Corporate Governanace

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Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012

International Corporate Governance

Defining Corporate Governance and Key Theoretical Models

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Lecture Aims

This lecture aims to introduce you to the subject area of corporate governance.

The lecture discusses the various definitions of corporate governance, reviews the main objective of the corporation and explains how corporate governance problems change with ownership and control concentration.

The lecture also introduces the main theories underpinning corporate governance.

While this course focuses on stock-exchange listed corporations, this lecture also discusses alternative forms of organisations such as mutual organisations, cooperatives and partnerships.

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Learning Outcomes

By the end of this lecture, you should be able to:1. Contrast the different definitions of corporate

governance2. Critically review the principal–agent model3. Discuss the agency problems of equity and

debt4. Explain the corporate governance problem

that prevails in countries where corporate ownership and control are concentrated

5. Distinguish between ownership and control.

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The Basics

In what follows, we focus on stock-exchange listed firms.

These firms are typically in the form of stock corporations that have equity stocks or shares outstanding.

Stocks or shares are certificates of ownership that frequently confer control rights, i.e. voting rights.

Voting rights enable their holders, the shareholders, to vote at the annual general shareholders’ meeting (AGM).

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The Basics (Continued)

Voting shares confer the right to appoint the members of the board of directors.

The board of directors is the ultimate governing body within the firm.

Its role, in particular that of the non-executive directors, is to look after the interests of all the shareholders.

It may also look after the interests of other stakeholders such as the employees and the firm’s creditors.

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The Basics (Continued)

More precisely, it is the non-executives’ role to monitor the firm’s top management, including its executives.

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Defining Corporate Governance

Most definitions are based on implicit or explicit assumptions about the main objective of the firm.

However, there is no universal agreement as to what this objective should be.

For example, Andrei Shleifer and Robert Vishny define corporate governance as “the ways in which suppliers of finance assure themselves of getting a return on their investment”.

This definition assumes that the main objective of the firm is to maximise shareholder value.

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Defining Corporate Governance (Continued)

They justify this focus by the argument that investments in the firm by the shareholders (as well as the debtholders) are sunk funds.

In contrast, the other stakeholders can easily walk away from the firm without losing their investments.

Hence, the shareholders are the residual risk bearers or the residual claimants to the firm’s assets.

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If the firm enters financial distress, the claims of all the other stakeholders will be met first before the claims of the shareholders can be met.

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In contrast, Marc Goergen and Luc Renneboog’s definition allows for differences across countries in terms of the main objective of the firm:“A corporate governance system is the combination of mechanisms which ensure that the management … runs the firm for the benefit of one or several stakeholders... Such stakeholders may cover shareholders, creditors, suppliers, clients, employees and other parties with whom the firm conducts its business.”

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For example, German corporate law explicitly includes other stakeholder interests in the firm’s objective function.

The German Co-determination Law of 1976 requires firms with more than 2,000 employees to have half of the supervisory board seats held by employee representatives.

Figure 1 – Whose company is it?

Notes: The number of firms surveyed is 50 for France, 100 for Germany, 68 for Japan, 78 for the UK and 82 for the USA.Source: Yoshimori, M. (1995), “Whose Company is It? The Concept of the Corporation in Japan and the West”, Long Range Planning 28, p.34.

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A more neutral definition is that corporate governance deals with conflicts of interests between– the providers of finance and the managers;– the shareholders and the stakeholders;– different types of shareholders (mainly the large

shareholder and the minority shareholders)

and the prevention or mitigation of these conflicts of interests.

This is the definition adopted by this module.

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Corporate Governance Theory

“It is in the interest of every man to live as much at his ease as he can; and if his emoluments are to be precisely the same, whether he does, or does not perform some laborious duty, it is certainly his interest, at least as interest is vulgarly understood, either to neglect it altogether, or, if he is subject to some authority which will not suffer him to do this, to perform it in as careless and slovenly a manner as that authority will permit.”

Smith, A. (1776), An Inquiry into the Nature and Causes of the Wealth of Nations, reprinted in K. Sutherland (ed.) (1993), World’s Classics, Oxford: Oxford University Press.

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Corporate Governance Theory (Continued)

This quote illustrates the conflict of interests that may exist between an agent and the agent’s principal.

Michael Jensen and William Meckling formalised these conflicts of interests in their principal–agent theory.

