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Corporate Governance: The Role of
Boards and Institutional Investors
Prof. Igor Filatotchev
Session 2
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Aims and Objectives
• To introduce main concepts of the agency
framework
• To outline basic elements of various corporate
governance practices
• To link this discussion to the topics of subsequent
sessions and case analyses
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Incomplete Contracting• some issues that parties may face are not
predictable at the contracting date;
• even if all issues could be foreseen, there may be
too many issues to write into the contract;
• monitoring the behaviour of others may be costly;
• enforcing the contracts may involve considerable
legal costs;
• it is difficult to make a full account of different
factors linked to human behaviour
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Principal-Agent Relationship and
the Firm
• The Principal (shareholders) delegates to the
Agent (managers) the responsibility for selecting
and implementing an action (production of goods
and services). The Agent is compensated by the
Principal, with the Principal being the residual
claimant to the outcome of the Agent’s act (profits).
Berle, A.A. & Means, G. C. (1932) The Modern Corporation and Private Property.
NY: Macmillan
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“Agency Problem”• The bulk of the profits goes to the outside
shareholders
• All major decisions are taken by the corporate
officers (CEOs)
• The outside shareholders are unable to control the
corporate officers
• The interests of CEOs and shareholders may
diverge widely. Senior managers are in a position
to enrich themselves at the expense of the
shareholders
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Basic Problems of Information
Asymmetry
• Moral Hazard: the principal and agent share the same
information up to the point at which the agent takes an action, but thereafter the principal is only able to observe
the outcomes.
• Adverse Selection: the principal does not know some
information which is relevant to the action, whereas the agent can make use of this information to his own
advantage.
The essence of the Agency Theory is that the Principal has inferior information to the Agent.
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Agency Costs and the Firm
• CEOs may derive non-pecuniary benefits from their actions:
- managers’ perquisites
- maximisation of growth versus profits
- mergers and acquisitions
• Different risk attitudes:
- shareholders maintain a diversified portfolio of assets
- manager’s wealth is tied to a particular firm
- managers may be more risk-averse and, for example, under-invest in R&D and innovation
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“The directors of companies, being managers of other people’s money than their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own”
Adam Smith, “The Wealth of Nations”, 1776
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Case example: ‘Free Cash Flow’ and
big oil companies in the USA in the
1980s
Free Cash Flow: ‘Liquid financial assets for which investments in current businesses are no longer economically viable’
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Corporate Governance and Control
• Regulatory system (insider trading, ban on anti-
competitive activities, etc.)
• Product and factors markets
• The internal control system (Corporate Boards,
managerial hierarchy, etc.)
• The external control systems (take-overs, board
participation by banks, etc.)
Corporate Governance is the process by which society exerts some control on the corporation and corporate
managers through markets or regulatory system.
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• Annual General Meeting of Shareholders
• Board of Directors that include the representatives of the
owners and has the responsibility to oversee the direction of the organisation chosen by the CEOs
• Internal control is the process by which the Board
oversees the management of a corporation
• Incentive clauses in managers’ contracts (ESOs; LTIPs)
Shareholder activism - shareholders take an active role in
the firm’s operations and attempt to secure drastic changes in the organisation when performance declined.
“Shareholder Activism” and the Role of
Boards
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Principles of “Good Corporate
Governance“
• Separate the roles of Chairman and Chief Executive Officer.
• Not less than one half of the Board should be Non
Executive (Independent) Directors, and their independence and effectiveness should be strengthened.
• Establish committee dominated by Non Executive Directors and independent of management (e.g.,
nomination, audit and remuneration committees).
• Short-term contracts for executive directors, etc.
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• Nomination committee is responsible for
recruitment of executive and non-executive board
members. Should be independent from the
executives.
• Remuneration committee determines director’s
remuneration packages, including bonuses, ESOs
and LTIPS
• Audit committee oversees internal audit
processes and relationships with external auditors.
Board Committees
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• “CEO duality” is when the roles of CEO and
Board Chairman are combined
• Non-executive (UK) or independent (USA)
directors board members who are not employed
by the firm in any executive position, do not have
business links with the firm and not involved in any
long-term relationships with the executives
(friends, family, etc.)
• Senior Independent Director (SID) oversees the
relationships with main shareholders.
Board Independence
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Corporate Governance and “Market
for Corporate Control”
• accumulation of shares by a ‘core’ investor
• corporate take-over is initiated when the managers of one firm, the raider, make an offer for another firm, the target,
that is resisted by the management of the target
• leveraged buy-out (LBO) occurs when investors acquire a
relatively large proportion of the outstanding stock of a firm using debt.
Corporate governance through ‘exit’: shareholders can sell their shares in the company to someone else.
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“Does it Really Work?”
• AGM attracts a very small fraction of
shareholders (vote by proxy);
• Gathering of information is expensive and
time consuming
• Why to bother if you can benefit from the
result in any case?
The effectiveness of shareholder activism is generally reduced by a ‘free rider’
problem:
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Managerial Incentives
• Lack of complete information about the manager’s abilities
• Management is a team work, recognising the influence of a
single manager may be difficult.
• Performance-related pay and misrepresentation.
• There may be other personal utility-creating activities which seem to the manager superior to seeking performance
improvements in the firm.
The salary a potential manager can command is assumed to reflect performance
to date, but:
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Market for “Corporate Control”
• Anti-take-over strategy:
- ‘poison pill’
- ‘golden parachutes’
- ‘greenmail’, etc.
• Market for Corporate Control is an expensive and
ethically controversial mechanism of governance.
Most managers fear take-overs because of the implied or direct thereat to their
jobs, but:
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New Perspectives on
Corporate Boards• Monitoring and
control
• Resource and ‘legitimacy’
• Strategy/Service
• Access to resources
• Strategic leadership
• Strategic restructuring expertise
• Corporate venturing
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Corporate Governance and ‘Entrepreneurial Leadership’
• “Wealth protection” and “wealth creation” roles of corporate governance
• Resource and strategy roles of corporate boards
• Boards as a “knowledge pool”
• The new roles of non-executive directors
• Individual entrepreneurship, corporate venturing and
innovation
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From Board Structure to Board Processes
• Are structural characteristics (% of
independent directors, CEO/Chairman, etc)
really important? Conflicting evidence
• Emphasis on board processes (engagement,
involvement, support and advise)
• What should a Chairman do?
• Strategic roles of internal and external audit
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Learning Outcomes
• Corporate Governance theory is underpinned
by agency framework which is focused on
potential costs of the ”principal-agent” problem
• Information asymmetries and managerial
opportunism may destroy shareholders’ values,
and corporate governance is there to protect
shareholders’ interests
• However, there are other roles of corporate
governance that may include resource,
strategy and knowledge aspects.
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Reading
• Filatotchev & Wright (2005) various
• Monks, R.G. and Minow, N. (2004) various
• Cadbury, A. 2002 Corporate Governance and
Chairmanship: a Personal View. Oxford: OUP.
• Shleifer, A. and Vishny, R. 1997. ‘A Survey of
Corporate Governance’, Journal of Finance, Vol
52, No 2, June.
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Questions?