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 “Corporate Governance is the system by which
Sushil Khanna
HHL Leipzig Graduate School of Management
And Indian Institute of Management Calcutta
 “Corporate governance is the system by which
companies are directed and managed. It influences
how the objectives of the company are set and
achieved, how risk is monitored & assessed, & how
performance is optimized.
 Good corporate governance structures encourage
companies to create value (through
entrepreneurialism, innovation, development &
exploration) and provide accountability & control
systems commensurate with the risks involved”
 (ASX Australian Stock Exchange)
companies are directed and controlled…”
(Cadbury Report, UK, 1992)
 “Involves a set or relationships between a
company’s management, its board, its
shareholders, and other stakeholders. Corporate
governance also provides the structure through
which the objectives of the company are set, and
the means of attaining those objectives and
monitoring performance are determined.”
 (OECD, Principles of Corporate Governance, 1999; 2004)
In its broadest sense,
“Corporate governance is concerned with holding the
balance between economic and social goals and between
individual and communal goals”.
The governance framework is there to ‘encourage the
efficient use of resources and equally to require
accountability for the stewardship of those resources’.
The aim is to align as nearly as possible the interests of
individuals, of corporations, and of society.
(Cadbury 2004)
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Corporate failures during the last two decades leading to

 Litigation between shareholders, directors and auditors.
 Exposés of various stories of managerial “excesses”

 Why is Governance Such an Common Wisdom:

 Failure to contain the conflict between managers and
Issue Today? shareholders
 Failure of regulation
Academic Wisdom:
 The root cause of the “problem” is separation of control and
ownership that follows from external financing of firms
 The supplier of finance need to “assure themselves of
getting returns” (Schleifer and Vishny, 1997)

 “Our perspective on corporate governance is a
straight forward agency perspective …” (Schleifer
and Vishny,1997)
 The American literature has adopted the Agency
Paradigm as the dominant paradigm for analyzing the
Corporate Governance
 Berle and Means (1932) first pinted out that
in USA, increasingly corporations are
controlled by professional managers, while
owners have little control
 They warned that the separation of ownership
and control in the modern corporation
“destroys the very foundation on which the
economic order of the past three centuries
has rested . . .

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 Some argue it is beneficial:  This would result in large firms -- an organizational

 The come from the interaction of three form that combines hierarchical organization and large
size with diversified and liquid investment may possess
factors
informational, transactional and productive efficiencies
◦ First, under certain conditions and for certain types
that make it superior to other organizational forms.
of decisions, hierarchical decision making may be
more efficient than market allocation.  The separation of ownership and control permits the
existence of an organization with these characteristics.
◦ Second, due to economies of scale in both
production and decision making, optimal firm size  In cases where the benefits outweigh the costs
can be quite large. (including agency costs) we would expect to see
◦ Third, optimal investment strategy requires organizations in which ownership and control are
investors to be able to diversify and pool and to be separated (see also, Knight, 1921; Arrow, 1974; Chandler, 1977
able to change their allocations in response to and Fama and Jensen, 1983).
changing market conditions

M.J. Roe, Political

Determinants of
Corporate Governance

Maturity Governance
challenges
Public Corporation
(Diffuse Shareholders)
• Maintain alertness
• Board assessment
•Advance value
commitments
Development

Public Corporation
Growth Governance challenges:
Corporate

(Majority Shareholders)

•Risk management
•Develop board directors.
IPO • Engage stakeholders.
(Initial Public Offering)

Private
Company

Founding Launch Governance Challenges:

Entrepreneurs • Raise capital
• Recruit board of directors
• Establish accountability

Time

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M.J. Roe, Political
Determinants of
Corporate Governance
 A conflict of interest inherent in any
relationship where one party is expected to
act in another's best interests. The problem is
that the agent who is supposed to make the
decisions that would best serve the principal
is naturally motivated by self-interest, and
the agent's own best interests may differ
from the principal's best interests.
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 Agency Problem occurs when one person or
entity (the "agent") is able to make decisions
on behalf of, or that impact, another person
or entity: the "principal". The dilemma exists
because sometimes the agent is motivated to
act in his own best interests rather than those
of the principal
 Examples
 Corporate management (agent) and
shareholders (principal),
 Politicians (agent) and voters (principal).
 Or consider a patient (the principal)
wondering whether his doctor (the agent) is
recommending expensive treatment because
it is truly necessary for the patient's health, or
because it will generate income for the doctor
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◦ Managerial opportunism: seeking self-
interest with guile (i.e., cunning or deceit)
 Opportunism: an attitude and set of
behaviors
 Decisions in managers’ best interests,
contrary to shareholders’ best interests
 Decisions such as these prevent
maximizing shareholder wealth
• How to establish governance and control
mechanisms to prevent agents from acting
opportunistically ??
 Financial markets are efficient if current asset
prices fully reflect all currently available relevant
information
 If financial markets are efficient, then there is no
“best time” to purchase an asset.
 Apparent past price patterns are not predictive for
future prices.
 If financial markets are efficient, asset price
changes are serially random.
 Cannot predict the future price based on
observing the history of past prices