While the agent has been asked by the principal to carry out a specific duty, the agent may not act in the best interest of the principal once the contract has been signed.

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The agent may rather prefer to act in his own interest.

Economists call this moral hazard. Moral hazard is not just an issue in corporate

governance, but it is also a major issue for insurance companies.

One way of addressing principal–agent problems is via so called complete contracts.

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Complete contracts are contracts which specify exactly what– the managers must do in each future contingency of the

world; and– what the distribution of profits will be in each

contingency. In practice, contracts are unlikely to be complete as

– it is impossible to predict all future contingencies of the world;

– such contracts would be too complex to write; and– they would be difficult or even impossible to monitor and

reinforce by outsiders such as a court of law.

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A necessary condition for moral hazard to exist and for complete contracts to be impossible is the existence of asymmetric information.

Asymmetric information refers to situations where one party, typically the agent, has more information than the other party, the principal.

If both parties had access to the same information at all times, then there would be no moral hazard problem.

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Moral hazard exists because the principal cannot keep track of the agent’s actions at all times.

Even ex post, it is sometimes difficult for the principal to judge whether failure is due to the agent or external circumstances.

Jensen and Meckling’s principal–agent model also assumes that there is a separation of ownership and control.

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Adolf Berle and Gardiner Means were the first to point out this separation in their 1932 book The Modern Corporation and Private Property.

A firm starts off as a small business, fully owned by its founder, typically an entrepreneur.

At this stage, there are no conflicts of interests as the entrepreneur both owns and runs the firm.

As the firm grows, it becomes more and more difficult for the entrepreneur to provide all the financing.

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Eventually, the entrepreneur will need to raise outside finance.

Once outside finance has been raised, the entrepreneur’s incentives to work hard have been reduced.

Ultimately, the entrepreneur will sell out and the firm ends up being run by professional managers on behalf of its shareholders.

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Hence, there is a clear division of labour in the modern corporation with– the manager, the agent, having the expertise to run

the firm, but not the funds to finance it; and– the shareholders, the principal(s), having the

required funds, but not the skills to run the firm.

In practice, control lies with the managers who run the day-to-day operations of the firm whereas the firm is owned by the shareholders.

Hence the separation of ownership and control.

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However, the agent may prefer to run the firm in his own interests rather than those of the principal.

This is the principal–agent problem (agency problem).

The main consequence of this problem is agency costs.

These are the sum of– the monitoring expenses incurred by the principal;– the bonding costs accruing to the agents; and– any residual loss.

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Agency Problems

The two main types of agency problems are– perquisites and– empire building.

Perquisites or perks consist of on-the-job consumption by the managers.

While the benefits from the perks accrue to the managers, their costs are borne by the shareholders.

Examples of perks are CEO mansions financed by the firm and personal usage of corporate jets.

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Agency Problems (Continued)

The former CEO of Tyco International had his company fund his wife’s 40th birthday party in Sardinia at a cost of US$1 million.

“Former Merrill CEO John Thain spent $1.2 million to renovate his offices, including installation of a $35,000 toilet.”Source: The Gazette, 28 March 2009, p. B1.

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While perks can cause public outrage, especially when they are combined with lacklustre performance, they tend to be modest compared to empire building.

Empire building consists of managers pursuing growth rather than shareholder-value maximisation.

While there is a link between the two, growth does not necessarily generate shareholder value and vice-versa.

Empire building is also referred to as Jensen’s free cash flow problem.

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The free cash flow problem consists of managers investing beyond the point where investment projects earn an adequate return given their risk.

So why would managers be tempted by empire building?

Managers derive benefits from increasing the size of their firm.

Such benefits include increased power and social status.

Managerial remuneration has also been shown to depend on firm size.

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Agency Problems of Debt and Equity

So far, we have focused on the agency problem of equity, i.e. the agency problem between the managers and the shareholders.

However, there also exists an agency problem of debt.

When there is very little equity left (e.g. when the firm is in financial distress), the shareholders may be tempted to gamble with the debtholders’ money.

They may do so by investing the firm’s funds into high-risk projects.

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Agency Problems of Debt and Equity (Continued)

If the project fails, the major part of the costs will be borne by the debtholders.

If the project is successful, most of its payoff will go to the shareholders given that the debtholders’ claims have a limited upside.

