E&CG

Corporate Governance
VII

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 Corporate governance issue- as old as
economics

‘ The directors of companies, being

managers of other people’s money, cannot be
expected to watch over it with the same
vigilance with which they watch over their
own ‘ ( Adam Smith 1776 )

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 Agenda
• What is Corporate Governance?
• Agency Problems
• Governance mechanisms
• Why do Governance Mechanisms Fail?
• Some Governance Frame works
• Indian regulatory frame work

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 What is Corporate Governance?

Corporate governance is the system by which

companies are directed and controlled (Cadbury,
1992)

Corporate governance is about nurturing an

enterprise while ensuring accountability in the exercise of
power and patronage by firms (world Bank, 1999)

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Separation of Ownership and managerial Control

• Basis of Modern Corporation

– Shareholders purchase stock, becoming residual
claimants
– Shareholders reduce risk by holding diversified
portfolios
– Professional managers are contracted to provide
decision making , operations

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• Modern public corporation form leads to efficient
specialization of tasks:
– Risk bearing by shareholders
– Strategy development and decision making by
managers
– The vital link between shareholders and the managers–
THE BOARD. The task-- strategy, directions ,control.
– One major issue. Does the board represent only the
share holders or all stakeholders?
– Do they represent only the dominant share holder(s) or
all the share holders ?
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 An Agency Relationship

Shareholders (Principals)
•Firm Owners
Hire

Managers (Agents)
•Decision Makers
and create

An Agency Relationship
•Risk Bearing Specialist (Principal)
•Paying Compensation to
•A Managerial decision-making
specialist agents

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 Asymmetry of information

• Managers have all the information

• Selective release of information

• Incomplete release of information

• Share holders always at a disadvantage

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 Agency Relationship Problems

• Principal and agent have divergent interests and

goals
• Shareholders lack direct control of large,
publicly traded corporations
• Agent makes decisions that result in the pursuit
of goals that conflict with those of the principal
• It is difficult or expensive for the principal to
verify that the agent has behaved appropriately
• Agent falls prey to managerial opportunism
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 Managerial Opportunism

• The seeking of self-interest with guile (cunning

or deceit)
• Managerial opportunism is:
– An Attitude (inclination)
– A set of behaviors (specific acts of self-interest)
• Managerial opportunism prevents the
maximization of shareholder wealth (the
primary goal of owner/principals)

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 Response to Managerial Opportunism

• Principals do not know beforehand which

agents will or will not act opportunistically
• Thus, principals establish governance and
control mechanisms to prevent managerial
opportunism

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 Examples of the Agency Problem
• Possible Problems
- Product diversification
- Increased size and relationship of size to managerial
compensation
- Reduction of managerial employment risk
• Use of Free Cash Flows
- Managers prefer to invest these funds in additional
product diversification
- Shareholders prefer the funds as dividends so they
control how the funds are invested
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Agency Costs and Governance Mechanisms

• Principals may engage in monitoring behavior to

assess the activities and decisions of managers
- However, dispersed shareholding makes it
difficult and inefficient to monitor management’s
behavior
• 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
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 Share holder’s dilemma
• Cost of monitoring high and may be counter
productive
• Lack of mechanism other than the Board to
ensure compliance
• Too much control may curb risk taking which is
the very essence of managerial working

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Governance Mechanisms

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 Internal Governance Mechanisms

• Ownership Concentration
– Relative amounts of stock owned by individual
shareholders and institutional investors
• Board of Directors
– Individuals responsible for representing the firm’s
owners by monitoring top-level managers strategic
decisions

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The Firm
 Internal Governance Mechanisms
• Executive Compensation
– Use of salary, bonuses, and long-term incentives to align
managers’ interests with shareholders interests

The Firm

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 External Governance Mechanisms
• Market for corporate Control
– Purchase of a firm that is underperforming relative to
industry rivals in order to improve its strategic
competitiveness

The Firm

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 Governance Mechanisms
Large Block shareholders have a
Ownership strong incentive to monitor
Concentration (a) management closely:
- Their large stakes make it
worth their while to spend
time, effort and expense to
monitor closely
- They may also obtain Board
seats which enhances their
ability to monitor effectively

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Governance Mechanisms (cont’d)

Ownership The increasing influence of

Concentration (b) institutional owners (stock
mutual funds and pension
funds)
- Have the size and incentive
(demand for returns to funds) to
discipline ineffective top-level
managers

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Governance Mechanisms (cont’d)

Ownership
Concentration (c) Shareholder activism:
-Shareholders can convene to
discuss corporation’s direction
-If a consensus exists,
shareholders can vote as a block
to elect their candidates to the
board

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Governance Mechanisms (cont’d)
Ownership •Board of directors
Concentration
- Groups of elected individuals
that acts in the owners’
Board of Directors interests to formally monitor
(a) and control the firm’s top-level
executives
•Board has the power to:
-Direct the affairs of the
organization
-Punish and reward managers
-Protect owners from
managerial opportunism

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Governance Mechanisms (cont’d)
Ownership
Concentration • Composition of Boards :
- Insiders: the firm’s CEO and
Board of Directors other top-level managers
(b) - 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

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Governance Mechanisms (cont’d)
• Criticisms of Boards of
Ownership Directors include:
Concentration -Too readily approve managers’
self-serving initiatives
Board of Directors - Are exploited by managers
(c) with personal ties to board
members
- Are not vigilant enough in
hiring and monitoring CEO
behavior
- Lack of agreement about the
number of and most
appropriate role of outside
directors
- Multiple directorships

