Chapter 1. Corporate Governance and Busines Objectives

8/3/2019 Chapter 1. Corporate Governance and Busines Objectives

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BUSINESS ECONOMICS

AND MANAGERIALDECISION MAKING

Leonid V. Volkov

Associate professor atEconomics and Crisis

Management Department

The Finance University under

Government of the RF


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BUSINESS ECONOMICS

AND MANAGERIALDECISION MAKING

CHAPTER 1: CorporateGovernance and Business

Objectives


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Content 1. Introduction in the business economics

and managerial decision making course

2. Ownership structures

3. Patterns of shareholding

4. Classifying firms as owner ormanagement controlled

5. Systems of corporate control

6. Constraints of managerial discretion

7. Improving corporate governance

8. Summary


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1. Introduction

The common characteristics of allfirms:

Owners; Managers;

Objectives;

A pool of resourses (labour, physicalcapital, financial capital, learne skillsand competences);

Administrative or organizationalstructures;

Perfomance assesment


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The main characteristic of

firm A firm is owned by someone or some

group of individuals or organizations

The shareholders are able to determine the objectives and

activities of the firm;

appoint the senior managers (top-

managers); bear the risks associated with operating

the firm;

have the right to receive the residual

income


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Where ownership is

dispersed control of the firm may not lie with

the shareholders but senior managers

Divorce between ownership and

control


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2. Owners

hip structures

The dominant model is LLC (the form variesbetween countries);

In some countries the control rights of

shareholders are limited by stakeholders(may share the appointment and supervisionof managers and set firms objectives);

There are also firms owned by members and

operated as cooperative or mutual enterprises; Some firms owned by national or local

government


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Stakeh

olders Suppliers;

Customers;

Workers; Local community;


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Classifying firms by interest Monistic (single interest group

shareholders) (the UK and the USA);

Dualistic (two interest groups shareholders and employees) (Franceand Germany);

Pluralistic (the company serves theinterests of stakeholders and not justshareholders) (Japan).


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Modern tendencies Some degree of convergence between

European and Anglo-American forms

of corporate organizations; Economic forces in Japan have put

significant pressure on companies toreduce the long-term employment

and place greater emphasis onprofitibality


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3.P

atterns of sh

areh

olding The pattern of share ownership varies

between countries and with time.

In the UK and the USA, ownership ismore widely dispersed than incontinental Europe and Japan whereit is more concentrated.


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The key features are:

The largest group of domestic owners ofcompany shares are financial institutions.

Financial institutions share of ownership

increased between 1963 and 1997, but fell to50% in 2001.

Individual ownership of shares has been inlong-term decline and fell to 14.8% in 2001.

Overseas ownership of UK companies hasincreased and stood at 31.9% in 2001.

This trend reflects the growinginternationalisation of the asset portfolios held

by financial institutions.


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Sh

areh

olding in EuropeIt shows that in each country the

structures are different in broad

terms compared with the UK: Holdings by financial institutions are lower.

Holdings by non-financial companies are moreimportant, particularly in Germany.

Individual ownership is more important in Italyand Spain, but less so in France.

Foreign owners are more important in Franceand Spain, but less significant in Germany andItaly.


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Corporate organization

structureShareholders

The board of directors (thesupervisory board)

The executive management (top-

managers) (the managementboard)

The operational management


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4. Classifying firms asowner or managementcontrolled The pattern of share ownership at

company level varies widely;

1. The UK and the USA dispersedownership structure

Quoted companies ownership is widelydispersed among large number of

shareholders; The largest shareholder often owns 5%

or less o the stock;

The board of directors typically own a

tiny proportion of the shares


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4. Classifying firms asowner or managementcontrolled 1. In France and Germany

concentrated ownership structure

In France and Germany shareholdingtends to be more concentrated withgreater blocks of shares held bycompanies and banks.

Concentrated ownership structures aremore likely to be found in most countries

in contrast to the dispersed ownership(typical only of the UK and the USA).


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How can companies beclassified as owner or

managerially controlled? If a single shareholder holds more than 50%

of the stock, then they can outvote theremaining shareholders and control the

company. If the largest shareholder owns slightly less

than 50% of the equity then they can beoutvoted if the other shareholders formed aunited front.

If the majority of shareholders do not form aunited front or do not vote, then an activeshareholder with a holding of substantially lessthan 50% could control the company.


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Berle and Means are famous

American economists They first identified the divorce

between ownership and control The

Modern Corporation and PrivateProperty (1932);

A stake of more than 20% would besufficient for that shareholder to

control a company but less than 20%would be insufficient and thecompany would be management-controlled.


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Oth

er point of views Radice (1971) used a largest

shareholding of 15% to classify a firm

as owner-controlled; and a largestshareholder owning less than 5% toclassify a firm as manageriallycontrolled.


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Oth

er point of views Nyman and Silberston (1978)

argued that the distribution and

ownership of holdings should beexamined more closely. Theyemphasized that there was a need torecognize coalitions of interests,

particularly of families, that do notemerge from the crude data.


