Chapter 1 Ethics and CG

Slide 1.
International Corporate Governance
Defining Corporate Governance and Key

Theoretical Models
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012
Slide 1.2
Lecture Aims
This lecture aims to introduce you to the subject area of corporate

governance. The lecture discusses the various definitions of
corporate governance, reviews the main objective of the corporation
and explains how corporate governance problems change with
ownership and control concentration. The lecture also introduces the
main theories underpinning corporate governance. While this course
focuses on stock-exchange listed corporations, this lecture also
discusses alternative forms of organisations such as mutual
organisations, cooperatives and partnerships.
Slide 1.3
Learning Outcomes
 By the end of this lecture, you should be able to:

1. Contrast the different definitions of corporate governance
2. Critically review the principal–agent model
3. Discuss the agency problems of equity and debt
4. Explain the corporate governance problem that prevails in
countries where corporate ownership and control are
concentrated
5. Distinguish between ownership and control.
Slide 1.4
The Basics
 In what follows, we focus on stock-exchange listed firms.

 These firms are typically in the form of stock
corporations that have equity stocks or shares
outstanding.
 Stocks or shares are certificates of ownership that
frequently confer control rights, i.e. voting rights.
 Voting rights enable their holders, the shareholders, to
vote at the annual general shareholders’ meeting
(AGM).
Slide 1.5
The Basics (Continued)
 Voting shares confer the right to appoint the members of

the board of directors.
 The board of directors is the ultimate governing body
within the firm.
 Its role, in particular that of the non-executive directors
(independent directors), is to look after the interests of
all the shareholders.
 It may also look after the interests of other stakeholders
such as the employees and the firm’s creditors.
Slide 1.6
The Basics (Continued)
 More precisely, it is the non-executives’ role to monitor

the firm’s top management, including its executives (other
type of directors sitting in the board of directors). So, the
board of directors encompasses non-executives
(independent) directors who have no any relationship with
the firm except their role as directors and executives how
are having relationship with the firm other than their role
as directors.
Slide 1.7
Defining Corporate Governance

 Most definitions are based on implicit or explicit assumptions
about the main objective of the firm.
 However, there is no universal agreement as to what this
objective should be.
 The objective of a firm is varied according to a country’s legal
system, culture, electoral system, governments’ political
orientation.
 For example, Andrei Shleifer and Robert Vishny define
corporate governance as “the ways in which suppliers of
finance assure themselves of getting a return on their
investment”.
 This definition assumes that the main objective of the firm is to
maximise shareholder value.
Slide 1.8
Defining Corporate Governance (Continued)
 They justify this focus by the argument that investments in

the firm by the shareholders (as well as the debtholders)
are sunk funds (the funds are invested and cannot be
changed by any new course of decisions).
 In contrast, the other stakeholders (e.g. employees,
costumers, and suppliers) can easily walk away from the
firm without losing their investments.
 Hence, the shareholders are the residual risk bearers or the
residual claimants to the firm’s assets.
Slide 1.9
 If the firm enters financial distress, the claims of all the

other stakeholders will be met first before the claims of
the shareholders can be met.
Slide 1.10
 In contrast, Marc Goergen and Luc Renneboog’s

definition allows for differences across countries in terms
of the main objective of the firm:
“A corporate governance system is the combination of
mechanisms which ensure that the management … runs
the firm for the benefit of one or several stakeholders...
Such stakeholders may cover shareholders, creditors,
suppliers, clients, employees and other parties with whom
the firm conducts its business.”
Slide 1.11
 For example, German corporate law explicitly includes

other stakeholder interests in the firm’s objective function.
 The German Co-determination Law of 1976 requires
firms with more than 2,000 employees to have half of the
supervisory board seats held by employee representatives.
Slide 1.12
Figure 1 – Whose company is it?
Notes: The number of firms surveyed is 50 for France, 100 for Germany, 68 for Japan, 78 for the UK
and 82 for the USA.
Source: Yoshimori, M. (1995), “Whose Company is It? The Concept of the Corporation in Japan and
the West”, Long Range Planning 28, p.34.
Slide 1.13
 A more neutral definition is that corporate governance

deals with conflicts of interests between
– the providers of finance (shareholders & debtholders) and the
managers;
– the shareholders and the stakeholders;
– different types of shareholders (mainly the large shareholder and
the minority shareholders)
and the prevention or mitigation of these conflicts of
interests.
 This is the definition adopted by this module.
Slide 1.14
Corporate Governance Theory
“It is in the interest of every man to live as much at his ease as he

