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Corporate Governance A Global Perspective 1 Defining Corporate Governance and Key Theoretical Models

For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

Lecture Aims This lecture aims to introduce you to the subject area of corporate governance. The lecture discusses the various definitions of corporate governance, reviews the debate on the main objective of the corporation and explains how corporate governance problems change across different levels of ownership and control. The lecture also introduces the main theories underpinning corporate governance. While the course focuses on stock-exchange listed corporations, this lecture also discusses alternative forms of organizations, i.e. mutual organizations and partnerships. 2

Learning Outcomes ▪ By the end of this lecture, you should be able to: 1. Contrast the different definitions of corporate governance 2. Critically review the principal-agent model 3. Compare the agency problems of equity and debt 4. Explain the corporate governance problem that prevails in countries where corporate ownership and control are concentrated 5. Distinguish between ownership and control

For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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The Basics ▪ In what follows, we focus on stock-exchange listed firms ▪ These firms are typically in the form of stock corporations that have equity stocks or shares outstanding ▪ Stocks or shares are certificates of ownership that frequently confer control rights, i.e. voting rights ▪ Voting rights enable their holders, the shareholders, to vote at the annual general shareholders’ meeting (AGM) For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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The Basics ▪ Voting shares confer the right to appoint the members of the board of directors ▪ The board of directors is the ultimate governing body within the firm ▪ Its duty, in particular that of the non-executive directors, is to look after the interests of all the shareholders ▪ It may also look after the interests of other stakeholders such as the employees and the firm’s creditors For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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The Basics ▪ More precisely, the non-executives have two main roles: 1. To monitor the firm’s top management, including the executive directors which are the other type of directors sitting on the firm’s board 2. To provide advice, such as strategic direction

▪ N.B. In the USA, non-executives are referred to as (independent or outside) directors and executives as officers For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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Defining Corporate Governance ▪ Most definitions are based on implicit or explicit assumptions about the main objective of the firm ▪ However, there is no universal agreement as to what this objective should be ▪ For example, Andrei Shleifer and Robert Vishny define corporate governance as “the ways in which suppliers of finance assure themselves of getting a return on their investment” ▪ This definition assumes that the main objective of the firm is to maximize shareholder value For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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Defining Corporate Governance ▪ They justify this focus by the argument that investments in the firm by the shareholders (as well as the debtholders) are sunk funds ▪ In contrast, the other stakeholders can easily walk away from the firm without losing their investments ▪ E.g., an employee should be able to find a job in another firm which values her human capital ▪ Another perspective does not focus on the firm being in financial distress For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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Defining Corporate Governance ▪ It focuses on who has the strongest incentive for the firm to be run efficiently ▪ That is the most junior claimant in the firm ▪ The claims of employees, customers and suppliers, etc. have to be met first before any monies can be paid to the providers of finance ▪ Put differently, the providers of finance can only eat until the other stakeholders have eaten ▪ Hence, the shareholders are the residual risk bearers or the residual claimants to the firm’s assets 9

Defining Corporate Governance ▪ In contrast, Marc Goergen and Luc Renneboog’s definition allows for differences across countries in terms of the main objective of the firm: “A corporate governance system is the combination of mechanisms which ensure that the management … runs the firm for the benefit of one or several stakeholders... Such stakeholders may cover shareholders, creditors, suppliers, clients, employees and other parties with whom the firm conducts its business.” For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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Defining Corporate Governance ▪ For example, German corporate law explicitly includes other stakeholder interests in the firm’s objective function ▪ The German Co-determination Law of 1976 requires firms with more than 2,000 employees to have half of the supervisory board seats held by employee representatives

For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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Defining Corporate Governance ▪ In a questionnaire survey sent to managers of German, Japanese, UK and US companies in the 1990s, Masaru Yoshimori asks the question as to whose company it is – 89% of UK and US managers state that the company’s objective is the shareholders – Only a minority of French, German and Japanese managers do so – 97% of Japanese managers believe the company belongs to the stakeholders rather than the shareholders For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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Defining Corporate Governance ▪ Still, if this survey were to be repeated today the views of French and German managers would likely to be closer to those of their UK and US counterparts

For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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Defining Corporate Governance ▪ A more neutral and less politically charged definition of corporate governance is that the latter deals with conflicts of interests between – – – –

the shareholders and the managers; the shareholders and the debtholders; the shareholders and the non-financial stakeholders; different types of shareholders (mainly the large shareholder and the minority shareholders);

and the prevention or mitigation of these conflicts of interests ▪ This is the definition adopted by this course 14

