Introduction to Corporate Governance

FB5690, City University of Hong Kong

Semester A, 2022-2023

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Group Formation

Form a group (≤ 3 students) and send an e-mail prior to Lecture 5

(i.e., Nov 22, 2022) for approval
Indicate the group members’ student IDs and names

In the email, send me your group’s choice of

Case for case presentation
I have posted all the cases on Canvas
Listed firm for written report
Firms not in the case list & not discussed in class

First come, first serve

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Group Case Presentation

Format
Front page: Indicate student name and ID, Programme, and Section.
40 minutes for each presentation: 25 minutes for presentation and 15
minutes for discussion.
All group members need to present.
Answer all the questions in the case.
Presented in class in Lectures 11 (i.e., Dec 13, 2022) and 12 (i.e., Dec
15, 2022) .

Everyone should attend, even without presentation tasks, prepared to

participate in discussions.

Please e-mail your presentation slides 1 day before your presentation.

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Group Written Report

Content
Basic background of that company
Corporate governance structure in question
Weaknesses (or strengths) of this structure
Recommendations on improving this company’s corporate governance

Grading Scheme for the Report

Adequacy of the institutional background (25%)
Clarity in describing the corporate governance structure (25%)
Applicability and efficacy of the recommendations offered (25%)
Critical application of theories covered in the course (25%)

Format
Front page: Indicate student name and ID, Programme, and Section
Provide references

Submit the written report by Dec 22, 2022.

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Mid-Term Examination

Held in Lecture 7 (i.e., Nov 29, 2022)

Covers materials of Weeks 1-5

Open-book exam
You are allowed to use paper-based and electronic version of the lecture
notes and textbook
You are not allowed to search on the internet or communicate with anyone
else

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Business Organizations

Sole proprietorship: one owner, unlimited liability, limited life

span (e.g., milk tea booth)

Partnership: more than one owner but less than a limited

number (e.g., <20), unlimited or limited liability (e.g., KPMG,
law firms)

Corporation: numerous owners, limited liability, double

taxation (e.g., Nayuki Holdings Limited)
Corporations are the dominant form of business today. In the
U.S., they account for about 90% of total business revenues.

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Modern Corporation

Limited liabilities: a company’s liabilities are not its shareholders’

liabilities; the maximum loss a shareholder bear is the capital he or she
contributed to the corporation.

Transferability of interest: an investor can freely transfer his or her

shares (stock trading).

Legal personality: perpetual life, sue or be sued.

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Modern Corporation

Separation of ownership and control:

Ownership is dispersed
Shareholders: not directly participate in management
Board of directors: determine the overall direction
Executives, who own (a) little stake, control the companies

Question: Is this true for Hong Kong companies?

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 Shareholders
Shareholders

Board of Directors

CEO

Operations Legal Risk Finance Treasury Purchasing Human Marketing

Management Suppliers Resources Sales
Alliances

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Agency Theory

Jensen and Meckling (1976)

Human beings are selfish and their objectives are to maximize their own
interest: No exception!

Principal-agent relationship (agency relationship): a contract under which

one or more persons (the principal) engage another person (the agent) to
perform some service on their behalf which involves delegating some
decision making authority to Uthe
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of HK All rights reserved 10
Agency Theory

Problem: The principal expects the agent to work to maximize the

principal’s welfare but the agent may take self-dealing actions, i.e.,
actions to increase his/her own interest but hurt the principal’s interest.
Stockholders: the principal
Executives: the agent
Stockholders’ objective: maximize value of shares

Adam Smith, the Wealth of Nations (1776) :

Being the managers rather of other people’s money than of 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 copartnery frequently watch over
their own.

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Agency Theory

Executives self-interest actions

Over pay themselves
Shirk (i.e., not work hard)
Over employ
Consume excess perks
Build empires
Entrench (i.e., try to keep their own positions although they know they are
not suitable or capable)

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Agency Theory

Evidence that executives’ self-interest behavior destroys shareholders’

value
Empire building: stock price declines upon the announcements of
acquisitions;
Entrenchment: stock price jumps upon the news of CEOs’ sudden deaths.

Johnson, Magee, Nagarajan, and Newman (1985)

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Agency Theory

Jensen and Meckling (1976): Page 6–7

“The problem of inducing an ‘agent’ to behave as if he were maximizing the

‘principal’s welfare is quite general. It exists in all organizations and in all
cooperative efforts – at every level of management in firms, in universities,
in mutual companies, in cooperatives, in governmental authorities and
bureaus, in unions, and in relationships normally classified as agency
relationships such as those common in the performing arts and the market
for real estate.”

How to ensure managers to work for shareholders’ interest?

We need corporate governance!

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What is Corporate Governance?

The process of supervision and control intended to ensure that the

company’s management acts in accordance with the interests of
shareholders (Parkinson, 1994).

The governance role is not concerned with the running of the business
of the company per se, but with giving overall direction to the
enterprise, with overseeing and controlling the executive actions of
management and with satisfying legitimate expectations of
accountability and regulation by interests beyond the corporate
boundaries (Tricker, 1984).

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Narrowly Defined Corporate Governance

Narrow definition in plain words:

Internal and external mechanisms used to motivate or monitor

managers to work for shareholders’ interest.

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Agency Theory: Discussion Question

How many principal-agent relationships exist in a corporation?

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Broadly Defined Corporate Governance

Corporate governance is the collection of mechanisms, processes and

relations by which corporations are controlled and operated (Wikipedia).

Corporate governance also includes the relationships among the many

players involved (the stakeholders) and the goals for which the
corporation is governed.