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Oth

er point of views Cubbin and Leech (1983) argued

that control was a continuous variable

that measures the discretion withwhich the controlling group is able topursue its own objectives withoutbeing outvoted by other

shareholders.


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Control of a company is a

function of th

e following factors: The size of the largest holding.

The size and distribution of the

remaining shares. The willingness of other shareholders

to form a voting block.

The willingness of other shareholdersto be active and to vote against thecontrolling group.


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5. SYSTEMS OF CORPORATECONTROL

The differences between countries inshareholder ownership patterns

influence the nature of theircorporate governance systems.

There are fundamental differencesbetween the corporate control

systems: the UK and the USA outsider

systems;

France, Germany and Japan insidersystems.


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Insider systems relatively few quoted companies;

concentrated ownership;

dominance of corporate and/orinstitutional shareholders andreciprocal shareholding;

shares are infrequently traded, but

when they are they often involve largeblocks;

takeover activity is largely absent, andwhere mergers take place they are

largely done by agreement.


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Insider systems More active owner participation;

Owners and other stakeholders arerepresented on the boards of companies, and

there is active investor participation incontrolling the company;

Ownership lies within the corporate sectorrather than with a multiplicity of individual

shareholders.


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Insider systems Directors are representatives of

other companies and interest

groups; A two-tier board structure allows a

wider group of stakeholders tooffer the company a broaderspectrum of advice tending toreinforce longer term goals andstability for the company.


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Insider systems Information about the firms problems

and performance is available more

readily to corporate or institutionalshareholders than to individualshareholders;


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Germany is an example of

an insider system Around 800 quoted companies

compared with nearly 3,000 in the UK

Ownership is much moreconcentrated with 85% of the largestquoted companies having a singleshareholder owning more than 25%

of the voting shares. Large ownership stakes tend to rest

in the hands of families or companies

with interconnectedh

oldings.


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Germany is an example of

an insider system For example, the largest shareholder in BMW is

the Quandt family which owns 46% of the votingequity. Stefan Quandt is one of four deputy

chairmen, and his sister Susanne is a member ofthe supervisory board. Head of the family isJoanna Quandt, who is the majority owner ofAltana, a pharmaceutical manufacturer; thismakes them the controllers of two of Germanys

top 30 companies. The supervisory board appoints the management board.

When the companys acquisition of British Leyland wasdeemed unsuccessful the chairman of the managementboard and two other directors were quickly dismissed by

insider action.


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Outsider systems are characterized by dispersed share

ownership, with the dominant ownersbeing nonbank financial institutions andprivate individuals.

Owners and other stakeholders are notrepresented on the boards of

companies. Shareholders are seen aspassive

investors (they are rarely interestedabout the way in which a company is

being operated).


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Outsider systems

Shares are easily sold and tend to be heldfor investment purposes, as part of adiversified portfolio, rather than for

control purposes;

This discourages active participation incompany affairs since shares are easilytraded.

Dissatisfaction with the performance of acompany leads the shareholder to sellshares, rather than initiate moves tochange the management or companyolicies.


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Outsider systems

Dispersed ownership is assumed tomean managerial control; this is

particularly true when financialinstitutions hold numerous smallstakes.

While such institutional investors may

have information advantages, they donot use this to influence managementdirectly but to maintain the value oftheir investment portfolios on behalfof clients.


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Insider and outsidersystems

In insider systems -- Themonitoring of managers is said to be

superior in insider systems, withdeteriorating performance morequickly acted on.

In the outsider system, changing

management and policies is a slowerprocess and may involve thetakeover of the failing business byother enterprises.


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6. Constraints ofmanagerial discretion

The degree of discretion that seniorexecutive managers have in setting

objectives is limited by both externaland internal constraints.


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6. Constraints ofmanagerial discretion

External constraints arise from theactive market in company shares;

Internal constraints arise from therole ofnon-executive boardmembers and stakeholders, trying toalign the managers and the

owners interests by the rulesshaping corporate governance.


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External constraints

There are five sources of externalconstraint on managerial behaviour

in any system of corporate control: 1) Holders of large blocks of shares who useor threaten to use their voting power tochange management or their policies if theybecome dissatisfied.

2) Acquirers of blocks of shares sold byexisting shareholders unhappy with theperformance of management.


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There are five sources of externalconstraint on managerial behaviourin any system of corporate control:

3) Bidders in the takeover processwho promise to buy all the votingshares of the enterprise.

4) Debtors/Investors, particularly intimes of financial distress, who act toprotect their interests in thecompany.

5) External regulators and auditors.


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In outsider systems, external control isexercised mainly through the workings ofthe stockmarket rather than voting.

In the stock market, the price of sharesreflects the relative numbers of buyers andsellers and their willingness to buy or sell.

A fall in the share price will make

management more vulnerable toshareholder activism either in selling sharesor in voting at shareholder meetings.


