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Corporate Governance Introduction: Ask not only “Can I do this?” but “Should I do this?” Early definition → (Indefinable term)

Corporate Governance is the system by which companies are directed (policies, management) and controlled (boundaries, limits) Its principles identify the distribution of rights and responsibilities among the Participants Participant stakeholders are: o board of directors (strategic, long-terms decisions, guardians of shareholder interest that chose them) o managers o shareholders (effective owners of the company. Today tendency to separate ownership and management)

o auditors (guarantors) o employees o creditors o suppliers o customers o consumers o regulators o community o and other stakeholders

Institutional investors lend in the company and receive a share of, it. They don’t have right to vote. Board of directors represent the interests of shareholders and control and help management Legislation can limit, regulate and facilitate corporations’ activity Societal stakeholders: interests growing because parts in play are increasing

Roles Boards of directors are responsible for the governance of their companies. The shareholders’ role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place Other def. Corporate governance describes the framework of rules, relationships, systems and processes within and by which authority is exercised and controlled in corporations. The expression ‘corporate governance’ embraces not only the models or systems themselves but also the practices by which that exercise and control of authority is in fact effected. The system of regulating and overseeing corporate conduct and of balancing the interests of all internal stakeholders and other parties (external stakeholders, governments and local communities) who can be affected by the corporation’s conduct, in order to ensure responsible behaviour by corporations and to achieve the maximum level of efficiency and profitability for a corporation A discipline in constant evolution: Overall, corporate governance continues to evolve. The metamorphosis () has yet to occur. Present practice is still rooted in the 19th century legal concept of the corporation that is totally inadequate in the emerging global business environment Why do we need C.G.? To prevent and solve possible conflicts of interest between participant stakeholders 2 live debate:

Why do we need C.G? (To prevent) • Corporate collapses, insolvency or bankruptcy of major business enterprises (e.g. Enron, MCI) • Corporate scandals, unethical behaviours by people within an organization (e.g. Madoff and the Ponzi scheme)

MANAGEMENT: They basically manage the company (CEO, Executives, Employees) GOVERNANCE: Owner, Board and CEO have governance of the company The CEO is in the middle. He takes care of governance and management. Board of director, CEO and executives run the company. Who actually initiate strategies? Strategies could be taken following a bottom-up or a top-down approach. If the company is managed properly, targets are aligned.

Who chose the CEO? The board of directors, but also the executives indirectly, because if they do not support the CEO and make troubles to him, he will be taken out. Thus, the CEO should appeal with both Board of director and executives.

TIMELINE OF ALL CORPORATIONS IN THE WORLD

OWNERS IPO PE VCs MF BAs

FINANCIAL ADVISORS INSTITUTIONAL INVESTORS ↓ returns FUND MANAGEMENT ↓ risk

FFF

BOARD OF DIRECTORS ↑ risk

OWNER CEO

↑ returns ↑ % interest to lend money

↓ % interest to borrow money: cheap capital

At the beginning, owner and CEO are the same person. The owner can only think about his business, it’s in his blood. In the last stage, we find many actors: - owners - financial advisors - institutional investors - fund management - board of director - CEO At this stage the owners don’t even know how the business is run. They face directly with financial advisors that advise to which investors they should put money. At this stage who takes care? Institutional investors only care about performances. Board take care in a professional manner, related with reputation. They do this role additionally. The CEO takes care? Many only care about money. They sometimes take care at the beginning and then their attention falls down. All that people at the end are working on a fee or bonus/salary, that is not necessarily directly related to company performance. How does company raise capital? FFF → Bas → Mentoring funding → VC Then it keeps growing → Private Equity That means more money and more complexity, but also less risk. Then the company decide to go to the public → IPO → it needs a board of directors. The cost of capital in stage 1 is higher than in 2, when the risk falls ↓. But also Returns ↓ (as dividends, ROI ecc)

What happens when performance ↓ ? → a % of the company is sold to private equity. They run revision to fix problems and then margin returns profitable → PE sells, and investors will buy %. It is therefore a dynamic cycle Following the legislation, in USA members of boards cannot know about business, so they may not be suppliers, lawyer, etc. The aim is to bring to board people less “contaminated”. This is best for US law, however, sounds weird in Asia and UE. We have 2 type of board: - supervision boards - operational boards and their committee Boards member chose the CEO. Who chose the members of the board?