Key parties involved include stakeholders such as the board of directors,

management, and shareholders. Other stakeholders include employees,
suppliers, customers, creditors, regulators, the environment and the
community at large.
Maximize stakeholders’ value.

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 Efficient Capital Regulatory
Markets Enforcement
Board Auditors

Investors Customers

Creditors Managers Suppliers

Analysts Unions

Regulators Media Accounting

Legal Tradition
Standards

Societal and Cultural Values

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Major Governance Mechanisms

Executive incentives
Used to align managers’ interest with shareholders’ so that managers
maximize their own interest when they maximize shareholders’
Short-term and long-term components
Hard to design
Performance measure issues
Induce managers’ opportunistic behavior

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Major Governance Mechanisms

Board of directors
Elected by shareholders
Supposed to work for shareholders
Select and appoint executives, make strategic decisions
Executives are usually board members as well
Non-executive, independent directors are critical

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Major Governance Mechanisms

Investors
Shareholder rights
Collective action problem
Block shareholders
Institutional investors
Creditors

Accounting and auditing

Information asymmetry
Financial reporting
External auditors

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Major Governance Mechanisms

Market for corporate control

Hostile takeover
A costly mechanism
Anti-takeover strategies

Legislation and regulations

Regulatory bodies
Security regulations

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Major Governance Mechanisms

International corporate governance, and governance issues in Mainland

and Hong Kong
Concentrated ownership
Business group
Family firms
State control
Political connections

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Stock Valuation

If you hold a stock forever …

What you receive: dividend payment (D)
Suppose a company distributes all earnings (E) in form of dividends to
shareholders
The rate of return you require (r)
The price you are willing to pay

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Stock Valuation

Stock price is determined by expected future performance and the rate

of return required by investors

r: required rate of return to investors

cost of capital to a company

Stock price changes if the expectation about future performance or/and

the required rate of return changes

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Is Governance Important?

Gompers, Ishii, and Metrick (2003): governance and firm value

Construct an index to measure the strength of corporate governance for
about 1500 largest firms in the U.S.
Firms with strong governance have higher market valuation, better stock
returns, higher profits and sales growth, and fewer corporate acquisitions.

Beasley (1996): governance and financial fraud

Examine financial statement fraud in the U.S.
Outside directors matter
Compared with companies without fraud, companies with financial frauds
tend to have
A smaller portion of outside directors on the board
Lower outside director equity ownership
Longer director tenure
Busier outside directors (i.e., their outsider directors on average hold more
directorships in other companies)

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Discussion Questions

• Corporate governance – the more the better?

• What are the cost associated with corporate governance?

• What is the boundary of governance?

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Why there is separation of ownership and control in the first place?
Investors have money but lack the ability to earn a return on their money.
Professional managers have ability, vision and leadership, and thus can help
investors to manage money and earn a return.

Corporate governance: advise and monitor but not excessively intervene

in managers’ activities.

Corporate governance mechanisms are costly.

Need a balance!

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Enron: An Overview

https://www.youtube.com/watch?v=Mi2O1bH8pvw

https://www.youtube.com/watch?v=hwollZoVmUc

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Enron: An Overview

Enron was once among 10 largest firms in the U.S.

It filed for bankruptcy protection in late 2001, which is the largest

bankruptcy case in the history until then.

A lot of accounting fraud and corporate governance weaknesses were

revealed.

Countries were shocked and began to examine their own corporate

governance.

The passage of Sarbanes-Oxley Act in the U.S., the most significant

securities regulation since 1930s.

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Enron: The Rise

1985 2000
No. of Employee 15,076 21,000
Business Coverage 4 >40
Total assets (Billion) 12.1 65.5
Sales (Billion) <5 >100
Pipe line (Km) 59,200 49,000
Rank in ‘Fortune’ top 500 - 18

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Reproduced from Akhigbe, Madura, and Martin (2005)

33
Enron: The Collapse

Aug 14, 2001, CEO Jeffrey Skilling resigned, citing ‘personal reasons’.

Oct 12, 2001, Enron disclosed a $638 million loss in its third quarter for
that fiscal year.

Nov 8, 2001, Enron restated its financial statements to reduce earnings

by an additional $586 million over the past four years.

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Enron: The Collapse

Enron announced it must pay $690 million in debt, with another $6

billion by next year.

Nov 19, 2001, S&P downgraded Enron’s debt to ‘junk status’.

Dec 2, 2001, Enron filed for the largest Chapter 11 bankruptcy

protection in U.S. history.

Enron’s stock price at last close: 67 cents, total shareholder value lost:
$63 billion.

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 Effects of November 2001 Restatements (Amounts in Millions)

1997 1998 1999 2000

Income As Reported 105 703 893 979

As Restated 77 570 645 880

Difference -28(-27%) 133(-19%) 248(-28%) 99(-10%)

Debt As Reported 10,938 13,051 14,622 23,213

As Restated 11,649 13,612 15,307 23,840

Difference 711(7%) 561(4%) 685(5%) 627(3%)

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Enron: Governance Issues

It is revealed later that

The CEO has unfettered power.

The internal audit committee did not function at all because of serious
conflicts of interest
The chairman’s husband is a senate who receive substantial political donation
from Enron;
A former committee member had a consulting contract with Enron when he was
on the committee.

External auditors had very close relationship with management.

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Enron: Discussion Questions

Why executives in Enron had tried to overstate earnings and understate

liabilities?

Is Enron’s demise avoidable?

Why and How?

Does governance matter?

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Enron: Long-term Impact

Arthur Anderson, the auditor for Enron, was forced to close down
because of destroying documents related to Enron.

A global attention on corporate governance.

The passage of Sarbanes-Oxley Act whose main provisions aim to cure

corporate governance weakness revealed in the Enron case.

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