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Corporate Governance:

An Overview
Professor Alexander Settles
Faculty of Management, State University
Higher School of Economics

Learning objectives

Corporate Governance and

Investor Protection
Role of Public Sector in Setting
Framework for Good Corporate
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
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

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

Dividend valuation model (DVM),

Book value,
Liquidation value, and
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

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 &
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.


(1 k ) (1 k )
(1 k ) n

V0 = value of the asset at time zero

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

Cost of Capital Models


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 + [ (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


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
Securities Exchange Act of 1934
Securities Act of 1933
Sarbanes-Oxley Act of 2002

Recent Corporate Failures


Even more recent failure related to risk

in the market

Fannie Mae & Freddie Mac

Meryl Lynch
Lehman Brothers

Corporate Governance Introduction

What is Corporate Governance?

Definition of Governance vs.
Administration, Management, or
Corporate Governance structures

Board of Directors
Chair of the Board
Corporate Secretary
Shareholders General Meeting of

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
corporations profit and the gains of the
corporations 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.
An ingenious device for obtaining individual profit
without individual responsibility. Ambrose Bierce,
The Devils Dictionary

Corporate Form
1. limited liability for investors;
2. free transferability of investor
3. legal personality (entityattributable powers, life span, and
purpose); and
4. centralized management.

Purpose of a Corporation

Human satisfaction
Social structure
Efficiency and efficacy
Ubiquity and flexibility
Personality morality ?

Measuring Performance

Long term versus short term

Market value
Human Capital

Corporate Governance Definitions

OECD internal means by which a

corporations are operated and
controlled which involve a set of
relationships between a companys
management, its board, its
shareholders and other

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.


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
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


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

Managerial opportunism self
Duty of loyalty of management to

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
Agency costs monitoring and
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 managers
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 Vishnys Conclusions

Investor protection and

concentrated ownership are the
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
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 boards accountability to the
company and shareholders.

Business Case for Corporate


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


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


Improving Access to Capital Markets


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

External mechanisms

board of directors
employee compensation

market for corporate control

monitoring by financial institutions
competition in product and input market

Reliance on legal mechanisms to protect shareholder

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
Crossshareholding in financial industrial
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
Lifetime employment system plays in corporate
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
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"

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.


Berle and Means (1932)

separation of ownership and control
through modern corporation
Agency Problem

Agency Problem

Separation of Ownership and

Contract between financiers and
Managerial discretion - Business
Managerial opportunism self

Agency Problem

Duty of loyalty of management to firm

Incentive contracts that align
management interests with investors
Agency costs monitoring and
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
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


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


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


Required number of Directors

At least five directors for companies with

1,000 and fewer shareholders with voting
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
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

Counting Commission members cannot be
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

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
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

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 candidates relationship with affiliated persons of
the company;
The candidates 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

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

Governance is Different from




Governance and Management

Management runs the business

the board ensures that the business
is well run and run in the right

Functions of the board



Strategy Formulation

Approve and work

through the CEO

Monitoring and

Past and present focused

Policy Making and


Future Focused

All Executive Board




O - executive directors

Majority executive board


O - executive directors
N non executive



Majority non executive board


O - executive directors
N non executive



Two tier board






O - executive directors
N non executive


Majority executive board



O - executive directors
N non executive


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

and background of board

Tying board remuneration closely to

Strategic thinking by the Board

Managing risk effectively

Role of the Board in Listing - IPO

Developing a robust audit

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

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
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 committees main


To monitor the integrity of the financial

To review the companys 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 committees main


To monitor/review the external auditors

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