02. Historical evolution of corporations Roots of CG: Early merchants and first monopolies Word Origin: Ancient Greek - “Corporate governance” appears only in 1980s - However, Shakespeare understood the problem in the 16th century (The Merchant of Venice, c.1596-1599) 1720: South sea bubble first financial bubble - influence - chamber of Tor could change -> negligence and intentionality Speculation -> pyramidal effect Many nobles ruined, in bankrupt, prison or workhouses Separation of ownership from operations XIX century • 1807 Société en commandité par actions à limited liability of external investors, unlimited liability of executive directors • 1855 & 1862 British Companies Acts à limited liability of all stakeholders

XX century › Companies grow big and complex › First stock exchanges › Management ← → Investors 1970s – years of regulations Examples of Corporate Governance regulators: • SEC (Securities and Exchange Commission) – aims to protect US investors by requiring listed companies to facilitate capital information (EDGAR database). • Companies House – central registry for all companies registered in the UK. • Colegio de Registradores (The Spanish Business Registrar) – collects information on over 800 000 firms, provides detailed statistical information and credit reporting on SMEs.

• Stock exchange listing rules – set of standards for the behaviour of public companies, including disclosure of information, meetings, rules of composing the Board, internal audit, voting right of stockholders etc. • USA - SEC recommends public companies to create audit committees (1972) • Europe – EEC proposed that two-tier boards are promoted (executive directors in management board decided about company’s objective and implement necessary measures, and non-executive directors in the supervisory board monitor decisions on behalf of other parties). • UK – Accounting standards steering committee produced The Corporate Report (1975) – all economic entities must report publicly and accept accountability to all those whose interests were affected by the directors’ decisions. 1980s – years of deregulations • State-run entities privatization • Deregulation of financial market • Drexel Burnham Lambert, Nomura Securities, Rothwells Ltd., Guinness collapses. • Increasing pressure on Boards of Directors 1990s: corporate governance codes arrive (as consequence of 80s’ deregulation) Cadbury Report (1992): • Wider use of independent directors defined as being “independent of management and free from any business or other relationship which could materially interfere with the exercise of independent judgment, apart from their fees and shareholding”. • Introduction of audit committee of the board with independent members • Division of responsibilities between the CEO and the Chairman • Use of remuneration committee of the board • Reporting publicly that the CG code had been complied with or, if not, explaining why. OECD (Organization for Economic Co-operation and Development) – global guidelines on corporate governance (1998) • Emphasis on contrast between the strong external investment and CG practices in the US and UK, and those in Japan, Germany and France, with less demanding governance requirements Early 21st century: reactions to more corporate collapses • Sarbanes-Oxley Act (2002) • Requires executives to certify accuracy of financial statement personally (20 years of jail) • Requires hiring independent auditors to review accounting practices • Prohibits external auditors from doing consulting work for their auditing clients. • Protects employees that report fraud and testify in court against their employers • Was a response on the lack of liability of corporate executives, which made it difficult to prosecute them

Corporate governance theories

The agency dilemma How to ensure that the executives (agents) act solely in the interests of investors/owners (principals)? Agency theory If both parties are utility maximizers there is good reason to believe that the agent will not always act in the best interests of the principal. Therefore they cannot be trusted. Agency Theory: top managers in large corporations as agents whose interests may diverge from those of their principals, the shareholders, as both parties are utility maximizers. More control = less losses for the principal Stewardship theory Directors’ legal duty is to their shareholders, not themselves, nor to other interest groups. They do not inevitably act in a way that maximizes their own personal interests: they can and do act responsibly with independence and integrity. Therefore they can be trusted. Stewardship Theory: top managers are not motivated by individual goals, but rather are stewards whose interests are aligned with the objectives of their principals. Stakeholder perspective Questioning of the role of major corporation in society. Directors must be accountable to a wide range of stakeholders (not only shareholders), which would be the price that the society demands from companies for the privilege of incorporation, and granting shareholders with limited liability for the company’s debts. … but … can a company be accountable to all stakeholders at a time?

