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CORPORATE GOVERNANCE

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Corporate governance mechanisms are economic and legal institutions that can be ... Couldn't the product market solve any corporate governance problems? ... – PowerPoint PPT presentation

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Title: CORPORATE GOVERNANCE


1
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?

2
  • 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

3
  • 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

4
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

5
  • 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)

6
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

7
  • 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

8
  • 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

9
  • 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)

10
  • 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

11
  • 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.)

12
  • 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.)

13
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)

14
  • 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

15
  • 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

16
  • 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

17
  • 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

18
  • 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

19
  • 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

20
  • 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

21
  • 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

22
  • 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
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