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In outsider systems, shareholders are inclinedto sell underperforming shares to maintaina balance in their diversified share portfolios.

In insider systems the selling of shares is moredifficult and, therefore,shareholders aremore likely to use their voting power toinfluencemanagement.


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In outsider systems the working of the stockmarket makes it feasible to acquire blocksof shares by purchase and to make a bid for all

the equity of a company, thereby threateningthe tenure of the existing management.

Other external constraints:

company law;

independent auditing of accounts ;

the lodging of company accounts with the regulators.


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Internal constraints

There are groups who may be able toinfluence management to changepolicies.

Independent non-executive directors;

The owners or shareholders;

Stakeholders within the company.


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Independent non-executivedirectors

They are appointed to the boards of UKcompanies to oversee the behavior of theexecutive directors.

They are often few in number and can beoutvoted by executive directors. One of theobjectives of corporate governance reform inthe UK is to make non-executives moreeffective.

In the German system the supervisory boardplays this role by influencing the managementboard, but its membership is more wide-ranging.


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The owners or shareholders

They can exercise their authority atmeetings of the companyor informallywith management.

Directors are elected at the annualgeneral meeting of the company.Dissatisfied shareholders can voteagainst the re-election of existing

executive directors

They can also vote against resolutionsproposed by the executive of thecompany, such as those relating toexecutive remuneration.


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The stakeholders within thecompany

employees of the firm;

customers,

suppliers, lenders

the local community.

They may do this by expressing theircriticisms/concerns either directly tothe executives or indirectly byinforming shareholders, the media

and outside experts.


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The stakeholders within thecompany

Investment banks and stockbrokersoffer advice to shareholders on thepotential future earnings of thecompany, and such comments mayhelp to influence attitudes towardmanagers.


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Aligning the interests ofmanagers and shareholders

The discretion executive managers exercise canbe limited by the development ofincentivemechanisms to ensure that the interests of

managers and owners are more closely aligned. If we assume that shareholders wish to

maximize profits, then managers may beencouraged to do so by the payment ofprofit-related bonuses in addition to their basic

salary and/or by rewarding successfulperformance withshare options in thecompany.


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7. IMPROVING CORPORATEGOVERNANCE

The final sources of constraint on thebehaviour of executive directors arethe rules that determine thegovernance structures andprocedures of companies.

The meaning of the term is

corporate governance


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Corporate governance

The Cadbury Committee, which wasset up in 1991 to investigatecorporate governance in the UK,defined it as the system by whichcompanies are directed andcontrolled.


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The Codes of CorporateGovernance

Across the world, many countries havedeveloped voluntary codes of practice toencourage good corporate practice.

The website of the European CorporateGovernance Network listed codes for 19countries together with those agreed by theOECD (Organization for Economic Cooperation

and Development) and various non-governmental organizations


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Corporate Governance(1998)

It requires each company to have:

Anon-executive chairman and chief executive witha clear division of responsibilities between them.

Each board of directors to have at least: Three non-executive directors independent of

management.

An audit committee including at least three non-executive directors.

A remuneration committee made up mainly ofnon-executive directors to determine the rewardof directors.

A nomination committee composed wholly of non-executive directors to appoint new directors.

Requirements to the annual report


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The requirements to theannual report

Anarrative account of how theyapply the broad principles of theCode, explain their governancepolicies and justify departures fromrecommended practice.

Payments to the chief executive

and highest paid director to bedisclosed in the annual report.

Directors should receive appropriatetraining to carry out their duties.


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The requirements to theannual report

The majority of non-executive directorsshould be independent, and boards shoulddisclose in their annual report which of the non-executive directors are considered to beindependent

The roles of chairman and chief executiveshould normally be separated, and companiesshould justify a decision to combine the roles.

The names of directors submitted for re-election should be accompanied bybiographical details, and directors who resignbefore the expiry of their term should give anexplanation.


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The Combined Code of CorporateGovernance (1998)

Compliance with the Code is one ofthe requirements for listing on theLondon Stock Exchange and non-compliance requires anexplanation in the annual companyreport.

The Code, however, does notguarantee good conduct on the partof executives and compliance with theCode does not necessarily improve

the com an s rofitabilit .


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8. Summary

The ownership structures of firms andthe pattern of shareholdings indifferent countries.

The divorce between ownership andcontrol led to the distinction betweenowner controlled and managerially

controlled enterprises.


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8. Summary

The nature of control in differentcountries was examined.

In whose interests firms are operatedwas also examined.

In the UK and the USA, where shareownership is widely dispersed, there are

outsider systems of control using marketmechanisms. In continental Europe and

Japan, where share ownership is moreconcentrated, there are insider control

systems.


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8. Summary

The major constraints on managerialdiscretion come through eitherexternalmechanisms, essentiallythrough the Stock Exchange, orinternal constraints whereshareholders and stakeholders use

their power of control within theformal and informal structures of thefirm.


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THANKS!!!

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Chapter 1. Corporate Governance and Busines Objectives

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