Agency Theory 200 years of economic research: an economic model of man     

Based on rational behaviour Both agents and principals seek to receive maximal utilities with minimal expenditure Ownership and control increasingly diverge as modern corporations exceed individual capital contribution Owners become principals when they contract with executives to manage firms for them. They delegate control As an agent, an executive is morally responsible to maximize shareholder utility, but executives may accept the agent role as an opportunity to maximize their own utility.

When agency costs appear…  

If both utilities coincide, there is no agency problem, both maximize their wealth Agency costs are incurred by the principals when both interests diverge, because given the opportunity, agents will rationally maximize their own utility at the expense of their principals

Principals do not know ex-ante which agents will self-aggrandize so they have to set limits to their potential losses  The objective in agency theory is to reduce agency costs to the principals by imposing controls Internal and external control mechanisms 

 

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If managers entrench themselves with the sole objective of ensuring their own power, the organisation is likely to lose sight of its competitive position and will fail If the internal control mechanisms proposed by the agency theory fail, more expensive external control mechanisms (acquisitions, divestitures, etc.) will emerge to control self serving managers Internal mechanisms are preferred as they are less costly than external ones

Agency governance mechanisms Two mechanisms: 1) Alternative executive compensation schemes: rewards and punishments to align principal-agent interests. Particularly useful when the agent has informational advantage 2) Governance Structures: Boards of Directors keep potentially self-serving executives in check by performing audits and performance evaluations. Also nonmanagement boards ensure that proper management oversight occurs …given the opportunity…

Assumptions for Stewardship Theory Other types of human’s behaviour Rooted in psychology and sociology; situations in which executives as stewards are motivated to act in the best interests of their principals Behaviours (> = higher utility) Pro-organizational, collectivistic > individualistic, self-serving Co-operation > Defection (game theory) The organization over the individual   

The steward seeks to attain the objectives of the organization (profits, etc.) This behaviour in turn will benefit principals (owners and super-ordinates) A steward protects and maximizes shareholders’ wealth through firm performance, because by doing so, the steward’s utility is maximized

The more you empower stewards, the more will be company's utilities less control -> less money

Why do not chose the cheapest? Because the risk. It's risky to a person if you don’t trust in it. The steward’s motivation      

A steward behaviour is organizationally-centred Stewards are motivated to make decisions in the best interest of the group and improve organizational performance Stewards believe their interests are aligned with that of the corporation and its owners If the executive’s motivations fit the stewardship theory, then empowering is appropriate A steward’s autonomy should be deliberately extended to maximize the benefits of a steward because he/she can be trusted: CEO chairing the Board of Directors Less control is better and cheaper as the executive’s interests are aligned with those of the principals

Stewardship Theory Risk aversion from the owners 2 alternative approaches: Facilitate and empower (st.) vs. monitor and control (ag.) Why not the cheapest (st.) one? Because of the owners’ risk aversion Or even better, why ever take risks (ag.)? Because, research shows mixed findings Factors that differentiate both theories - Psycological: motivation Simon vs. Argyris (Maslow) Extrinsic motivation (ag.) tangible commodities, self-serving… vs. intrinsic motivation (st.) growth, achievement, collective-serving… - Psychological: Social comparison, Identification - Economic or class-related separation between principal and agent. Fairness is compensation - Identification with the corporate mission, vision and values. Membership and affiliation. He/she takes comments about the organization personally. - A manager who identifies with the organization will work to achieve its goals, overcome barriers and solve its problems: they want it to succeed - Psychological: Power Agency: coercive, institutional/organizational power (derived from the position of the principal in the organization). Reward and control Stewardship: personal power, interpersonal relationship, not affected by position Power type used depends on the personal characteristics and the organizational culture

