2020 FM101 Lecture 7 Ch2 cor gov for stud PDF

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Introduction FM101

Lecture 7 : Corporate Governance Lent Term 2020 Dr Elisabetta Bertero Reading: Finance (2020)textbook, Chapter 2

Inthelecturessofarwehavelookedatfinancial decisionsfromtheperspectiveofindividual firmsandhouseholds. Inthenext threelectureswelookatthreetopics thatrequireabroader perspective.

Recommended optional reading for those who are interested: 2015 paper by Andy Haldane (Bank of England Chief Economist) “Who owns a company?” posted on Moodle FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 1

Lecture7:Overall corporatefirmlevel

FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 2

Lecture7.Corporategovernance Motivationandquestions • Corporategovernance

Lecture8:Overall • Functionsofthefinancial financialsystemlevel system Lecture9:Overall financialmarkets level

• Financialinstrumentsand financialinstitutions

Lecture10:Global systemicrisklevel

• Financialcrises:2007and Eurozone2010 FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 3

• Howdofirmsorganise andgovern themselves inordertofulfiltheirobjectives? • Howisthepursuingoftheobjectives (performanceofthefirm)monitored? • Thisiswhatisstudiedintheareaofcorporate governance FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 4

Lecture7.CorporateGovernance Overview 1.FormsofBusinessLegalOrganisation 2.Conflictsofinterestandagencytheory 3.Firms’stakeholders 4.InternationalCorporateGovernance • A.Investorprotection • B.Controlmechanisms • C.Codesofcorporategovernance

5.Differenttypesoffinancialsystems

1.Types ofcorporatefirms Partnership

LimitedCorporation

• Easytoform • Requiresapartnership agreement • Limitedandunlimited partners • Partnershipisterminated whenapartnerdiesor leavesthefirm • Difficulttoraisecash • Profitstaxedaspersonal income • Controlledbygeneral partners– sometimes votesarerequiredon majorbusinessdecisions

• Articlesand Memorandumof IncorporationRequired • LimitedLiability • Profitstaxedatcorporate taxrate • BoardofDirectors • Lifeofcompany hypotheticallyunlimited

SoleProprietorship • OwnedandManagedby oneperson • Veryeasytoform • Profitstaxedaspersonal income • Unlimitedliability • Lifeofcompanylinkedto lifeofowner • Amountoffundingis limitedbyowner’s personalwealth

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Information requiredforLtd ArticlesofIncorporation

MemorandumofAssociation

• Nameofthecorporation. • Intendedlifeofthecorporation(it maybeforever). • Businesspurpose. • Numberofsharesthatthe corporationisauthorizedtoissue, withastatementoflimitationsand rightsofdifferentclassesofshares. • Natureoftherightsgrantedto shareholders. • Numberofmembersoftheinitial boardofdirectors.

• Therulesbywhichthecorporation isorganised

FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 6

Organizationofthecorporation: TheBoardofDirectors– SingleTier Countries Chairman/ Chief Executive

Directors

FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 7

• OBJECTIVE:maximisation ofshareholders’wealth • (stakeholders’interests)

Non‐ Executive Directors FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 8

TheBoardofDirectors– Two‐TierCountries

Unitaryvs DualBoardStructures

Directors

• BoardReportsto Shareholders • Shareholderselect directorsatAGM • Directorsnominate/hire managers

Non‐Executive Directors

Liquidityand Marketability VotingRights Taxation

• Partnership:RestrictedTrading • Corporation:Tradedeasilysometimesonstock exchange

• Partnership:Partnershavecontrol • Corporation:Eachsharegivesavotingright

• Partnership:Profitstaxedatpersonaltaxrate • Corporation:Profitstaxedatcorporatetaxrate

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• Boardreportsto supervisoryboard • Supervisoryboardelects directors • Supervisoryboardconsists ofrepresentativesfrom banks,government,trade unions,otherstakeholders

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Financialimplicationsofdifferenttypesof firms:Partnershipsvs Corporations

Two‐Tier

Chairman/Chief Executive

Unitary

Supervisory Board

Partnershipsvs Corporations • Partnership:Allprofitsallocatedtopartners

Reinvestmentand • Corporation:Totalfreedomindividenddecisions DividendPayout Liability Continuityof Existence

• Partnership:GeneralPartnershaveunlimited liability • Corporation:Shareholdershavelimited liability

• Partnership:Limitedlife • Corporation:Unlimitedlife

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Table2.1 NamesofCorporations

2.Conflictsofinterestandagencytheory

TypeI

•Relationshipbetween managersand shareholders

TypeII

•Relationshipbetween majorityshareholders andminorityinvestors FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 14

FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 13

(i)TypeIagencyproblemandinformation

TypeIagencyproblemanddifferentgoals

Oneparty(managers)isanagentandmakesdecisionsforits principal(shareholders):principal– agentproblem

Oneparty(managers)hasinformationthattheotherparty (shareholders)doesnothaveregardingthedailyrunningofthe firm:asymmetricinformationleadingtomoralhazardand adverseselection

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Managerswantto maximisetheirown wealthandpower (sizeofthefirm)

Shareholders want managersto maximisethevalue ofthecompany

FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 16

TypeIAgencyCosts

AgencyCosts

Costs Thecostsof(resolving) problematicagency relationships

1.Corporateexpenditurethatbenefitsmanagersatthe expenseofshareholders(e.g.privatejet)ifmanagersnot sufficientlymonitored 2.CorporateExpendituretomonitorandcontrolmanager activities(forexample,paymentofauditors) IndirectCosts:Lostbusinessopportunitiesbecauseofthe conflictofinterest

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Inwhatwaycanshareholders ensurethatmanagersactintheirinterest andloweragencycosts?

