Corporate Governance

Dr. M.K. Nandakumar

1
 KNOWLEDGE OBJECTIVES

1. Define corporate governance and explain why it is used to

monitor and control managers’ strategic decisions.
2. Explain why ownership has been largely separated from
managerial control in the modern corporation.
3. Define an agency relationship and managerial opportunism
and describe their strategic implications.
4. Explain how three internal governance mechanisms—
ownership concentration, the board of directors, and executive
compensation—are used to monitor and control managerial
decisions.

10–2
 KNOWLEDGE OBJECTIVES (cont’d)

5. Discuss the types of compensation executives receive and

their effects on strategic decisions.
6. Describe how the external corporate governance mechanism
—the market for corporate control—acts as a restraint on top-
level managers’ strategic decisions.
7. Discuss the use of corporate governance in international
settings.
8. Describe how corporate governance fosters ethical strategic
decisions and the importance of such behaviors on the part of
top-level executives.

10–3
 Corporate Governance Failure at Wells Fargo
• Known for its commitment to customers, ethics and trust
• Survived the financial crisis of 2007-09
• Wells Fargo became the most trusted bank in the world by the end of 2015
• On 8th September 2016, three government agencies announced that Wells
Fargo had been fined $185 million for opening more than 2 million
accounts for its retail customers without their knowledge
• To save their face they terminated 5300 employees for opening
unauthorized accounts and apologized to their customers
• The real cause for this crisis was a 2011 corporate incentive program that
set aggressive quotas for new account openings and backed them up with
a carrot (bonuses) and stick (demotion or termination) incentive program
• The employees would create new accounts for an existing customer-
sometimes by forging that customer’s signature to open the account, and
move a small amount of money from an existing account into the new one
4
Recent Corporate Frauds
Misleading account

Money being siphoned from employee pension funds

Unjustified executive pay levels

Collapse of firms with little or no prior warning of difficulties

Bribery

Infringement of employee rights

Concealing of defects
10–5
Six Signals to Detect a Possible Financial Fraud
• Pricey Acquisitions – Siphon cash to promoters
• Large Idle Cash Reserves – Should be either returned to
shareholders as dividend or used to retire debt
• Capitalized Expenses – Expenditure which is capitalized is not
written off during the financial year and hence is added to the profits
for the year
• Rise in Cash and Bank Balances – Should match the cash flow
• Large Revenue Jumps – Especially ones that do not follow a
proportionate increase in the number of employees
• Change in Promoter Shareholdings – Should be monitored to detect
management confidence in the company
Global Issues in Corporate Governance
Switzerland – Swissair (A series of strategic
decisions leading to its collapse); UBS (Subprime
crisis)
Sweden – ABB (Pension scandal)
Korea – Daewoo (Accounting fraud)
Japan – Mitsubishi (Hiding customer complaints)
Germany – Deutsche Bahn (Spying of workers,
journalists, board members); Siemens (Bribery)
France – Vivendi (Opportunistic share purchases)
Italy – Permalat (Accounting fraud) 10–7
Global Issues in Corporate Governance
(cont’d)

United States – Madoff (Securities fraud through

Ponzi scheme); Enron (Hid billions of dollars
debts from failed deals and projects through
poor financial reporting. Pressured their auditor
Arthur Anderson to ignore them); Lehman
Brothers (Subprime mortgage crisis)
India – Satyam (Inflated the revenue and profit
figures, Inappropriate acquisition of Maytas
Properties and Maytas Infrastructure)
8
CORPORATE GOVERNANCE

SHAREHOLDERS

BOARD
Financial
Other markets
MANAGEMENT
stakeholders

Product markets 10–9

 Shareholders Vs Stakeholders
• Should a corporation be run for the benefit of shareholders or
stakeholders?

• In the 1930s, two famous law professors, Adolf Berle and

Merrick Dodd held a very public argument about the
purpose of the corporation

• Berle – For the benefit of shareholders

• Dodd – For the benefit of the entire community

• Berele’s position – Shareholder Primacy Model

• Dodd’s position – Stakeholder Model

10
 The Shareholder Primacy Model
• Shareholders receive two property rights from the corporation

• They have claim to the residual earnings (profits after all other
stakeholders have been paid)

• They buy the right to monitor the management team

• The first right specifies their reward, but the second right protects
them

11
Reasons to support Shareholder Primacy Model
Proponents of shareholder primacy model cite 3 reasons for their
support.

• Shareholders are legal owners of the corporation’s assets

• Financial capital is the most important input into making a

business successful

• Some businesses try to maximize the welfare of some other

stakeholder groups like employees or local community. However
they fail to do so and instead cause damage to economies,
communities and the natural environment

12
Criticisms against Shareholder Primacy Model
Critics point to 3 issues as evidence against this model

• Shareholders don’t really own the corporation, since they own stock that
they can easily trade

• Shareholders have different objectives for investing in a firm. Some

investors like pension funds buy stocks as long-term investments and
want to obtain greatest long-term returns. Other investors like hedge
funds look for short-term gains. Managers have to make difficult trade-
offs to satisfy one shareholder group at the expense of others.