can; and if his emoluments are to be precisely the same, whether he
does, or does not perform some laborious duty, it is certainly his
interest, at least as interest is vulgarly understood, either to neglect
it altogether, or, if he is subject to some authority which will not
suffer him to do this, to perform it in as careless and slovenly a
manner as that authority will permit.”
Smith, A. (1776), An Inquiry into the Nature and Causes of the Wealth of
Nations, reprinted in K. Sutherland (ed.) (1993), World’s Classics, Oxford:
Oxford University Press.
Slide 1.15
Corporate Governance Theory (Continued)
 This quote illustrates the conflict of interests that may

exist between an agent and the agent’s principal.
 Michael Jensen and William Meckling formalised these
conflicts of interests in their principal–agent theory.
 While the agent has been asked by the principal to carry
out a specific duty, the agent may not act in the best
interest of the principal once the contract has been signed.
Slide 1.16
 The agent may rather prefer to act in his own interest.

 Economists call this moral hazard (Principal – agent).
 That is, the agent acts in ways that may harm the principal
while clearly serving his own interests.
 Moral hazard is not just an issue in corporate governance,
but it is also a major issue for insurance companies.
 One way of addressing principal–agent problems is via so
called complete contracts.
Slide 1.17
 Complete contracts are contracts which specify exactly

what
– the managers must do in each future contingency of the world;
and
– what the distribution of profits will be in each contingency.
 In practice, contracts are unlikely to be complete as
– it is impossible to predict all future contingencies of the world;
– such contracts would be too complex to write; and
– they would be difficult or even impossible to monitor and
reinforce by outsiders such as a court of law.
Slide 1.18
 A necessary condition for moral hazard to exist and for

complete contracts to be impossible is the existence of
asymmetric information.
 Asymmetric information refers to situations where one
party, typically the agent, has more information than the
other party, the principal.
 If both parties had access to the same information at all
times, then there would be no moral hazard problem.
Slide 1.19
 Moral hazard exists because the principal cannot keep

track of the agent’s actions at all times.
 Even ex post, it is sometimes difficult for the principal to
judge whether failure is due to the agent or external
circumstances.
 Jensen and Meckling’s principal–agent model also
assumes that there is a separation of ownership and
control.
Slide 1.20
 Adolf Berle and Gardiner Means were the first to point out
this separation in their 1932 book The Modern Corporation
and Private Property.
 They argue that a firm starts off as a small business, fully
owned by its founder, typically an entrepreneur.
 At this stage, there are no conflicts of interests as the
entrepreneur both owns and runs the firm. This implies that
the entrepreneur has the perfect incentives to work hard
since all revenues go to his pocket.
 As the firm grows, it becomes more and more difficult for
the entrepreneur to provide all the financing.
Slide 1.21
 Eventually, the entrepreneur will need to raise outside

finance.
 Once outside finance has been raised, the entrepreneur’s
incentives to work hard have been reduced.
 Ultimately, the entrepreneur will sell out and the firm ends
up being run by professional managers who own none or
little of the firm’s capital on behalf of its shareholders.
Slide 1.22
 Hence, there is a clear division of labour in the modern

corporation with
– the manager, the agent, having the expertise to run the firm, but
not the funds to finance it; and
– the shareholders, the principal(s), having the required funds, but
not the skills to run the firm.
 In practice, control lies with the managers who run the
day-to-day operations of the firm whereas the firm is
owned by the shareholders: hence the separation of
ownership and control.
Slide 1.23
 However, the agent may prefer to run the firm in his own
interests rather than those of the principal.
 This is the principal–agent problem (agency problem).
 The main consequence of this problem is agency costs.
 These are the sum of
– the monitoring expenses incurred by the principal;
– the bonding costs accruing to the agents; and
– any residual loss by principal.
Slide 1.24
Agency Problems
 The two main types of agency problems are

– perquisites and
– empire building.
 Perquisites or perks consist of on-the-job consumption by
the managers.
 While the benefits from the perks accrue to the managers,
their costs are borne by the shareholders.
 Examples of perks are CEO mansions financed by the firm
and personal usage of corporate jets.
Slide 1.25
Agency Problems (Continued)
The former CEO of Tyco International had his company

fund his wife’s 40th birthday party in Sardinia at a cost of
US$1 million.
“Former Merrill CEO John Thain spent $1.2 million to

renovate his offices, including installation of a $35,000
toilet.”
Source: The Gazette, 28 March 2009, p. B1.
Slide 1.26
 While perks can cause public outrage, especially when