- Situational Mechanisms: Management Philosophy, Time frame, Risk-orientation Control-oriented vs. involvement-oriented Control: short-term, cost control, productivity, not sustainable long term. Ok in hard situations because of low turnover. + Risk-> + Control Involvement: environment is changing and control-oriented approaches are less viable, performance enhancement + Risk-> + Empowerment - Situational Mechanisms: Cultural Differences, Individualism vs. Collectivism Individualism vs. Collectivism: nations and regions differ in this approach: - USA, Canada, W.EUR-> Individualism. - ASIA, LA, S.EUR ->collectivism In collectivist cultures, the self is part of the group. Memberships are an important part of identity. Members are identified by family names, harmony, group success. Long-term relationships…get to know, trust, handshake (STEWARDSHIP) In individualist cultures, rational, short-term, non-personal, cost-benefit analysis, contract (AGENCY) - Situational Mechanisms: Cultural Differences, Power Distance High power distance culture accepts well the difference in power: obedience, discipline, dependency, privileges and status symbols are popular Low power distance culture is more egalitarian, independence is encouraged and class symbols criticised

Conclusions Agency theory to explain conflicts between agent and principal However, managerial behaviour and motivation is often more complex Hence, the stewardship theory, derived from psychological and sociological traditions

04. Shareholders’ rights, duties and responsibilities Company’s incorporation - Normally with an indicator (Inc./Corp./Co./ S.A.) - Tend to be registered in the states/autonomies with a low corporate tax and/or court system sympathetic to Boards. - Societas Europaea (SE) –– (European company) a company registered in accordance with the corporate law of the European Union (2004) - Can be private or public: • Public companies – offers shares to the general public. Not all public companies are listed in a stock exchange, but all listed companies must be public and meet listing requirements. • Private company – cannot offer its shares to general public. Requirements are not as demanding as those for public companies. Classes of Shares - Ordinary shares (one vote per share) no special rights to vote. Ranked after preferred in getting dividends. Some companies have categories of ordinary shares (A, B, C, etc.) - Non-voting shares (no right to vote and, sometimes, to attend meetings)

- Preferred shares (have a preferential right to a fixed amount of dividends expressed as a % of nominal value of the share) preferred shares give a preference in paying dividends. Normally they do not have voting rights - Deferred ordinary shares (no dividend will be paid until other classes of shares have received a minimum dividend) subtype of ordinary NOT paying dividend after other have received. Even in case of liquidation. - Management shares (extra voting rights so as to retain control of the company in particular hands, e.g. through multiple votes per each share) – often issued by original owners Shareholders’ rights - Are determined by a company’s law, and depend on terms of issues of the shares, and their types - Right to attend general meetings and vote (depending on shares’ class) - Once they have voted, they can’t influence the company’s day-to-day management - Share of the company’s profits (dividends) - Copy of the company’s annual accounts - Right to sue the company Holding a chare entitle you to: 1. part of the corporation (no debt) 2. dividends if ...profit (based on agreement) There's gonna be an agreement. It depends of shat shares you own 3. to sell it (may be could be some conditions) 4. information. Annual report. Financial information 6. voting rights (through voting you can governate the company) 7. Appoint outside 8. Actual generl meetings and shareholder meetings 9. you are entitled to know management salaries and benefits 10. sue the company

Shareholders’ right to information - Financial and operating results of the company - Company objectives and non-financial information - Major share ownership, beneficial owners and voting rights - Remuneration of Board members - Board members’ information - Foreseeable risk factors - Issues regarding employees and other stakeholders Shareholders’ dilemma - Shareholders’ activism: Shall

we allow...