Corporate Governance Theory “It is in the interest of every man to live as much at his ease as he can; and if his emoluments are to be precisely the same, whether he does, or does not perform some laborious duty, it is certainly his interest, at least as interest is vulgarly understood, either to neglect it altogether, or, if he is subject to some authority which will not suffer him to do this, to perform it in as careless and slovenly a manner as that authority will permit.” Smith, A. (1776), An Inquiry into the Nature and Causes of the Wealth of Nations, reprinted in K. Sutherland (ed.) (1993), World’s Classics, Oxford: Oxford University Press.

For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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Corporate Governance Theory ▪ This quote illustrates the conflict of interests that may exist between an agent and the agent’s principal ▪ Michael Jensen and William Meckling formalized these conflicts of interests in their principal-agent theory ▪ While the agent has been asked by the principal to carry out a specific duty, the agent may not act in the best interest of the principal once the contract has been signed For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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Corporate Governance Theory ▪ The agent may rather prefer to act in his own interest ▪ Economists call this moral hazard ▪ Moral hazard is not just an issue in corporate governance, but it is also a major issue for insurance companies ▪ One way of addressing principal-agent problems is via so called complete contracts

For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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Corporate Governance Theory ▪ Complete contracts are contracts which specify exactly what – the managers must do in each future contingency of the world; and – what the distribution of profits will be in each contingency

▪ In practice, contracts are unlikely to be complete as – It is impossible to predict all future contingencies of the world – Such contracts would be too complex to write – They would be difficult or even impossible to monitor and reinforce by outsiders such as a court of law 18

Corporate Governance Theory ▪ A necessary condition for moral hazard to exist and for complete contracts to be impossible is the existence of asymmetric information ▪ Asymmetric information refers to situations where one party, typically the agent, has more information than the other party, the principal ▪ If both parties had access to the same information at all times, then there would be no moral hazard problem For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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Corporate Governance Theory ▪ Moral hazard exists because the principal cannot keep track of the agent’s actions at all times ▪ Even ex post, it is sometimes difficult for the principal to judge whether failure is due to the agent or external circumstances ▪ Jensen and Meckling’s principal-agent model also assumes that there is a separation of ownership and control

For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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Corporate Governance Theory ▪ Adolf Berle and Gardiner Means were the first to point out this separation in their 1932 book The Modern Corporation and Private Property ▪ A firm starts off as a small business, 100% owned by its founder, typically an entrepreneur ▪ There are no conflicts of interests as the entrepreneur owns 100% of the firm and runs the firm ▪ As the firm grows, it becomes more and more difficult for the entrepreneur to provide all the financing For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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Corporate Governance Theory ▪ Eventually, the entrepreneur will need to raise outside finance ▪ Once outside finance has been raised, the entrepreneur’s incentives to work hard have been reduced ▪ Ultimately, the entrepreneur will sell out and the firm ends up being run by professional managers on behalf of its shareholders

For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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Corporate Governance Theory ▪ Hence, there is a clear division of labour in the modern corporation with – the managers, the agents, having the expertise to run the firm, but not the funds to finance it; and – the shareholders, the principals, having the required funds, but not the skills to run the firm

▪ In practice, control lies with the managers who run the day-to-day operations of the firm whereas the firm is owned by the shareholders ▪ Hence the separation of ownership and control For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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Corporate Governance Theory ▪ However, the agent may prefer to run the firm in his own interests rather than those of the principal ▪ This is the principal-agent problem (agency problem) ▪ The main consequence of this problem is agency costs ▪ These are the sum of – the monitoring expenses incurred by the principal; – the bonding costs accruing to the agents; and – any residual loss 24

Corporate Governance Theory ▪ Monitoring consists of the principal observing the agent and keeping a record of the latter’s behaviour ▪ It also consists of intervening in various ways to constrain the agent’s behaviour and to avoid unwanted actions ▪ Bonding costs are costs incurred by the agent in order to signal credibly to the principal that she will act in the interests of the latter ▪ One credible way for the agent to bond herself to the principal is to invest in the latter’s firm 25

Corporate Governance Theory ▪ The residual loss is the loss incurred by the principal due to fact that the agent may still make some decisions that do not maximize the value of the firm for the former and which are not prevented by monitoring and bonding

For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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Agency Problems between Managers and Shareholders

