Corporate Governance:

An Overview

Professor Alexander Settles

Faculty of Management, State University
– Higher School of Economics
Email: asettles@hse.ru
Learning objectives
 Corporate Governance and
Competitiveness
 Investor Protection
 Role of Public Sector in Setting
Framework for Good Corporate
Governance
 Knowledge about theory of board
operation and Role of directors
 Theories of board organization
 Regulation concerning corporate boards
 Practice in corporate boards
Corporate Finance, Corporate
Governance and Valuation

 Corporate Governance is at the

intersection of strategy, control and
finance
 Corporate Governance is a primary
driver of firm specific and market
risk in valuation approaches
Review of Valuation Models
 Asset approach
 Market approach
 Guideline Public Company method
 Transaction Method or Direct Market Data
Method
 Income approach
 Discounted cash flows method
 Capital Asset Pricing Model (CAPM)
 Weighted Average Cost of Capital (WACC)
Review of Valuation Models

Understand concept of market

efficiency and four techniques to
determine value of common
shares:
1) Dividend valuation model (DVM),
2) Book value,
3) Liquidation value, and
4) Price/Earnings (P/E) multiple.
Discounts and premiums

 Discount for lack of control

 Discount for lack of marketability
 Minority discount
 Control premium
 Lack of marketability
 Key person discount
Risk Premiums

 Risk Premiums vary with specific

issuers and issue characteristics
including:
 Default risk,
 Maturity risk,
 Liquidity risk,
 Contractual provisions, and
 Tax risk.
 Risk and Return
 Investors must be compensated for
accepting greater risk with higher
expected returns.
Why Russian market down so much
more than US/Western Markets?

 BRIC effect – China off 60% Brazil off

21% India off 34% (Big gains in 2006 –
2007 – now investors cashing out to meet
capital needs in western markets due to
the credit crunch)
 Return of Country Effect
 Stalled reform on corporate governance
 Threats of government control (Mechel &
Evraz)
 Geopolitical risk reevaluation
 Is your money safe in Russia?
 Basic Valuation Model
 The value of any asset is the Present
Value of all future cash flows it is
expected to provide over the relevant
time period.
CF1 CF2 CFn
V0    ... 
(1  k ) (1  k )
1 2
(1  k ) n

V0 = value of the asset at time zero

CFt = cash flow expected at the end of year t
k = appropriate required rate of return (discount
rate)
n = relevant time period
Cost of Capital Models

 CAPM
 Where:
 is the expected return on the capital asset
 is the risk-free rate of interest
 (the beta coefficient) is the sensitivity of the asset
returns to market returns, or also ,
 is the expected return of the market
 is the market premium or risk premium (the difference
between the expected market rate of return and the risk-free rate
of return)
 Changes in Risk
 Although k is defined as the
required return, it is directly related
to the nondiversifiable risk, which
can be measured by beta.
 Recalling the equation for the CAPM:
ks = RF + [β  (km - RF)]
 Thus, actions that increase risk
contribute toward a reduction in
value, and actions that decrease risk
contribute to an increase in value.
Historical Tradition in Corporate
Governance

 Formation of Open Joint Stock Companies

in England and Holland 16th century
 Use of OJSC in US as public companies in
19th and early 20th Century as engines of
industrial growth – Corporate governance
scandals of the 19th far exceed recent
scandals
 Securities Exchange Act of 1934
Securities Act of 1933
 Sarbanes-Oxley Act of 2002
Recent Corporate Failures

 Enron
Corporation
 Worldcom
 Parmalat
 GlobalCrossing
 Aledphia
Even more recent failure related to risk
in the market