they are combined with lacklustre performance, they tend
to be modest compared to empire building.
 Empire building consists of managers pursuing growth
rather than shareholder-value maximisation.
 While there is a link between the two, growth does not
necessarily generate shareholder value and vice-versa.
 Empire building is also referred to as Jensen’s free cash
flow problem.
Slide 1.27
 The free cash flow problem consists of managers investing

beyond the point where investment projects earn an
adequate return given their risk.
 So why would managers be tempted by empire building?
 Managers derive benefits from increasing the size of their
firm.
 Such benefits include increased power and social status.
 Managerial remuneration has also been shown to depend
on firm size.
Slide 1.28
Agency Problems of Debt and Equity
 So far, we have focused on the agency problem of equity,

i.e. the agency problem between the managers and the
shareholders.
 However, there also exists an agency problem of debt.
 When there is very little equity left (e.g. when the firm is
in financial distress), the shareholders may be tempted to
gamble with the debtholders’ money.
 They may do so by investing the firm’s funds into high-
risk projects.
Slide 1.29
Agency Problems of Debt and Equity (Continued)
 If the project fails, the major part of the costs will be borne
by the debtholders.
 If the project is successful, most of its payoff will go to the
shareholders given that the debtholders’ claims have a
limited upside.
Slide 1.30
Figure 2 – Firm value
Value of debt and

equity
Value of
equity
Value of
debt 10%
Financial Firm value

distress
Slide 1.31
Agency Problems of Debt and Equity
 Jensen and Meckling argue that, given that there are

agency costs from both debt and equity, there is an optimal
mix of debt and equity which minimises the sum of the
agency costs of debt and equity.
Slide 1.32
Figure 3 – Agency costs of debt and equity
Slide 1.33
The Expropriation of Minority Shareholders
 The principal–agent model is based on the Berle-Means

premise that, as firms grow, ownership eventually separates
from control.
 However, this is only an accurate description of the Anglo-
American system of corporate governance.
 In the rest of the world, most stock-exchange listed firms
have large shareholders (Block-holders) exerting significant
control over the firm.
 Hence, the main conflict of interests is between the large
shareholder and the minority shareholders.
Slide 1.34
The Expropriation of Minority Shareholders (Continued)
 Minority shareholders may face the danger of being

expropriated by the large shareholder via e.g.
– tunnelling;
– transfer pricing;
– nepotism; and
– Infighting.
 Tunnelling consists of the large shareholder transferring
the firm’s assets or profits into his own pockets.
Slide 1.35
 The large shareholder may also expropriate the minority

shareholders via transfer pricing, i.e. by overcharging the
firm for services or assets provided.
 Tunnelling and transfer pricing involving the large
shareholder are also sometimes referred to as related-
party transactions.
 Large shareholders may be even more tempted to engage
in related-party transactions in the presence of ownership
pyramids (one share – one vote).
Slide 1.36
Figure 4 – Expropriation of the minority shareholders

by the large shareholder
Large shareholder
51% 100%
Firm A Firm B
Slide 1.37
Figure 5 – Leveraging control and increasing

the potential for expropriation
Large shareholder
51% 100%
Holding Co. Firm B

H Co. owns 51% of firm A.
so, Large shareholder owns
(51% *51% = 26.01%) of 51%
firm A. with this ownership
(26.01%) the large Firm A
shareholder controls firm A
with 51% control.
Slide 1.38
 Other forms of minority shareholder expropriation include

nepotism and infighting.
 Nepotism consists of the large family shareholder
appointing family members to top management positions
rather than the most suitable candidates on the job market.
 Infighting may not necessarily be a wilful form of
expropriating the firm’s minority shareholders, but
nevertheless is likely to deflect management time as well
as other firm resources.
Slide 1.39
Nepotism
Slide 1.40
Alternative Forms of Organisation and

Ownership
 The main alternative to the stock corporation is the mutual

organisation.
 A mutual organisation is owned by and run on behalf of its
members.
 For example, a mutual bank is owned by its savers and
borrowers.
 Both stock corporations and mutual organisations are
likely to suffer from the principal–agent problem.
Slide 1.41

Ownership (Continued)
 However, this problem may be more severe in mutual

organisations given that stock corporations benefit from a
range of mechanisms that mitigate agency problems.
 These include
– the threat of a hostile takeover
– monitoring by large shareholders
– ownership of stock options and stocks by managers and
employees
– a market price for the stocks.
Slide 1.42

 As each member of a mutual organisation has only one

vote, this prevents the emergence of powerful owners.
 Through the 1980s/90s, a number of UK mutual building
societies went through a demutualisation.
 They changed their legal status to a stock corporation and
applied for a stock exchange listing.
 At the time, it was thought that this would result in a
major improvement in the efficiency of these
organisations.
Slide 1.43

