5/03/2014

IBU5GW

Governance
in a Globalising World

Week 2
Corporate governance theories

This week
Introduction to different models of corporate
governance
Theoretical
Practical
Consider regulatory and international
frameworks

Ch.2 Theories of
Corporate Governance
Thomsen, S., Conyon, M., 2012,
Corporate Governance; Mechanisms and
Systems, McGraw Hill.

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Introduction

Chapter reviews corporate governance theories

Market model of standard microeconomics

Agency theory

Related non-governance disciplines with

applications in corporate governance

The market model

The firm is a black box characterised by a

technology and profit maximisation
The economy works by itself under the price
mechanism
Based on pre-industrial society
Buyers and sellers compete prices down
Centralised exchange
Full information
Complete markets
No transaction costs

Agency theory

Different parties have different interests

potential risk of people acting in their own interest on the other partys
expense

Agents and principals

Principals = owners, or anyone who hire someone else to do a certain
job at their expense

Agents = managers, a person hired to do a certain job in exchanged
for an agreed compensation

Whenever in a contract, one party therefore needs to

1) monitor the other party
2) find ways to ensure that interests are aligned

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Agency theory

RULE OF MAN

INTEREST DIVERGENCE

AGENCY PROBLEMS

AGENCY COSTS

CONTROL MECHANISMS

The owner-manager problem

Separation of ownership and control give rise to
the need for professional managers
Owners employ managers to run the firm in the
best interest of the investors and most managers
do
However, some managers act criminal and
embezzle shareholder funds
Another classical agency problem is excess
expenditure: what expenses are business
motivated and what is the managers private
consumption (consider a private company jet)?

Assumptions in agency theory

Homo Economicus is rational,
individualistic and
opportunistic

Always seeks to maximise

own benefits and personal
utility

Moral responsibilities to act in

someone else's interest are
second priority

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Assumptions in agency theory

Agency theory operates
when two Homo Economicus
meet, for example owners
and managers

In firms the conflict of

interest becomes especially
important since only one
party bears the cost for
running the firm

Types of agency problems

Type I agency conflicts most common in

firms/nations with dispersed ownership
Collective action problems and free rider
problems (no one has incentive to monitor)
Type II agency conflicts most common in
firms/nations with concentrated ownership
Private benefits
Type III agency conflicts in both dispersed
and concentrated ownerships

Information problems
Information problems concern primarily two
types of asymmetric information between
owners and managers
Adverse selection occurs before the
manager makes a decision, while moral
hazard occurs after a decision has been
taken

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Moral hazard
Hidden action
Occurs when the activity of the agent (manager)
cannot be observed by the principal (owner)
Moral hazard illustrates the trade-off between risk
and incentives: if you dont carry any risk you
loose your incentives to protect yourself against it
Managers can be given incentives to share some of
the shareholders risk, for example by being
remunerated with stock options or bonuses for
excellent firm performance

Adverse selection
Hidden knowledge

Owners know less about the state of

the firm than managers, and they know
less about a the capabilities of a new
manager than the manager herself

Consider the example with Monday

cars lemons

Adverse selection can partly be solved

through monitoring

Extensions to agency theory

We can imagine three types of extensions

1. With additional layers of agency relationships, as ownership

shifts to institutional. Portfolio managers are not the ultimate
owners of the invested capital. Thus, also the portfolio manager
requires monitoring in the same way as the firm manager.
2. Most firms have several owners; principals might not share the
same objectives and aims
3. Agency problems have a time dimension. Bad decisions lead to
bad reputation for the manager which provides incentive to
improve.

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Incomplete contracts

Incomplete contracts theory provide that whoever has asset

ownership possesses the residual right of control

Residual right of control means the right to control in all

situations not already covered by contracts

Explains why large corporations cannot replicate the

incentives of small entrepreneurial firms. As employees do
not have the residual right of control they lack incentives to
make an effort as the employer can act in his own interest
whenever hes not covered by a complete contract

Transaction costs

Transaction cost lead to many deviations from the

market model

The existence (and size) of transaction costs affect

firm decisions to trade or produce

Thus, transaction costs can explain vertical

integration and why firms grow large, thus causing
the need for external finance which makes
ownership separate from control

Psychology

Behavioural economics rise with the recognition
that underlying assumptions of agency theory
might be incorrect

Human beings are not completely rational or
selfish

Several streams of research can be applied to
corporate governance settings:

Deviations from rationality

Managers looking for information that coincides with
their personal ideas and preferences

People consider their own mistakes as a result of bad
luck

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Sociology

The relevance of sociology concerns mainly:

Social networks theory that describes connections
between companies, boards and investors
The study of social norms, values, and cultures
Social networks can be considered as a set of agents
connected through various ties (boards, ownership etc)
which can be clustered to measure the size of a network
Norms and values have obvious bearing on corporate
governance as attitudes of honesty and fairness reduce
agency problems

Political science

Politics is highly important because it shapes the

law

Parallels can also be drawn between models of

democracy and corporate governance
One share, one vote principle: shareholders vote by the
size of their holdings and dual-class shares significantly
affect voting outcomes
Free rider problems make it disadvantageous for smaller
investors to engage in voting procedures