 Fannie Mae & Freddie Mac

 BearSterns
 Meryl Lynch
 AIG
 Lehman Brothers
Corporate Governance Introduction
 What is Corporate Governance?
 Definition of “Governance” vs.
“Administration,” “Management,” or
“Control”
 Corporate Governance structures
 Board of Directors
 Chair of the Board
 Corporate Secretary
 Shareholders – General Meeting of
Shareholders
 Why is it important to corporate finance?
Cost of Capital
What is a Corporation?
“The business corporation is an instrument
through which capital is assembled for the
activities of producing and distributing goods
and services and making investments.
Accordingly, a basic premise of corporation law
is that a business corporation should have as its
objective the conduct of such activities with a
view to enhancing the corporation’s profit and
the gains of the corporation’s owners, that is,
the shareholders.” Melvin Aaron Eisenberg
What is a Corporation?
“When they [the individuals composing a corporation] are
consolidated and united into a corporation, they and their
successors are then considered as one person in law . . .
For all the individual members that have existed from the
foundation to the present time, or that shall ever hereafter
exist, are but one person in law – a person that never
dies: in like manner as the river Thames is still the same
river, though the parts which composite are changing
every instant.” Blackstone

“An ingenious device for obtaining individual profit without

individual responsibility.” Ambrose Bierce, The Devil’s
Dictionary
Corporate Form

1. limited liability for investors;

2. free transferability of investor interests;
3. legal personality (entity-attributable
powers, life span, and purpose); and
4. centralized management.
Purpose of a Corporation

 Human satisfaction
 Social structure
 Efficiency and efficacy
 Ubiquity and flexibility
 Identity
 Personality – morality ?
Measuring Performance

 Long term versus short term

 Market value
 EVA
 Human Capital
 Externalities
Corporate Governance Definitions

 OECD – “internal means by which a

corporations are operated and
controlled … which involve a set of
relationships between a company’s
management, its board, its
shareholders and other
stakeholders.”
IFC – Russia Corporate
Governance Manual
 Corporate Governance is a system of
relationships, defined by structures and process.
[Shareholders – Management]
 These relationships may involve parties with
different and sometimes contrasting interests.
 All parties are involved in the direction and
control of the company
 All this is done to properly distribute rights and
responsibilities – and thus increase long term
shareholder value.
Definitions

 “Corporate governance deals with

the ways in which suppliers of
finance to corporations assure
themselves of getting a return on
their investment”, The Journal of
Finance, Shleifer and Vishny [1997,
page 737].
Other Definitions
 "Corporate governance is about promoting
corporate fairness, transparency and
accountability" J. Wolfensohn, president of the
Word bank, as quoted by an article in Financial
Times, June 21, 1999.
 “The directors of companies, being managers of
other people's money than their own, it cannot
well be expected that they should watch over it
with the same anxious vigilance with which the
partners in a private co-partnery frequently watch
over their own.” Adam Smith, The Wealth of
Nations 1776
Corporate Governance System
Corporate Governance
Basics of Corporate Governance
 By issuing corporate securities, firms sell claims
to control the companies` resources
 The interests of the various security holders differ
 Separation of ownership and control implies agency
relationships.
 Interests of agents (management) are different
from those of security holders, particularly from
those of stockholders.
 Monitoring the activities of agents is costly - hence,
full monitoring is not optimal.
 The value forgone due to imperfect optimal
monitoring is an explicit agency cost.
Legal and Economic Institutions

 Legal protection of shareholders

 Concentrated ownership strategy
Contract Theory of Corporate
Governance

 Contract are arranged between principles

(owners) and agent (managers)
 Contracts are also made between the firm
and providers of capital
 Problems with contracts:
 Moral Hazard
 Incomplete contracts
 Adverse selection bias
 Coase 1937, Jensen & Meckling 1976,
Fama and Jensen 1983
Agency Problem

 Managerial discretion - Business

judgement
 Managerial opportunism – self
dealing
 Duty of loyalty of management to
firm
Fiduciary Duty
 The fiduciary duty is a legal relationship between two
or more parties (most commonly a "fiduciary" or
"trustee" and a "principal" or "beneficiary") that in
English common law is arguably the most important
concept within the portion of the legal system known
as equity.
 A fiduciary will be liable to account if it is proved that
the profit, benefit, or gain was acquired by one of three
means:
 In circumstances of conflict of duty and interest
 In circumstances of conflict of duty and duty
 By taking advantage of the fiduciary position.
 Therefore, it is said the fiduciary has a duty not to be
in a situation where personal interests and fiduciary
duty conflict, a duty not to be in a situation where their
fiduciary duty conflicts with another fiduciary duty, and
not to profit from their fiduciary position without
express knowledge and consent. A fiduciary cannot
have a conflict of interest.
Agency Problem Duty of loyalty of
management to firm

