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Corporate Governance

Msc. Arabela Ichim

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Content
• What is corporate governance
• Agency theory
• Why is corporate governance important
• Influence of corporate governance on firm performance
• Efficient market for corporate control
• Agency theory and the MCC
• Corporate governance across the world
• Corporate governance systems comparison
1.What is Corporate Governance
• “Corporate Governance is the system by which 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… 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)
Corporate Governance Systems
Owner-
Two-tier corporate One-tier corporate
entrepreneur
Shareholders Shareholders

Owner
Public company

Public company

Board of
Directors/Supervisory Board
Private
company Board
Executive Board (Non-executives + Executives)
Agency Theory
• In the modern firm, control is separated from ownership
• It is duty of controlling agents (i.e. managers) to satisfy the interests of
owning principals (i.e. shareholders): the firm should be run in their
interest as they are both owners and residual risk bearers
• By assumption, the interests of agents (i.e. managers) are contrary to
those of principals (i.e. shareholders): each group/person strives to
appropriate value
• Thus, if given the opportunity, agents (i.e. managers) will misappropriate
value (from the principal’s perspective)
• E.g., they may redirect free cash flow to superfluous investment projects,
perks and salaries, including M&A
Why is Corporate Governance important?
• Increasing scale and activity of corporations
• Growth of investment institutions
• Deregulation of financial markets
• Effective monitoring necessary for security of investments
• Recognition that governance matters for accountability, performance
and attracting capital
• A general trend in society towards openness, transparency and
disclosure
• Last but not least: the huge incidence of corporate fraud, self-serving
managerial behavior, financial crisis
Why is Corporate Governance important?
Total Number of US Corporation Earnings Re-Statements (1997-2005)
Source: Adapted from Coffee J. (2002), Glass, Lewis and Co (2006)
Full source: Adapted from Coffee Jr J.C. (2002). “Racing Towards the Top: The Impact of Cross-Listings and Stock MarketCompetition on International Corporate Governance”. Columbia Law Review
107(7):1757-1831; Glass Lewis &Co (2006)
Why is Corporate Governance important?
Top Five US CEOs vs Five US Fund Managers CEOs 2008 (US$ millions)
Source: Compilation from Forbes CEO Compensation 2008 Report; Institute of Policy Studies: Executive Excess 2008. 3700

2800
2500

1700
1500

557

155 223
112 117

Aubrey McClendon Michael Watford John B. Hess Ray Irani Lawrence Ellison Kenneth Griffin Philip Falcone James Simons George Soros John Paulson
Chesapeake Ultra Hess Occidental Oracle Citadel Investment Harbinger Reinaissance Soros Fund Paulson & Co
Energy Petroleum Petroleum Group Partners Technologies Mgmt
Influences of Corporate Governance on
Performance
• It affects the development & functioning of capital markets and
exerts a strong influence on resource allocation.
• Can impinge upon the development of equity markets, R & D,
innovative activity, entrepreneurship, and the development of an
active SME sector, and thus impinge on economic growth
• “It is thought that poor corporate governance mechanisms (…) have
proved, in part, to be a major impediment to improving the
competitiveness of firms.” (OECD, 1999)
Influence of Corporate Governance on
performance
• Negative examples: Wolkswagen
Source: Bloomberg( September 21,2015)
Efficient market for corporate control
• The economy is populated by certain well-performing and certain
underperforming firms, we want the first, not the latter
• Underperforming firms must display relatively low market value
• This is only known to those firms themselves and to smart investors,
including well-performing firms
• In an efficient MCC there will be a permanent (fluid) process of takeovers
of underperforming firms by smart investors
• Given that executives are assumed to maximize their own utility (income,
status, perks), they will try to protect their firms against takeovers
• Governments should therefore guarantee a free MCC
Agency Theory and the Theory of the Market
for Corporate Control

• Executive pay must derive from interests of principals, i.e. must be


derived from market value indicators: internal control
• Executives must be subject to replacement if they underperform:
external control
• Internal control realized through stock-related pay (stock; options;
bonuses related to market value)
• External control realized through the takeover mechanism
Agency Theory and the Theory of the Market
for Corporate Control

• Reliance on modern agency theory = adopting shareholder value as


reference model

• The market for acquisitions must be allowed to work without barriers


Corporate Governance Systems
Owner- Two-tier corporate One-tier corporate
entrepreneur
Shareholders Shareholders

Owner
Public company

Public company

Board of
Directors/Supervisory Board
Private
company Board
Executive Board (Non-executives + Executives)
Literature

Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency
costs and ownership structure. Journal of financial economics, 3(4), 305-360
Jensen, M. C., & Ruback, R. S. (1983). The market for corporate control: The scientific evidence.
Journal of Financial economics, 11(1), 5-50.
Special credits go to Hans Schenk, Professor of Economics at Utrecht
School of Economics.