DirectCosts:

FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 18

(ii)TypeIIAgencyCosts: majorityandminorityshareholders

A.ManagerialCompensation • Performancebasedpay

B.ControlthroughtheBoard • ShareholderselectmembersoftheBoardofDirectors(whothenhireandfiremanagers)

C.ClassesofShares • Somefirmshavemorethanoneclassofordinaryequity.Oftentheclassesarecreatedwith unequalvotingrights.Originalownerscouldhavemorevotespersharetokeepcontrol

D.Pre‐EmptiveRights • Acompanythatwishestosellequitymustfirstofferittotheexistingshareholdersbefore offeringittothegeneralpublic.Thepurposeistogiveoriginalshareholderstheopportunity toprotecttheirproportionateownershipinthecorporationandthereforecontrol.

Costs

Majorityshareholdermakesoneofherfirms tradeonattractivetermswithanotherofher firms.KnownasaRelatedPartyTransaction. Amajorityshareholdercanforcethecompany todeclarealargedividendbecauseheneeds thecash.

E.Dividends • Paymentsbyacorporationtoshareholders,madeineithercashorshares.Dividends paymentsasaformofdiscipline FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 19

FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 20

3.Firm’sstakeholders

Stakeholdersofthefirm Shareholders

Clients

Astakeholderissomeone, otherthanashareholder,who hasaninterestinthefirmand potentiallyhasaclaimonthe cashflowsofthefirm.

Employees

Firm

Consumers

Local employment

Regional government

Suppliers

Environment

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Corporategovernanceapproaches (optional) • Shareholders’model Objective: maximizationofshareholder’swealth Disciplineonmanagers:takeovers,managers’compensation schemes,debt(Jensen1977) •

•

Stakeholders’model Objective:maximizationofstakeholders’interests Discipline:Supervisoryboardswithemployees,monitoringby financialintermediaries “State‐holder’smodel” Objectives: maxtaxpayers’wealthbutalsoemployment,regional development,industrialpolicy Discipline:balancedbudgetrules,supranationalauthority

FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 23

4.International differencesin CorporateGovernance A.InvestorProtection B.ControlMechanisms C.FinancialSystems D.CorporateGovernanceCodesofConduct FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 24

A.InvestorProtection:Legal Systems CommonLaw •Lawdevelopsfollowingjudge’s decisions,courtrulings •Flexibleandcanadjustquicklyto events

Figure2.1 LegalSystemsaroundtheworld

CivilLaw •Lawisdevelopedthrough regulationandcodeoflaws •Judgesinterpretthelaw •Basedoncodeofprinciples

Also:

FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 25

InvestorProtection:LawEnforcement

FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 26

Table2.2 TransparencyInternational’s CorruptionPerceptionIndex

• Manycountrieshavestrongregulationsbut veryweakenforcement • So,two separateissuestoconsider: • TheEfficiency oftheJudicialSystem • IstheRuleofLawandOrderfollowed?Towhatextent doesagovernmentenforceitslaws?

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FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 28

B.ControlMechanisms: OwnershipStructure WidelyHeldFirms (nomajorityshareholder) •Separationbetweenownershipand control •AgencyIssuesTypeIbetween managersandshareholders •Shorttermhorizon(short‐termism)

Table2.4 OwnershipStructure of20Largest CompaniesinEachCountry

CloselyHeldFirms (Family,banks,governments) •Managerandshareholder incentivesaligned •AgencyIssuesTypeIIbetween controlling(majority)andnon‐ controlling(minority)shareholders •Longertermhorizon

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C.FinancialSystems: Bank‐basedvsMarket‐Based (How are firms financed? Capital structure) BankBasedSystems •Banksarecentraltothe processofmovingfunds betweendemandersand suppliersofcapital •Moreactivemonitoring •GermanyandJapanare examples

MarketBasedSystems •Securitiesmarketsareas importantasbanksandcanbe significantlymoreimportant •Externalmarketdiscipline •USandUKareexamples

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FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 30

Bank‐basedvs Market‐Basedfinancialsystems: Measures BankingDevelopment • BankLiquid Liabilities/GDP • BankAssets/GDP • DomesticBank Deposits/GDP

MarketDevelopment • Market Capitalisation/GDP • TotalTrading Volume/GDP

FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 32

Table2.3 BankVersusMarketBasedFinancialSystems

Class7 Country

Population (Millions)

GDP per capita (US$)

Stock Market Capitalization (%GDP)

Deposit- moneybank assets to GDP (%)

Banks concentration (%)

US UK Japan Germany Country of your choice Country of your choice

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FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 34

D.RelevantCodesofCorporateGovernance

Activities

(optional)

UK

OECD

• TheStewardshipCodeforInstitutional Investors(2010) • TheAuditFirmGovernanceCode(2009) • ReviewoftheCombinedCode:FinalReport (2009) • AReviewofCorporateGovernanceinUK BanksandOtherFinancialIndustryEntities (TheWalkerReview)(2009) • TheCombinedCodeofCorporate Governance(2008) • OECDPrinciplesofCorporateGovernance (2004) FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 35

Reading • Finance (2020) textbook, Chapter 2

Nextassignment • Classwork 7

Optional reading for those who are interested in this topic • Haldane (2015) “Who owns a company?”, Bank of England (on Moodle)

FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 36...