Figure 2 – Firm value

Value of debt

Value of equity

Financial Firm value distress

Value of debt andequity

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Agency Problems of Debt and Equity

Jensen and Meckling argue that, given that there are agency costs from both debt and equity, there is an optimal mix of debt and equity which minimises the sum of the agency costs of debt and equity.

Figure 3 – Agency costs of debt and equity

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The Expropriation of Minority Shareholders

The principal–agent model is based on the Berle-Means premise that, as firms grow, ownership eventually separates from control.

However, this is only an accurate description of the Anglo-American system of corporate governance.

In the rest of the world, most stock-exchange listed firms have large shareholders exerting significant control over the firm.

Hence, the main conflict of interests is between the large shareholder and the minority shareholders.

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Minority shareholders may face the danger of being expropriated by the large shareholder via e.g.– tunnelling;– transfer pricing;– nepotism; and– Infighting.

Tunnelling consists of the large shareholder transferring the firm’s assets or profits into his own pockets.

The Expropriation of Minority Shareholders (Continued)

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The large shareholder may also expropriate the minority shareholders via transfer pricing, i.e. by overcharging the firm for services or assets provided.

Tunnelling and transfer pricing involving the large shareholder are also sometimes referred to as related-party transactions.

Large shareholders may be even more tempted to engage in related-party transactions in the presence of ownership pyramids.


Figure 4 – Expropriation of the minority shareholders by the large shareholder

Large shareholder

Firm A Firm B

51% 100%

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Figure 5 – Leveraging control and increasingthe potential for expropriation

Large shareholder

Holding Co. Firm B

51%

51%

100%

Firm A

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Other forms of minority shareholder expropriation include nepotism and infighting.

Nepotism consists of the large family shareholder appointing family members to top management positions rather than the most suitable candidates on the job market.

Infighting may not necessarily be a wilful form of expropriating the firm’s minority shareholders, but nevertheless is likely to deflect management time as well as other firm resources.


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Nepotism

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Alternative Forms of Organisation andOwnership

The main alternative to the stock corporation is the mutual organisation.

A mutual organisation is owned by and run on behalf of its members.

For example, a mutual bank is owned by its savers and borrowers.

Both stock corporations and mutual organisations are likely to suffer from the principal–agent problem.

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Alternative Forms of Organisation andOwnership (Continued)

However, this problem may be more severe in mutual organisations given that stock corporations benefit from a range of mechanisms that mitigate agency problems.

These include– the threat of a hostile takeover– monitoring by large shareholders– ownership of stock options and stocks by managers

and employees– a market price for the stocks.

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As each member of a mutual organisation has only one vote, this prevents the emergence of powerful owners.

Through the 1980s/90s, a number of UK mutual building societies went through a demutualisation.

They changed their legal status to a stock corporation and applied for a stock exchange listing.

At the time, it was thought that this would result in a major improvement in the efficiency of these organisations.


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However, roughly 20 years later several of the demutualised building societies had to be nationalised as a result of the subprime mortgage crisis.

Northern Rock was the object of the first bank run on a British financial institution for more than 150 years.

Overall, it is still unclear which of the two organisational forms is superior.


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One of the potential benefits of the mutual form is that it avoids conflicts of interests between owners and customers.

These conflicts tend to be severe for long-term products and services as the owners may be tempted to expropriate the customers.

For these products and services the mutual form is superior as it merges the functions of owner and customer.


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While mutual organisations are not subject to the disciplining role of the stock market, they have their own disciplinary mechanism.

The members of a mutual organisation are allowed to withdraw their funds at any time.

Such withdrawals reduce the financial basis of the mutual.

In contrast, stock corporations do not see their funds shrink when shareholders sell their shares.


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Some commercial organisations are in the form of partnerships and owned by their employees– Goldman Sachs– John Lewis Partnership.

Sanford Grossman, Oliver Hart and John Moore’s theory of property rights predicts when employees should have ownership of their firm.

Employees should be given property rights if they have to make investments in their human capital which are highly specific (idiosyncratic) to the firm.


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Defining Ownership and Control

Ownership is defined as ownership of cash flow rights.

Cash flow rights give the holder a pro rata right to the firm’s assets and earnings.

Control is defined as ownership of control rights.

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Conclusions

The link between the objective of the firm and the definition of corporate governance.

The principal–agent model. The expropriation of minority shareholders. Conflicts of interests as the definition of

corporate governance adopted by this module. Ownership versus control.

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Corporate Governanace

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