 Incentive contracts that align

management interests with
investors
 Agency costs – monitoring and
compliance
 Shareholder actions- shareholder
democracy, proxy fights, access to
the proxy ballot, derivative lawsuits
Choice of Capital Structure
 Debt versus Equity as CG problem
 Creditor/owners ability to exert control
 Debt instrument can reduce the adverse
selection bias by reducing the manager’s
insider information concerning repayment
 Collateral value opposed to firm value
decides the cost of debt
 Debt provides greater protection to
outsider financers – in risky CG
environments there are lower costs of
capital for the issuance of debt
Shleifer and Vishny’s Conclusions

 Investor protection and

concentrated ownership are the
best
 Corporate Governance system
evolve to meet the current
challenges of the day
 The type of Large Investor matters
Four core values of the OECD
corporate governance framework

 Fairness: The corporate governance

framework should protect shareholder
rights and ensure the equitable treatment
of all shareholders, including minority and
foreign shareholders.
 Responsibility: The corporate governance
framework should recognize the rights of
stakeholders as established by law, and
encourage active co-operation between
corporations and stakeholders in creating
wealth, jobs, and the sustainability of
financially sound enterprises.
OECD Core Values
 Transparency: The corporate governance
framework should ensure that timely and
accurate disclosure is made on all
material matters regarding the company,
including its financial situation,
performance, ownership, and governance
structure.
 Accountability: The corporate governance
framework should ensure the strategic
guidance of the company, the effective
monitoring of management by the board,
and the board’s accountability to the
company and shareholders.
Business Case for Corporate
Governance

 Well governed companies have

lower cost of capital
 Reduction of risks
 Higher valuation of human capital in
companies that are well governed
 Higher share valuation
IFC Business Case
Advantages of Good Corporate
Governance
 Stimulating Performance and Improving
Operational Efficiency
 Better oversight and accountability
 Improved decision making
 Better compliance and less conflict
 Less self-dealing
 Better informed
 Avoidance of costly litigation through
adherence to laws and regulations
Advantages of Good Corporate
Governance

 Improving Access to Capital Markets

 Transparency, accessibility, efficiency,
timeliness, completeness, and accuracy
of information critical
 Listing requirements
 Inclusion of Corporate Governance in
investment decision process
Anglo-Saxon Model
 US, UK, Canada, Australia, New Zealand
 Shareholder value maximization
 “outsider” model – arms length investor
 Internal governance mechanisms
 board of directors
 employee compensation
 External mechanisms
 market for corporate control
 monitoring by financial institutions
 competition in product and input market
 Reliance on legal mechanisms to protect shareholder
rights
 Short term financial performance key
German (Continental) Model
 Co-determination - partnership between capital
and labor
 Social cooperation
 The two-tier board structure that consists of a
supervisory board and executive board –
greater efficiency in separation of supervision
and management
 Cross–shareholding in financial – industrial
groups
 Role of banks as major shareholders
 Primary sources of capital – retained earnings
and loans
Japanese Model
 Formal role of large and almost entirely executive
boards – single tier board
 Historical roots of the Keiretsu network
interlocking business relationships
 Existence of significant cross holdings and
interlocking-directorships,
 Lifetime employment system plays in corporate
policy
 Role of banks
 Market share maximization over shareholder
value maximization
 Long term perspective
Corporate Governance Framework
in Russia
 Concentrated Ownership
 The observation that there is little
separation between ownership and
control
 Holding structures and
reorganizations used to deny free
exercise of ownership rights
 Inexperienced Directors
 Government Intervention
Market for Corporate Control
 “Friendly Takeover”
 When a bidder makes an offer for another, it
will usually inform the board of the target
beforehand. If the board feels that the value
that the shareholders will get will be greatest
by accepting the offer, it will recommend the
offer be accepted by the shareholders.
 A takeover would be considered "hostile"
if
1) the board rejects the offer, but the bidder
continues to pursue it, or
2) if the bidder makes the offer without
informing the board beforehand.
Theory