▪ The two main types of agency problems are – Perquisites – Empire building

▪ Perquisites or perks consist of on-the-job consumption by the managers ▪ While the benefits from the perks accrue to the managers, their costs are borne by the shareholders ▪ Examples of perks are CEO mansions financed by the firm and personal usage of corporate jets For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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Agency Problems between Managers and Shareholders

The former CEO of Tyco International had his company fund his wife’s 40th birthday party on Sardinia at a cost of US$1 million “Former Merrill CEO John Thain spent $1.2 million to renovate his offices, including installation of a $35,000 toilet.” Source: The Gazette, 28 March 2009, p. B1 For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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Agency Problems between Managers and Shareholders ▪ While perks can cause public outrage, especially when they are combined with lacklustre performance, they tend to be modest compared to empire building ▪ Empire building consists of managers pursuing growth rather than shareholder-value maximization ▪ While there is a link between the two, growth does not necessarily generate shareholder value and viceversa ▪ Empire building is also referred to as Jensen’s free cash flow problem For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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Agency Problems between Managers and Shareholders ▪ The free cash flow problem consists of managers investing beyond the point where investment projects earn an adequate return given their risk ▪ So why would managers be tempted by empire building? ▪ Managers derive benefits from increasing the size of their firm ▪ Such benefits include increased power and social status ▪ Managerial remuneration has also been shown to depend on firm size 30

Agency Problems of Debt and Equity ▪ So far, we have focused on the agency problem of equity, i.e. the agency problem between the managers and the shareholders ▪ However, there also exists an agency problem of debt ▪ When there is very little equity left (i.e. when the firm is in financial distress), the shareholders may be tempted to gamble with the debtholders’ money ▪ They may do so by investing the firm’s funds into high-risk projects For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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Agency Problems of Debt and Equity ▪ If the project fails, the major part of the costs will be borne by the debtholders ▪ If the project is successful, most of its payoff will go to the shareholders given that the debtholders’ claims have a limited upside

For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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Figure 1.1 – Firm value

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Agency Problems of Debt and Equity ▪ Jensen and Meckling argue that, given that there are agency costs from both debt and equity, there is an optimal mix of debt and equity which minimizes the sum of the agency costs of debt and equity

For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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Figure 1.2 – Agency costs of debt and equity

For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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The Expropriation of Minority Shareholders ▪ The principal-agent model is based on the BerleMeans premise that, as firms grow, ownership eventually separates from control ▪ However, this is only an accurate description of the Anglo-American system of corporate governance ▪ In the rest of the world, most stock-exchange listed firms have large shareholders exerting significant control over the firm ▪ Hence, the main conflict of interests is between the large shareholder and the minority shareholders For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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The Expropriation of Minority Shareholders ▪ Minority shareholders may face the danger of being expropriated by the large shareholder via e.g. – – – –

Tunnelling Transfer pricing Nepotism Infighting

▪ Tunnelling consists of the large shareholder transferring the firm’s assets or profits into his own pockets For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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The Expropriation of Minority Shareholders ▪ The large shareholder may also expropriate the minority shareholders via transfer pricing, i.e. by overcharging the firm for services or assets provided ▪ Tunnelling and transfer pricing involving the large shareholder are also sometimes referred to as related-party transactions ▪ Large shareholders may be even more tempted to engage in related-party transactions in the presence of ownership pyramids For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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Figure 1.3 – Expropriation of the minority shareholders by the large shareholder

For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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Figure 1.4 – Leveraging control and increasing the potential for expropriation

For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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The Expropriation of Minority Shareholders ▪ Other forms of minority shareholder expropriation include nepotism and infighting ▪ Nepotism consists of the large family shareholder appointing family members to top management positions rather than the most suitable candidates on the job market ▪ Infighting may not necessarily be a wilful form of expropriating the firm’s minority shareholders, but nevertheless is likely to deflect management time as well as other firm resources For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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Alternative Forms of Organisation and Ownership

▪ The main alternative to the stock corporation is the mutual organization ▪ A mutual organization is owned by and run on behalf of its members ▪ For example, a mutual bank is owned by its savers and borrowers ▪ Both stock corporations and mutual organizations are likely to suffer from the principal-agent problem

For use with Corporate Governance: A Global Perspective by Marc Goergen © Cengage EMEA, 2018

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Alternative Forms of Organization and Ownership

▪ However, this problem may be more severe in mutual organisations given that stock corporations benefit from a range of mechan...