CORPORATE GOVERNANCE

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CORPORATE GOVERNANCE

• Corporate governance deals with ways in which
  suppliers of finance to corporations assure
  themselves of getting a return on their
  investment
• How do suppliers of finance get managers to
  return some of the profits to them?
• How do they make sure that managers do not steal
  the capital they supply or invest it in bad
  projects?
• How do suppliers of finance control managers?

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• Corporate governance mechanisms are economic and
  legal institutions that can be improved through
  political decisions
• Corporate governance systems in developed
  economies differ (e.g., US/UK with widely
  dispersed ownership compared to Germany/France
  with concentrated ownership)
• Less developed and developing economies can
  significantly improve their corporate governance
  systems

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• Couldnt the product market solve any corporate
  governance problems?
• In other words, shouldnt inefficient firms fail
  or experience a decrease in the amount of capital
  supplied to them?
• Yes, but the product market still does not
  prevent managers from expropriating funds after
  the amount of capital is invested

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THE AGENCY PROBLEM

• The main issue in corporate governance is to
  address the agency problem
• Suppliers of finance (shareholders/owners) are
  the principals who need to monitor the
  managers, referred as the agents, to ensure
  that they receive the expected return on their
  investments

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• The agency problem is known as the separation of
  ownership and control issue
• Principals own the firm
• However, agents may have more control on the
  decision-making process
• Most modern corporations are organized in this
  way shareholders are not the managers
• In some cases, owners are also the managers
  (e.g., a family business)

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HOW DOES THE AGENCY PROBLEM ARISE?

• Suppose an entrepreneur has a great idea and
  raises money from investors to implement it
• Investors need the entrepreneur (also manager) to
  run the business due to her knowledge of the
  idea
• Suppose also that the manager does not have
  enough funds and needs the investors

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• How can the investors be sure that their funds
  will not be wasted on unprofitable projects?
• One solution is for the two parties to write a
  contract that explicitly states
• What the manager can and cannot do with the funds
• How the returns from the investment are divided
  between the manager and the investors

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• The problem with this solution is that, in an
  incomplete world (when we cannot cover any
  possible scenario in the contract), there is
  uncertainty about all possible future states of
  the world
• E.g. if the company considers expanding into a
  new market overseas, due to favorable demand
  conditions, who makes that decision?
• Thus, the owners and the manager must allocate
  residual control rights

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• This means that they must agree, a priori, as to
  who will have the right to make decisions as to
  what the firm can and cannot do (e.g., investment
  decision)
• Other examples may involve the way the company
  will raise additional funds (financing decision)
  or allocate its profits (payout decision)
• One way to solve the problem of residual control
  rights is for the owners to keep these rights
  (owners always make the decisions)

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• The problem is that the manager knows a lot about
  the business and the owners need the managers
  knowledge
• Thus, the manager ends up having a lot of those
  residual controls and, as a result, discretion
  as to how funds will be allocated
• Another problem is that any contract between the
  owners and the manager must be simple enough to
  be enforced by courts

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• Also, if the funds are collected from many
  investors, they may be too small and poorly
  informed to deal with the manager
• Managers can then expropriate funds by, for
  example
• Transfer funds to businesses of their relatives
• Consume perquisites (drive fancy cars and have
  fancy offices, etc.)

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• Try to expand the business beyond its scope for
  personal benefits (e.g. empire-building through
  mergers, etc.)
• Expropriate investors by making it difficult for
  owners to replace them
• Hidden agency problems (cronyism, nepotism,
  racism, etc.)

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HOW CAN WE SOLVE THE AGENCY PROBLEM?

• Corporate governance deals with finding optimal
  mechanisms that
• Will give managers incentives to put constraints
  on themselves
• Will allow owners to put constraints on the
  managers
• In this case, owners funds will not be
  misallocated ex post (after they have financed
  the firm)

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• Thus, owners will have an incentive to supply
  funds ex ante
• A few such mechanisms are
• Performance-based pay for the CEO
• The role of the Board of Directors
• The role of major shareholders
• Takeovers

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• Shareholders often do not know what actions the
  CEO can take or which of these actions will
  increase shareholder wealth
• In this case, the CEO compensation can be
  designed in a way to give the CEO incentives to
  maximize shareholder wealth
• Note that CEOs have the incentive to decide on
  taking a certain action by simply comparing the
  benefits and costs to themselves

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• Some mechanisms that align the CEOs incentives
  with the interests of shareholders are
• performance-based salary and bonuses revisions
• stock options
• performance-based dismissal decisions

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• The Board of Directors should represent the
  interests of shareholders and monitor the CEO and
  top management
• The BOD plays a governance role by
• writing top managements employment contracts
• evaluating and ratifying proposals for major
  decisions of strategic importance
• replacing top management

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• However, CEOs participate in the BOD and, often
  times, have considerable influence on who sits on
  the board and how the members decide
• There are three types of directors on the board
• inside directors
• gray directors
• outside directors

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• The corporate governance role of the board
  improves with more outside directors
• Board members are often unwilling to stand up to
  the CEO because they
• Value old friendships, connections, and a
  harmonious atmosphere
• Try to avoid a reputation of being a trouble
  maker
• Try to avoid being asked to resign, since
  directors who disagree with the majority of board
  members may be asked to leave

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• Also, major shareholders (controlling 10 or 20
  percent of the firm) can play a role in corporate
  governance and they often sit on the BOD
• Large shareholders have an incentive to collect
  information about the firm and the CEO and
  monitor managements activities
• Large shareholders can exercise their role only
  if their voting rights are legally protected

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• This corporate governance mechanism is stronger
  in countries with strong legal systems
• In the US, large (institutional) shareholders
  make management turnover more sensitive to
  performance
• E.g., CALPERS monitors firms in its portfolio and
  firms that are on the list of monitored firms
  for bad performance see their share prices rise

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• In countries where large shareholders are
  uncommon (US and UK), another corporate
  governance mechanism is hostile takeovers
• Hostile takeovers typically target poorly
  performing firms whose management is then
  replaced
• Thus, the threat of a hostile takeover will
  convince managers to align their decisions with
  shareholders interests