 Berle and Means (1932) –

separation of ownership and control
through modern corporation
structures
 Agency Problem
Agency Problem

 Separation of Ownership and

Control
 Contract between financiers and
management
 Managerial discretion - Business
judgement
 Managerial opportunism – self
dealing
Agency Problem

 Duty of loyalty of management to

firm
 Incentive contracts that align
management interests with
investors
 Agency costs – monitoring and
compliance
 Shareholder actions- shareholder
democracy, proxy fights, access to
the proxy ballot, derivative lawsuits
Control Mechanisms
More Theory
 Conventional Wisdom (Manne 1971) :
 The business literature describing the
classical functions of boards of directors
typically includes three important roles:
(1) establishing basic objectives,
corporate strategies, and board policies:
(2) asking discerning questions; and (3)
selecting the president.
Some Early Research (Manne 1971)

 First classical role

 Found that boards of directors of most large
and medium-sized companies do not
establish objectives, strategies, and policies
however defined
 These roles are performed by company
management
 Presidents and outside directors generally
agreed that only management can and
should have these responsibilities.
Some Early Research (Manne 1971)
 A second classical role assigned to boards of
directors is that of asking discerning questions -
inside and outside the board meetings. Again it
was found that directors do not, in fact, do this.
Board meetings are not regarded as proper
forums for discussions arising out of questions
asked by board members.
 A third classical role usually regarded as a
responsibility of the board of directors is the
selection of the president. Yet it was found that
in most companies directors do not in fact
select the president, except in the two crisis
situations cited earlier.
Research that confirms Stewardship
Theory
 Muth and Donaldson (1997) challenged
agency theory, which underpin
conventional assumptions about the
benefits of checks and balances –
 Boards with well connected, executive
directors perform better than those that meet
the paradigms of conventional governance
thinking
 Also research has shown that increasing
governance conformance and compliance
may not add to corporate performance - it
can actually detract - Donaldson and
Davies (1994)
Theoretical Challenges to Agency
Theory

 Stewardship theory, the alternative

perspective, takes an altogether
broader frame of reference, being
based on the original and legal view
of the corporation in which directors
have a fiduciary duty to their
shareholders to be stewards for
their interests.
Performance Governance Relationship

 Yit is one of the firm performance

measures, Govit is a governance
rating, Xit is a vector of control
variables and e it is the error term.
Russian Corporate Governance
Structures
Required number of Directors
 At least five directors for companies with
1,000 and fewer shareholders with voting
rights;
 At least seven directors for companies
with more than 1,000 shareholders with
voting rights;
 At least nine directors for companies with
more than 10,000 shareholders with
voting rights.
Who can be a director?
 Only individuals with “full dispositive capacity” can
be directors. Directors should have the capacity to
acquire and exercise civil law rights by their
actions, be able to create civil law obligations,
and fulfill these rights and obligations;
 A legal entity cannot be a director, although an
individual who happens to be a representative of
a legal entity can be elected to the Supervisory
Board. In this case, the individual elected to the
Supervisory Board may only serve in his capacity
as a director and not as a representative of the
legal entity, i.e. he must act in the interest of the
company on whose Supervisory Board he is
sitting and not of the company he is representing
Who can not be a director?
 Revision Commission members cannot be
directors
 Counting Commission members cannot be
directors
 An Executive Board member or the
General Director of Company A can only
be a director of Company B after the
Supervisory Board of Company A has
given its consent.
Types of Directors