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Governance Mechanisms (cont’d)
Ownership
Concentration Enhancing the effectiveness of
boards and directors:
-More diversity in the
Board of Directors
backgrounds of board members
(d) - Stronger internal
management and accounting
control systems
- More formal processes to
evaluate the board’s
performance
- Changes in compensation of
directors

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Governance Mechanisms (cont’d)
* Forms of compensation:
Ownership
- Salary, bonuses, long-term
Concentration
performance incentives, stock
awards, stock options
Board of Directors
•Factors complicating executive
Executive compensation:
Compensation (a) - Strategic decisions by top-
level managers are complex,
non-routine and affect the firm
over an extended period

* Other variables affecting the

firm’s performance over time

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Governance Mechanisms (cont’d)

Ownership
Concentration
* Limits on the effectiveness of
Board of Directors executive compensation:
- Balance sheet not showing
executive wealth
Executive - Options not expensed at the
Compensation (b) time they are awarded

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Governance Mechanisms (cont’d)

Ownership * Managerial defense tactics

Concentration increase the costs of mounting a
takeover
Board of Directors •Defense tactics my require:
-Asset restructuring
Executive -Changes in the financial
Compensation structure of the firm
- Shareholder approval
Market for corporate * Market for corporate control
control (b) lacks the precision of internal
governance mechanisms

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 Additional Governance Mechanisms
• Debt holders
- Large debt holders can assume the role of active monitors
- When a firm defaults or violates debt covenants, the debt
holders reserve a variety of control rights
- The need to make on going cash payments provides the firm
management with more incentives to operate efficiently to
generate even more cash flow
• Legal and Regulatory Mechanisms
• Auditors
• Banks and Analysts
• Media and Public Activists

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 Why do governance mechanisms fail?
• Shareholder concentration, identity and goals
- Principal-Principal goal incongruence
- Business Group structures (pyramidal, cross-holdings)
- Dual class equity shareholdings
• Board Composition
- CEO and chairperson duality
- Inside/Outside director nomination and composition
• Insider trading

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 International corporate governance

• USA
• Most ungovernable/ungoverned system
• Philosophy demands no interventions
• External mechanism –stock holder driven
worked
• Repeated scandals
• SOX- emphasis on reporting

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 International Corporate Governance

• Germany
- Owner and manager are often the same in
private firms
- Public firms often have a dominant
shareholder, frequently a bank
- Frequently there is less emphasis on
shareholder value than in U.S. firms although
this may be changing

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 International Corporate Governance

Germany: (Two-tiered Board)

Vorstand Responsible for the functions of

direction and management

Aufsichtsrat Responsible for appointing

members to the Vorstand

Employees Union Responsible for appointing

members members to the Aufsichtsrat
Shareholders

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 International Corporate Governance:
• Japan
- Important governance factors:
* Obligation
* “Family”
* Consensus
- Banks (especially “main bank”) are highly
influential with firm’s managers
- Keiretsus: strongly interrelated groups of firms
tied together by cross-shareholdings
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 International Corporate Governance
• Japan (cont’d)
- Other governance characteristics:
* Powerful government intervention
* Close relationships between firms and
government sectors
* Passive and stable shareholders who exert little
control
* Virtual absence of external market for
corporate control
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 Internal and External Governance Mechanisms:
A Global Perspective

External governance mechanisms

weak Strong

Strong
Germany
Canada
Japan
Internal
Governance
Mechanisms
United States
United Kingdom
Weak

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Indian Regulatory Framework
* The Companies Act – Disclosure of Interest,
approval levels in organizations, corporate
processes
* Clause 41 of Listing Agreement with Stock
Exchanges
* Clause 49 of Listing Agreement with Stock
Exchanges
* Disclosure of price-sensitive information
* SEBI Insider Trading Regulations
* SEBI Takeover Regulations
* Regulations for Merchant Bankers,
Depositories, Debenture Trustees, Brokers,
Mutual Funds, Venture Capital Funds
* Sarbanes Oxley Act, 2002 37
 The Companies Act –
A governance perspective
* Disclosure of Interest
* Approval by shareholders
* Approval by creditors
* Approval by Company Law Board
* Audit Committee

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 Listing Agreement – Clause 41
* Furnish unaudited financial results on a quarterly basis
within one month from the end of quarter to the stock
exchanges
* Make an announcement to the stock exchange where the
company is listed, immediately within 15 minutes of the
closure of the board meeting in which the unaudited
financial results are placed
* Number of investor complaints pending at the beginning of
the quarter, received and disposed off during the quarter
and lying unresolved at the end of the quarter
* Announce the same within 48 hours of the conclusion of
the board meeting, in at least one English and one regional
daily, where the registered office of the company is situated

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Listing Agreement – Clause 49
* Board of Directors – composition, compensation,
Independent director, procedure, code of conduct,
term of office
* Audit Committee – qualified and independent,
meetings, powers & role, review of information
by Audit Committee, Audit Report & Audit
Qualification
* Subsidiary companies
* Disclosures – related party transactions, board
disclosures & risk management, proceedings
from IPOs, Remuneration of Directors,
Management, Shareholders
* CEO/CFO certification
* Report on Corporate Governance 40
 Regulations - governance
* Disclosure of price-sensitive information
* SEBI Insider Trading Regulations
* SEBI Takeover Regulations
* Regulations for Merchant Bankers, Depositories,
Debenture Trustees, Brokers, Mutual Funds,
Venture Capital Funds
* Sarbanes Oxley Act, 2002

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 Cases for the next class

• Satyam from a corporate governance

perspective

• Universal Engineering
Submit a one page (each ) report on the 2 cases.
Work in groups

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