Law

Five core characteristics across jurisdictions:
1. Legal personality: company is independent from its
owners, and thus, shielded from personal creditors of the
owners
2. Limited liability: risk can be shared with creditors who
have no recourse to the shareholders
3. Transferable shares: allows the firm to continue business
independently of changes in ownership structure
4. Centralised management: company is run by the board
that is formally separate from both management and
shareholders
5. Investor ownership: right to control and right to profits

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Philosophy

Relevant primarily when discussing business

ethics
Stakeholder theory emphasises that the purpose of
a corporation is to create value for its
stakeholders (customers, employees, creditors etc)
Based on the argument that this is the right thing
to do, and thus highly philosophical
Others argue that profit is significantly dependent
on close relationships with your stakeholders

Enlightened agency theory

Starts with the basic agency problem and expands

by taking the psychology of individuals into
account
Egoistic objectives might lead controlling investors
and managers to actions
Extraction of private benefits by blockholding families
Imperial construction by CEOs
This cannot be calculated for in mathematical
agency theory

Summary
Agency theory is the most influential theory in
corporate governance
It has been challenged with perspectives from a
wide variety of academic fields
Basic assumptions of agency theory, particularly
concerning the human nature, can be questioned
on the basis of psychology, sociology and other
alternative perspectives
Different approaches to corporate governance
should be considered complementary

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Divergence and convergence

The polarisation of corporate governance
may have arisen from differences that exist
between cultural and legal systems. However,
in general, countries attempt to reduce the
differences to facilitate international co-
operation and trade.
[Solomon]

 and 

Global Convergence of Systems

International harmonisation now becoming
common due to:-
International investment, foreign subsidiaries
Accounting and financial reporting within
International Accounting Standards
OECD [Organisation for Economic Co-operation and Development]
ICGN [International Corporate Governance Network]
European Union
World Bank
Global Corporate Governance Forum

Variation in Systems
Corporate ownership structure;
State of the economy;
Legal system;
Government policies;
Culture;
History;
Extent of capital inflows from abroad;
Cross-border investment.

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Demands of Capital
Effective legal and regulatory systems to minimise
capital being stolen or wasted;
Boards of Directors who protect shareholder
interests;
Properly audited accounts;
Accurate corporate reporting transparency;
Fair shareholder voting system;
Freedom to sell shares to highest bidder;
Rights of stakeholders.

Organisation for Economic Co-operation

and Development [OECD]
A forum for governments to discuss, develop
and enhance economic and social policies.

A global model for corporate governance.

Formulate minimum standards of fairness,

transparency, accountability, disclosure and
responsibility for business practice.

OECD

Membership of 34
countries
Principles are basic
requirements of good
governance
However no
legislative power
But reference point
for self-assessment
and for developing
own standards

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OECD Principles
Corporate governance frameworks promote
transparent and efficient markets, be
consistent with rule of law;
Facilitate shareholder rights;
Ensure equitable treatment of all
shareholders;
Recognise rights of stakeholders;
Timely and accurate disclosure of all
relevant matters

ICGN Principles
An international organisation for corporations
and individuals interested in corporate
governance reform.
Promote discussion on governance issues;
Annual conference;
Promotes OECD principles;
Provide guidance on how to implement OECD
principles

European Union
No attempts at harmonisation best
practice;
42 governance codes exist;
Harmonisation will be by evolution
not revolution;
Convergence at the margins but no
one model;
Standards issued in 2004 by
European Commission transparency,
shareholder rights, disclosure, functions of the
Board

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World Bank
International financial institution that provides loans to developing
countries for capital programmes.
Official goal to reduce poverty;
Measures to improve governance world-wide;
Offers technical and expert assistance;
Knowledge sharing;
Loans tied to corporate governance reform.

Research
Countries that pursue privatisation without putting good
governance structures in place experience worse economic
growth.

[James Wolfensohn Past President World Bank]

Global Corporate Governance Forum

Established 1999 by World Bank and OECD

Established Centres of Excellence across
Africa
Sponsored a project to promote role of
media as a watchdog
Regional roundtables
Partnerships with regional private sector
groups

International Monetary Fund

188 countries working to encourage global
monetary co-operation, secure financial stability,
facilitate international trade, promote high
employment, sustainable economic growth and to
reduce poverty.
Monitors world economies and lends to members
in economic difficulty;
Promoters exchange rate stability;
Members represented through quota system
based on relative size.

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Two Types of Systems

Insider-dominated systems publicly listed
companies owned and controlled by a small
number of major shareholders e.g. France,
Germany, Japan.
Outsider-dominated systems large firms
controlled by managers but owned by outside
shareholders e.g. Australia, UK, USA

Insider-Dominated Systems
Shareholders are family, banks or
government.
Advantages management and shareholder interests
aligned; hostile takeovers rare; shareholders have a strong
voice.
Disadvantages abuse of power, little transparency,
misuse of funds, lack of knowledge by minority
shareholders, excessive control by small group of
shareholders, weak investor protection in law.

Outsider-Dominated Systems
Separation of control and ownership
Advantages management actions accountable to
shareholders, transparency, shareholders vote, strong
investor protection in law.
Disadvantages managers not always work for
shareholder interests, hostile takeovers, shareholders not
loyal can sell shares anytime

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Next week

Mechanisms of governance
Individual assignment workshop
Understand assessment criteria!
Come prepared with questions!
Share ideas!

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