients (principal) — doctors (agent).
Employers (principal) — employees/contractors (agent) — managerial accounting.
Who Controls the Company?
Residual control rights are the rights to make any decisions regarding an asset's use that are not explicitly assigned to another party in a contract.
Cash flows
Key resources
Company strategy
Management hire and fire
Voting rights
Key Conflicts of Interests
Shareholder vs. Manager:
Ownership and control.
Minority investor protection.
Voting rights.
Executive compensation.
Dividend policy.
Change of ownership.
Shareholder vs. Creditors:
Optimal capital structure.
Cost of capital.
Debt overhang.
Risk-taking.
Shareholder vs. Stakeholders:
Corporate social responsibilities.
Employee rights and regulations (national and international).
Social and environmental externalities of business.
Institutional shareholders vs. Individual shareholders: Large shareholders may influence firms at the expense of other shareholders.
Agency Theory: Main Challenges
Contract incompleteness (Hart 1995): Investors and managers can’t write contracts ex ante on all future contingencies and specify all potential solutions.
Information asymmetry (Akerlof 1970): Managers know more about the company than investors. It’s costly for investors to effectively monitor managers’ efforts or verify the managers’ claims.
Agency Theory (Jensen and Meckling 1976)
Separation of ownership and control leads to agency problems.
Agency problems exist in all organizations and all cooperative efforts.
A corporation is a legal fiction that serves as a nexus of contracts among individuals.
Agency costs:
Monitoring costs by the principal.
Bonding costs by the agent.
Residual losses.
Agency Costs
Monitoring costs:
Board of Directors to monitor managers and represent shareholder’s interests
Large shareholders monitor and engage with management
Shareholder activists monitor and influence management
Binding costs:
Managers pay dividends, signaling to shareholders that the firm is profitable.
(Timely and honest) disclosure of financial and non-financial information to stakeholders
Residual costs:
Managers pursue their own interest at the cost of the principals.
Transaction Cost Economics (Coase 1937)
Should Tesla produce batteries in-house or purchase from a supplier?
It depends on the transaction costs of producing or purchasing.
A firm is a governance structure to allocate resources more efficiently, at lower costs than the operation of markets.
Firm size increases if the internal market is more efficient.
The choice of governance structure can reduce transaction costs internally.
Shareholder vs Stakeholder Theory
Shareholder theory (Friedman 1970):
By maximizing shareholder value, all other stakeholders also improve their welfare in the Neo-Classic model.
The responsibility is to conduct business in accordance with the basic rules of society, both those embodied in law and those embodied in ethical custom.
Stakeholder theory (Freeman 1984):
An organization's effectiveness is measured by its ability to satisfy not only the shareholders, but also those stakeholders who have a stake in the organization.
The implied governance structure and monitoring mechanism of shareholder and stakeholder theories are different.
In the US and UK, a one-tier board contains only shareholder-elected executive and non-executive members.
In France and Germany, labor union, local government, and banks have representatives on the supervisory board of firms.
Resource Dependence Theory
Corporations and their external environment are interdependent.
The relationship with stakeholders like employees, suppliers, customers, investors, and regulators must be managed with care to ensure access to critical resources.
Stewardship Theory
Managers are intrinsically motivated to act in the best interests of the corporation and its stakeholders.
The firm should run as a team with shared vision and a strong sense of commitment from the managers.
In contrast with managers under agency theory that need to be monitored and incentivized.
Many corporate governance codes also require the stewardship role of managers.
Institutional Theory
Corporations are embedded in a broader institutional environment.
Corporations must conform to the institutional norms and expectations to gain legitimacy to operate.
Corporate Governance Structure
Corporation
Individual and institutional Shareholders /creditors/stakeholders
Audit assurance
Regulators
Accounting standard setters
CEO and board of directors
Financial and non-financial reports
Credit rating agency
Corporate Governance and ESG rating agencies
Recap
Corporate governance describes the processes, structures, and mechanisms that influence the control and direction of corporations.
Agency problems arise from the separation of ownership and control, conflict of interests, contract incompleteness, and information asymmetry.
Governance quality influences firm value and the well-being of the financial markets.
Corporate governance theories:
Agency theory
Transaction cost theory
Stakeholder theory
Resource dependence theory
Stewardship theory
Institutional theory