 Weak Form Efficient Market

◦ Prices reflect information about past stock prices
or returns
◦ Random Walk Hypothesis is a special case
 Semi-strong Form Efficient Market
◦ Prices reflect all publicly available information
 Strong Form Efficient Market
◦ Prices reflect all available information

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 Do efficient markets Mitigate Agency

Problem?
 Efficient Market Hypothesis based on levels of
current information available to market
 Do Efficient Markets Mitigate  They do not mitigate problems arising from
the Agency Problem ? `information asymmetry’, where managers
have more information about the investment
decisions and its consequences as well as
risk, than the investors or other market
participants

• Two benefits that accrue to top-level

managers and not to shareholders:  Diversification reduces these risks because
• Increase in firm size: product a firm and its managers are less vulnerable
diversification usually increases the size of to reductions in demand associated with a
a firm; that size is positively related to single/limited number of businesses
executive compensation
• 2. Firm portfolio diversification, which can
reduce top executives’ employment risk
(i.e., job loss, loss of compensation, and
loss of managerial reputation)

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◦ Free cash flow: resources remaining after the firm

has invested in all projects that have positive net
present values within its current businesses

• Use of Free Cash Flows

◦ Managers inclination to over-diversify and
invest these funds in additional product
diversification
◦ Shareholders prefer distribution as dividends,
so they can control how the cash is invested

 If company is undiversified in its product-
market scope, what risk does it face?
 Survival during a industry contraction
 Jobs for employees
 Investment projects to be abandoned?
 Impact on local communities
 Taxes to government
 Employees liabilities – pension funds, retirement
benefits
 RISK
◦ In general, shareholders prefer riskier strategies
than managers
 DIVERSIFICATION
◦ Shareholders prefer more focused diversification
◦ Managers prefer greater diversification, a level
that maximizes firm size and their compensation
while also reducing their employment risk
◦ However, their preference is that the firm’s
diversification falls short of where it increases
their employment risk and reduces their
employment opportunities (e.g., acquisition
target from poor performance)

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 AGENCY COSTS: the sum of incentive costs,  Agents can destroy or create value for
monitoring costs, enforcement costs, and principals (shareholders)
individual financial losses incurred by principals,
 The solution lies in aligning the interest of
because governance mechanisms cannot
Agent (manager) with those of the Principal
guarantee total compliance by the agent
(shareholders)
 Principals may engage in monitoring behavior to  More close monitoring
assess the activities and decisions of managers
 Hiring and firing managers – Or changing the
 However, dispersed shareholding makes it managers
difficult and inefficient to monitor management’s
behavior.

 The “solution” often focuses on  Individual Contracts for incentives linked to

information on employee performance
 Incentive contracts and compensations  Because of differences in quality / quantity of
 Independent directors information available about individual’s
 Institutional monitoring and reforms performance, the ability of employee to bear risk,
and manipulate evaluation methods, the
 Legal protection to minority shareholders contracts vary widely:
◦ Piece rate
 Auditor Independence ◦ Options(share)
 `Markets for Corporate Control’ ◦ Discretionary bonus
◦ Profit sharing
◦ Efficiency wages,
◦ deferred compensation etc.

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 Who should be eligible for incentive  Factors complicating executive compensation:

contracts? • Strategic decisions by top-level managers are
◦ Few top managers? complex, non-routine and affect the firm over an
◦ All managers? extended period, making it difficult to assess the
◦ All employees? current decision effectiveness
 Level of Incentives • Other intervening variables affect the firm’s
◦ Small part of salary with ceiling (Indian PSUs upto performance over time
150% of salary with ceiling Rs 5 million) • Alignment of pay and performance: complicated
◦ Large bonuses ($100 mill?) board responsibility
• The effectiveness of pay plans as a governance
mechanism is suspect

 What happens when the market conditions  What about variation in the level of intrinsic
make it difficult to earn large profits despite psychological satisfaction to be had from
best efforts? different types of work.
 Oil Industry Today?  Sociologists and psychologists frequently argue
that individuals take a certain degree of pride in
 SCI in 2014
their work, and that introducing performance-
related pay can destroy this "psycho-social
compensation", because the exchange relation
between employer and employee becomes much
more narrowly economic, destroying most or all
of the potential for social exchange