a) Executive Directors
Executive directors can be defined as
those that also hold an executive
position in the company, namely
that of:
The General Director;
An Executive Board member; or
A manager of the company who is not an
Executive Board member.
Types of Directors
b) Non-Executive Directors
Non-executive directors are Supervisory Board
members that do not hold an executive
position in the company.
c) Independent Directors
Russian law does not define the concept of
independent directors. The Company Law
does, however, refer to independent directors
under specific circumstances to determine the
position of individuals engaged in related party
transactions and to prevent possible conflicts
of interests.
Independent Director
 In this respect, an independent director is defined as
an individual who has not been in any of the following
positions at the time of the approval of a business
transaction, or during one year immediately preceding
the approval of such a transaction:
 The General Director, the External Manager, an
Executive Board member or a member of the
governing bodies (Supervisory Board, General Director
and Executive Board) of the External Manager; or
 A person whose spouse, parents, children, brothers,
and sisters by one or both parents are the External
Manager or hold a position in the governing bodies of
the External Manager; or
 A person whose adoptive parents or adopted children
are the External Manager or hold a position in the
governing bodies or the External Manager; or
 An affiliated person other than a director of the
company.
What is Independence?
 Independence of a Director: a Director must
always act in a manner independent of
management and never be conflicted by any
relationship to management (i.e., financial,
familial, or social). Independence measurements
include:
Relatedness of the Director:
- Employee (in last three years);
- Professional advisor (in last three years);
- Executive of any affiliated company;
- Other income from company;
- Kinship or social ties;
• Interlocks with other Directors;
• Number of Boards on which Director serves.
Independent Director
 In conflict situations, an Independent Director
shall be guided by the principles of increasing
shareholder value and an equitable approach to
the interests of all shareholder groups, and
encourage the parties involved in the decision to
adhere to the same principles.
 An Independent Director shall not abuse his/her
position to the detriment of the company or its
shareholders or for the purpose of gaining direct
or indirect personal advantage or advantage for
any other associated person, except for the
remuneration for Board membership.
Independent Director
 Observance of the independence requirement is
the most important aspect of the activity of an
Independent Director.
(1) An Independent Director shall refrain from any
actions that could lead to a loss of his/her
independence. Where circumstances arise which
make an Independent Director lose his/her
independence, the Independent Director must
immediately notify the shareholders, the
management and the Association accordingly.
(2) An Independent Director shall be prepared to
provide arguments in support of his/her position if
he/she disagrees with the majority of members of
the Board of Directors, its chairman, the president
of the company, or its managing director.
Independent Director
 Transparency and openness to dialog are
the distinguishing characteristics of an
Independent Director.
 (1) An Independent Director shall strive to
establish constructive dialog with the
company's Board of Directors and executive
management. An Independent Director's
ethical standards, decision making principles
and reasons for disagreeing with a proposed
decision should be clear for the Board of
Directors and executive management.
 (2) An Independent Director is recommended
to present the present Code to the company's
Board and the management.
Independent Director
 An Independent Director acts as an agent
of all the company shareholders and
therefore shall, within the limits of his/her
authority, protect the rights and
legitimate interests of all of the
company's shareholders and help
establish constructive dialog between the
company's shareholders and
management.
 An Independent Director shall endeavor
to ensure that shareholders are given
access to corporation information.
Independent Director
 When dealing with third parties, an Independent
Director shall be loyal to the company and its
shareholders and protect their interests.
 When dealing with the investment community and
stock market analysts, an Independent Director
shall make every possible effort to enable all the
parties concerned to have simultaneous access to
the information disclosed.
 An Independent Director shall disclose only
accurate information that may be disclosed
according under applicable laws and does not
damage the company's business.
Best Practices: Election of Board
Members
Shareholders should receive sufficient information to
determine the ability of Supervisory Board
nominees to fulfill their duties and, if applicable,
to ascertain their independence. Some useful
items of information include:
• The identity of the candidate;
• The identity of the shareholder (or the group of
shareholders) that nominated the candidate;
• The age and educational background of the
candidate;
• The positions held by the candidate during the last
five years;
• The positions held by the candidate at the moment
of his nomination;
• The nature of the relationship the candidate has with
the company;
Best Practices: Election of Board
Members continued
• Other Supervisory Board memberships or official
positions held by the candidate;
• Other nominations of the candidate for a position on
the Supervisory Board or official positions;
• The candidate’s relationship with affiliated persons
of the company;
• The candidate’s relationship with major business
partners of the company;
• Information related to the financial status of the
candidate, and other circumstances that may affect
the duties and independence of the candidate as a
Board member; and
• The refusal of the candidate to respond to an
information request of the
company.
The Election of Directors

 All directors must be elected with cumulative voting.

