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Introduction to Corporate Governance

Learning Outcomes:
o Introduce Corporate Governance
o Types of corporate entities
o The limited liability companies
o Separation of ownership and control
o Evolution of corporate governance

All corporate entities need a governing body (board of directors):

- profit-orientated companies, public and private
- joint ventures
- co-operatives
- partnerships
- not-for-profit organizations =
voluntary and community organizations
charities
academic institutions
governmental corporate entities
Quangos

 They are called directors because they are responsible for setting the direction of the
firm, strategy formulation and policy making. Also responsible for supervising
management and being accountable

What is Corporate Governance?

§ Corporate governance concerns the way power is exercised over corporate entities
§ Corporate governance is different from management
§ Executive management is responsible for running the enterprise: the governing body
ensures that it is running in the right direction and being run well
§ Directors are responsible for setting the organization’s direction, formulating
strategy and policy making, as well as its performance
§ The board is also responsible for supervising management and being accountable.

Why study Corporate Governance?

§ Corporate governance is of paramount importance to a company
§ It is almost as important as its primary business plan.
§ When executed effectively, companies can operate more efficiently, to improve
access to capital, mitigate risk and safeguard stakeholders.
§ When executed effectively it can prevent corporate scandals, fraud and the civil and
criminal liability of the company

The Phrase ‘Corporate Governance’:

 Chaucer (c1343 -1400), the English writer, philosopher and courtier, used the word,
governance (although he could not decide how to spell it (gouernance, governaunce)
 But the phrase ‘corporate governance’ did not come into use until the 1980s
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The Limited Liability Companies:

Unincorporated Company:
In early 1800s, a company financed by another party; If it goes bankrupt, creditors can
pursue what is owed from all the owners (their assets aren’t safe). Not paying debt led to
debtors' prison. = This was a disincentive for investors to invest in companies. This changed
with the introduction of limited liability companies leading to huge industrial growth around
the world

The joint stock, Limited liability company:

• A brilliant concept of the 19th century (1855 in UK)
• Incorporate a legal corporate entity
• Separate from its owners, but with similar legal rights
 to buy and sell own assets
 to employ people
 to contract and incur debts
 to sue and be sued
• Companies have an existence independent of owners
• Shares can be transferred, traded (Company had life of its own)
• Liability of shareholders for company debts limited to their equity
• Ownership still basis of power, they elect directors
• Directors stewards for shareholders = directors’ fiduciary duty to act on their behalf

Separation of ownership and control:

- In the early days, limited-liability companies were relatively small and simple
- Shareholders drawn from wealthier classes and could attend shareholder meetings
- In those days there were no chains of financial institutions, pension funds, hedge
funds, brokers, or agents between the investor and the boardroom.
- But by the 20th century, many companies became large and complex. Their
shareholders numerous, geographically spread, with different needs and
expectations

- The numerous widespread shareholders (owners) had little power over the
management (control) of the company
- The governance agency dilemma arises whenever ownership or shareholders are
separated from executive management control
- "The directors of companies, being the managers of other people's money rather
than their own, cannot well be expected to watch over it with the same anxious
vigilance with which (they) watch over their own. (Adam Smith, The Wealth of
Nations, 1776)
- Growing separation of power between executive Management and shareholders
(Berle and Means, 1932)

- The rise of the modern corporation has brought a concentration of economic power
which can compete on equal terms with the modern state - economic power versus
political power, each strong in its own field.
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- The state seeks in some aspects to regulate the corporation, while the corporation,
steadily becoming more powerful, makes every effort to avoid such regulation…
(Berle and Means 1932, revised 1967)

Evolution of Corporate Governance:

1970s 1980s collapses,

US = audit committee required Maxwell (UK)
EU/UK, = Bond (Australia)
two tier boards promoted in EU Nomura (Japan)
Bullock Report (UK) backed unitary boards Burnham Drexall/Boesky (USA)
Stakeholder ideas (Watkinson & Nader)

Developments in the 1990s

1990s calls for codes of best practice
Corporate governance codes arrive:
1992 Cadbury Report based on recognized good practice (UK)
Defined corporate governance as ‘the system by which companies are
directed and controlled’
§ wider use of independent non-executive directors, the
introduction of an audit committee of the board with
independent members
§ division of responsibilities between the chairman of the
board and the chief executive
§ a remuneration committee of the board to oversee
executive rewards
§ a nomination committee to propose new board members
§ reporting publicly that the corporate governance code had
been complied with or, if not, explaining why.
 1997 US Business Roundtable Statement on Corporate Governance

Codes of best practice around the world: Subsequent UK codes:

1. Australia (1993) 1. Cadbury (1992)
2. Canada (1994) 2. Greenbury (1995)
3. Holland (1997) 3. Hampel (1998)
4. Hong Kong, Italy, India, Japan (1998) 4. Turnbull (1999)
5. Russia (2001) 5. Myners (2001)
Codes from international 6. Higgs (2003)
agencies 7. Smith (2003)
 OECD/World Bank, Commonwealth 8. Tyson (2003)
(1999) 9. Walker (2009)
Codes from institutional 10. Davis (2010)
investors 11. UK Combined Code (2012)
 CalPERS, Hermes …  Overtime regulations have been
updated due to other scandals that
has occurred.
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Definition

Sir Adrian Cadbury (1999) “Corporate governance is concerned with holding the balance
between economic and social goals and between individual and communal goals…. the
aim is to align as nearly as possible the interests of individuals, corporations, and society”.

How did the global financial crisis occur?

• Western world lending and asset bubble = massive liquidity
• lax monetary policies = cheap money
• Companies used low-interest loans to leverage their financial strategies
• Personal borrowing soared

2007 in US
• after a decade of substantial growth house prices fell
• Some owners in negative equity
• Worse, many loans were to poor credit risks, the so-called sub-prime market
• Foreclosures escalated
• House prices fell further

Global crisis - financial institutions fail:

In US
- Bear Stearns (bailed out by Government)
- Fannie Mae and Freddie Mac (Government guarantees)
- AIG Insurance (Government loan facility)
- Lehman Brothers (allowed to become bankrupt after 158 years)
In UK
- Northern Rock bank (nationalised)
- RBS (Royal Bank of Scotland) (nationalised)
- HBOS (nationalised)
- Lloyds Bank (major government stake)
In Iceland
- All three banks and stock market collapsed (supported by IMF)

Corporate Governance Issues in the Financial Crisis: Corporate Governance response to Financial Crisis:

Where were: US SEC changes to regulatory procedures for listed

- the directors of these institutions? (Internal
governance mechanism)
- Regulators? (External governance
mechanism)
- Auditors? (External governance mechanism)
- Credit agencies? (External governance
mechanism)
Was bailing out the firms a good idea?
Why was nobody held to account?
Did compensation structure encourage excessive risk
taking?
companies
§ obligatory (though non-binding) shareholder
votes on top executive remuneration
§ annual election of directors
§ creation of board-level committees to focus
on enterprise risk exposure
§ separation of the CEO role from that of the
board chairman suggested