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 Who will monitor the manager?
◦ `Independent Director’
◦ Large Shareholder?
◦ Institutional Investors?
◦ Regulator?
◦ Government?
 Who has the skills and talent to monitor
managers who (expected to) create large
wealth?
 Boards of Directors have a fiduciary duty to
shareholders to monitor management
 However, Boards of Directors are often accused
of being lax in performing this function
 Costs associated with agency relationships, and
effective governance mechanisms should be
employed to improve managerial decision
making and strategic effectiveness
 In response, U.S. Congress enacted:
◦ Sarbanes-Oxley (SOX) Act in 2002
◦ Dodd-Frank Wall Street Reform and Consumer
Protection Act (Dodd-Frank) in mid-2010
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 Group of shareholder-elected individuals
(usually called ‘directors’) whose primary
responsibility is to act in the owners’
interests by formally monitoring and
controlling the corporation’s top-level
executives
 As stewards of an organization's resources, an
effective and well-structured board of
directors can influence the performance of a
firm:
• Oversee managers to ensure the company is
operated in ways to maximize shareholder wealth
• Direct the affairs of the organization
• Punish and reward managers
• Protect shareholders’ rights and interests
• Protect owners from managerial opportunism
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 Three director classifications: Insider, related
outsider, and outsider:
• Insiders: the firm’s CEO and other top-level
managers
• Related outsiders: individuals uninvolved with
day-to-day operations, but who have a
relationship with the firm
• Outsiders: individuals who are independent of the
firm’s day-to-day operations and other
relationships
Historically, BOD dominated by inside managers:
• Managers suspected of using their power to select and
compensate directors
• NYSE implemented an audit committee rule requiring
outside directors to head audit committee (a response to
SEC’s proposal requiring audit committees be made up
of outside directors)
• Sarbanes-Oxley Act passed leading to BOD changes
• Corporate governance becoming more intense through
BOD mechanism
• BOD scandals led to trend of separating roles of CEO and
Board Chairperson
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 Criticisms of Boards of Directors include that they:
• Too readily approve managers’ self-serving
initiatives
• Are exploited by managers with personal ties to
board members
• Are not vigilant enough in hiring and monitoring
CEO behavior
• Lack agreement about the number of and most
appropriate role of outside directors
 What incentive do Independent Directors have
to monitor the managers?
 Independent of whom?
 How are they selected?
 If managers have discretion in all aspects as
Principal is dispersed and atomized; will they
not be the main actors in selection of other
Directors?
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 Institutional Investors have fudiciary
responsibility tom their members, and to
disperse risk they invest in several unrelated
industries
Outside directors (problems)
• Limited contact with the firm’s day-to-day operations
and incomplete information about managers:
 Results in ineffective assessments of managerial
decisions and initiatives
 Leads to an emphasis on financial, rather than
strategic controls to evaluate performance of
managers and business units, which could reduce
R&D investments and allow top-level managers to
pursue increased diversification for the purpose of
higher compensation and minimizing their
employment risk
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Outside directors:
 Improve weak managerial monitoring and
control that corresponds to inside directors
 Tend to emphasize financial controls, to the
detriment of risk-related decisions by
managers, as they do not have access to
daily operations and a high level of
information about managers and strategy
 Large number of outsiders can create
problems
 Enhancing the effectiveness of the Board of
Directors:
1. Increase the diversity of the backgrounds of
board members (e.g., public service,
academic, scientific; ethnic minorities and
women; different countries)
2. Strengthen internal management and
accounting control systems
3. Establish and consistently use formal
processes to evaluate the board’s
performance
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 4. Modify the compensation of directors,
especially reducing or eliminating stock
options as part of their package
 5. Create the “lead director” role that has
strong powers with regard to the board
agenda and oversight of non-management
board member activities
 6. Require that directors own significant
equity stakes in the firm to keep focus on
shareholder interests
 Many Corporations, often out performing
markets, often targets of M&A and Bust – up
 (Nabisco)
 M&A Waves in Industry where often
underperforming firms target more
innovative firms to shore up their returns
 Hostile Takeovers and Market Reaction to
Short Term Earning Announcements, often
bring companies into`play’
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 The external corporate governance mechanism is
Market for Corporate Control
 This market is a set of potential owners seeking to
acquire undervalued firms and earn above-average
returns on their investments by replacing ineffective
top-level management teams.
• In theory:
• Becomes active only when internal controls
have failed
• Ineffective managers are usually replaced in
such takeovers
 Do you think this is what happens?
 Board Structure has been the object of
Cadbury and all other Governance Codes
 Assumption: Board Structure tells you
something about quality of Board (satyam)
 Research shows this has little effect on
governance Quality
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 Regulation Improves Governance

 Evidence on Effectiveness of Sarbanes-Oxley,

and Dodd-Frank Act is dubious

 Entire Financial Crash – due to excessive risk

taking and widespread 0ff-balance sheet risk
and liabilities could not be prevented

 There is little evidence that recommended best practices

like : Governance systems Auditors
◦ Independent Directors to Meet Separately are diverse because EFFICIENT CAPITAL Board Customers
REGULATORY
◦ AUDIT comm should not have insider Directors these factors MARKETS ENFORCEMENT

◦ Shareholders should have a say in executive compensation com bine in different

ways in different
 Uniform best practices do not exist in governance. countries.
Investors Suppliers

 Corporations are organizational systems. Their success Managers

is predicated on their external setting, the interactions
of their constituents, and the processes by which the Creditors Unions

 corporate strategy is planned and executed

 Hard to imagine that the complexity of Analysts Media

 such an undertaking can be reduced to a checklist LEGAL

TRADITION
Regulators ACCOUNTING
STANDARDS
 that is no more difficult to follow
SOCIETAL AND CULTURAL VALUES

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