 Cumulative voting is a system that helps minority
shareholders pool their votes to elect a representative
for the Supervisory Board. The election of directors
cannot be done if a GMS is held by written consent.
 How Cumulative Voting Works:
 Candidates for the Supervisory Board are voted on
collectively, i.e. as a group;
 Each shareholder has a maximum number of votes equal to
the number of directors that must be elected (according to
the charter or a decision of the GMS) multiplied by the
number of voting shares held;
 Shareholders can allocate their votes to one candidate or
divide them among several candidates as they please;
 The top X candidates with the most votes are considered
elected, whereby X equals the number of Supervisory Board
members to be elected as specified by the charter or the
decision of the GMS.
 Cumulative Voting: Minimum number of
votes to elect one director

where D — the number of directors to be

elected, S — the number of outstanding voting
shares and n — the total number of directors the
majority shareholder wants to elect
Company Practices in Russia
 Representatives of major shareholders
(35%),management and employees (30%) are
the most common types of directors,
 Independent directors (18%) and minority
shareholder representatives (9%) still constitute a
minority on most Supervisory Boards.
 A positive correlation exists between the number
of shareholders in a company and the number of
representatives of majority shareholders on the
Supervisory Board. Hence, Supervisory Boards of
large companies with many shareholders tend to
include more representatives of large
shareholders.
Governance is Different from
Management

Governance

Management
Governance and Management

 Management runs the business

 the board ensures that the business
is well run and run in the right
direction
 Functions of the board

Outward Providing Strategy Formulation

looking Accountability

Approve and work

through the CEO

Inward Monitoring and Policy Making and

Looking Supervising Revising

Past and present focused Future Focused

 All Executive Board

Governance

O
O O
O O

O - executive directors
Management
 Majority – executive board

Governance
N

N
N O
O
O O

O - executive directors
N – non executive
Management
directors
 Majority – non executive board

Governance
N

N
N O
O
O O

O - executive directors
N – non executive
Management
directors
 Two – tier board

Governance N N N

N N
N N
N N

O - executive directors O
N – non executive O O
Management
directors
O O
 Majority – executive board

Governance
N
N
N
N
N O

O O

O - executive directors
N – non executive
Management
directors
Corporate Governance and
Initial Public Offerings

 Corporate Governance is a principle

variable in evaluating risk / setting
discount for IPOs
 Firms reaching the market make
significant CG changes to their
board structure and practices to
conform to market expectations
Role of the Board in a Public Company
IPO / Listing Experience

 The Board
 Effectiveness
 Talents and background of board
members
 Tying board remuneration closely to
performance
 Strategic thinking by the Board
 Managing risk effectively
Role of the Board in Listing - IPO

 Developing a robust audit

committee
 Taking corporate social
responsibility on board
 Encouraging and active dialogue
with shareholders
The Effective Board

 Clear strategy aligned to capabilities

 Vigorous implementation of strategy
 Key performance drivers monitored
 Effective risk management
 Sharp focus on views of the capital
market and other key stakeholders
 Regular evaluation of board
performance
What does the market look for in a
board member?

 Asks the difficult questions

 Works well with others

 Has industry awareness

 Provides valuable input

 Is available when needed

 Is alert and inquisitive

What does the market look for in a
board member?

 Has business knowledge

 Contributes to committee work
 Attends meetings
 Speaks out appropriately at board
meetings
 Prepares for meetings
 Makes long-range planning contribution
 Provides overall contribution
Implementing effective strategy and
change programs

 The blueprint for the strategy

 The business case
 The transformation program
 A mobilized organization
 A ‘transformation map’
The audit committee’s main
responsibilities

 To monitor the integrity of the financial

statements
 To review the company’s internal
financial controls, internal control and
risk management systems.
 To monitor/review the effectiveness of
the internal audit function.
 To make recommendations to the board
on the appointment/removal of the
external auditor
The audit committee’s main
responsibilities

 To monitor/review the external auditor’s

independence/objectivity and the
effectiveness of the audit process.
 To develop/implement policy on the
engagement of the external auditor to
supply non-audit services
 To review arrangements by which staff
may raise concerns about possible
improprieties (‘whistleblowing’)
Flotation – who ends up steering the
boat?