 However, roughly 20 years later several of the

demutualised building societies had to be nationalised as a
result of the subprime mortgage crisis.
 Northern Rock was the object of the first bank run on a
British financial institution for more than 150 years.
 Overall, it is still unclear which of the two organisational
forms is superior.
Slide 1.44

 One of the potential benefits of the mutual form is that it

avoids conflicts of interests between owners and
customers.
 These conflicts tend to be severe for long-term products
and services as the owners may be tempted to expropriate
the customers.
 For these products and services the mutual form is
superior as it merges the functions of owner and customer.
Slide 1.45

 While mutual organisations are not subject to the

disciplining role of the stock market, they have their own
disciplinary mechanism.
 The members of a mutual organisation are allowed to
withdraw their funds at any time.
 Such withdrawals reduce the financial basis of the mutual.
 In contrast, stock corporations do not see their funds
shrink when shareholders sell their shares.
Slide 1.46

 Some commercial organisations are in the form of

partnerships and owned by their employees
– Goldman Sachs
– John Lewis Partnership.
 Sanford Grossman, Oliver Hart and John Moore’s theory
of property rights predicts when employees should have
ownership of their firm.
 Employees should be given property rights if they have to
make investments in their human capital which are highly
specific (idiosyncratic) to the firm.
Slide 1.47
Defining Ownership and Control
 Ownership is defined as ownership of cash flow rights.

 Cash flow rights give the holder a pro rata right to the
firm’s assets and earnings.
 Control is defined as ownership of control rights.
Slide 1.48
Conclusions
 The link between the objective of the firm and the

definition of corporate governance.
 The principal–agent model.
 The expropriation of minority shareholders.
 Conflicts of interests as the definition of corporate
governance adopted by this module.
 Ownership versus control.

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Slide 1.

International Corporate Governance

Defining Corporate Governance and Key

This lecture aims to introduce you to the subject area of corporate

 By the end of this lecture, you should be able to:

 In what follows, we focus on stock-exchange listed firms.

The Basics (Continued)

 Voting shares confer the right to appoint the members of

The Basics (Continued)

 More precisely, it is the non-executives’ role to monitor

Defining Corporate Governance

Defining Corporate Governance (Continued)

 They justify this focus by the argument that investments in

Defining Corporate Governance (Continued)

 If the firm enters financial distress, the claims of all the

Defining Corporate Governance (Continued)

 In contrast, Marc Goergen and Luc Renneboog’s

Defining Corporate Governance (Continued)

 For example, German corporate law explicitly includes

Figure 1 – Whose company is it?

Defining Corporate Governance (Continued)

 A more neutral definition is that corporate governance

Corporate Governance Theory

“It is in the interest of every man to live as much at his ease as he

Corporate Governance Theory (Continued)

 This quote illustrates the conflict of interests that may

Corporate Governance Theory (Continued)

 The agent may rather prefer to act in his own interest.

Corporate Governance Theory (Continued)

 Complete contracts are contracts which specify exactly

Corporate Governance Theory (Continued)

 A necessary condition for moral hazard to exist and for

Corporate Governance Theory (Continued)

 Moral hazard exists because the principal cannot keep

Corporate Governance Theory (Continued)

Corporate Governance Theory (Continued)

 Eventually, the entrepreneur will need to raise outside

Corporate Governance Theory (Continued)

 Hence, there is a clear division of labour in the modern

Corporate Governance Theory (Continued)

 The two main types of agency problems are

Agency Problems (Continued)

The former CEO of Tyco International had his company

“Former Merrill CEO John Thain spent $1.2 million to

Agency Problems (Continued)

 While perks can cause public outrage, especially when

Agency Problems (Continued)

 The free cash flow problem consists of managers investing

Agency Problems of Debt and Equity

 So far, we have focused on the agency problem of equity,

Agency Problems of Debt and Equity (Continued)

Figure 2 – Firm value

Value of debt and

Financial Firm value

Agency Problems of Debt and Equity

 Jensen and Meckling argue that, given that there are

Figure 3 – Agency costs of debt and equity

The Expropriation of Minority Shareholders

 The principal–agent model is based on the Berle-Means

The Expropriation of Minority Shareholders (Continued)

 Minority shareholders may face the danger of being

The Expropriation of Minority Shareholders (Continued)

 The large shareholder may also expropriate the minority

Figure 4 – Expropriation of the minority shareholders