• Managing for shareholder value could create negative consequences for

firms, investors, and society at large (e.g. Enron, Lehman Brothers, Wells
Fargo etc)
13
 The Stakeholder Model
According to Merrick Dodd, since the community grants the corporation the right
to exist, the managers should run the corporation for the benefit of the
community as a whole.

Primary stakeholder groups are:

• Shareholders
• Customers
• Suppliers
• Employees
• Local Communities

Secondary stakeholder groups are:

• Competitors
• National or Global Communities
• Special interest groups like environmental protection groups 14
Reasons to support the Stakeholder Model

Those who advocate stakeholder models do so from 2 grounds.

• Managers spend most of their time interacting with and managing the
demands and needs of different stakeholder groups (e.g. understanding
customer needs, negotiating wages, dealing with working conditions for
employees, responding to government regulations etc)

• Many people believe that stakeholder groups have the right to be

considered in decisions that will have an impact on them. This is known
as the intrinsic stakeholder model.

15
Criticisms against the Stakeholder Model
• It is difficult to prioritize the claims of different stakeholders and
hence managers find it difficult to run their firms efficiently and
effectively. On the other hand, the managers are focussed while
following a shareholder model.

• Stakeholders may make, and try to enforce, unreasonable and

narrow-minded claims on the firm. For example, GM continues to
incur huge costs due to union contracts signed decades ago.

16
 Mapping Stakeholder Influence

Mapping Stakeholder Influence

When a firm clearly understands how company actions

affect stakeholders, how stakeholders can affect the firm and
the formal mechanisms in place for the firm to attend and
listen to its different constituencies, it can better design
actions, policies and strategies to create positive interactions
with different stakeholder groups.

17
 Mapping Stakeholder Influence
Stakeholder Group Is Affected by the Business through…. Affects the Business by…… Tools for listening and responding to
Stakeholders

Customers Products and services Purchases Market research groups

Warranties, after-sales service Word-of-mouth advertising Warranty fulfilment
Integrity/Honesty during sales process Formal complaints Customer hotlines
Branding and advertising Boycotts Code of ethics, mission statements
Influencing brand perception and value

Employees Wages Productivity Employee councils

Benefits Loyalty (turnover) Employee hotlines
Safe working conditions Word of mouth and reputation Safety programs
Flex time Lawsuits Wages and benefits
Training and development Trade secrets Flex time, telecommuting
Career paths Theft of sabotage Training opportunities
Code of ethics, mission statements
Suppliers Timely payment Quality products Supplier councils
Order consistency Timely delivery Quality control policies
Protection of intellectual property Price and payment terms Payment policies
Word of mouth and reputation Willingness to innovate Join ventures, alliances, or other
Flexibility in responding to crises or mechanisms to promote cooperation
unusual demands
Investors Earning Providing capital Investor conference calls and guidance
Integrity/honesty in accounting policies Short selling Investor relations offices
and reporting Inducing others to buy Board of directors
Information disclosure about strategies Analyst reports and recommendations Code of ethics, mission statements
and other material events

Communities/ Environmental pollution, traffic Tax policy

Governments Tax revenue and demand for public
services
Employees living in the community
Philanthropy and volunteering
Lobbying and other legal activity
Regulations and enforcement
Investments in community Infrastructure
Educational systems and quality
Quality of life for employees
18
 R. Edward Freeman 1984

Stakeholder Theory of organizational management and business ethics

Stakeholder Theory is a view of capitalism that stresses the interconnected

relationships between a business and its customers, suppliers, employees,
investors, communities and others who have a stake in the organization.
The theory argues that a firm should create value for all stakeholders, not
just shareholders.

Source: Stakeholdertheory.org

19
 Corporate Governance
• Corporate governance is:
• Is concerned with the structures and systems of control by
which managers are held accountable to those who have a
legitimate stake in an organisation.
• A relationship among stakeholders that is used to determine
and control the strategic direction and performance of
organizations.
• Concerned with identifying ways to ensure that strategic
decisions are made more effectively.
• Used in corporations to establish order between the firm’s
owners and its top-level managers whose interests may be in
conflict.
10–20
Separation of Ownership and
Managerial Control
• Basis of the modern • Modern public corporation
corporation form leads to efficient
specialization of tasks:
• Shareholders purchase
stock, becoming residual • Risk bearing by
claimants. shareholders
• Shareholders reduce risk by • Strategy development and
holding diversified decision making by
portfolios. managers
• Professional managers are
contracted to provide
decision making.

10–21
An Agency Relationship

10–22
 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.

10–23
 Challenges in the principal–agent model
The key challenges are:
• Knowledge imbalances: agents typically know
more about what can and should be done.
• Monitoring limits: it is very difficult for the
principal to closely monitor the agent’s
performance especially if they have diverse
interests.
• Misaligned incentives: without appropriate
incentives agents may pursue their own
objectives.
 Examples of the Agency Problem
• The Problem of Product Diversification
• Increased size, and the 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 (see above).
• Shareholders prefer the funds as dividends so they
control how the funds are invested.

10–25
Manager and Shareholder Risk and Diversification

10–26
 Agency Costs and Governance
Mechanisms
• Agency Costs
• The sum of incentive costs, monitoring costs, enforcement
costs, and individual financial losses incurred by principals,
because governance mechanisms cannot guarantee total
compliance by the agent.
• 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.

10–27
 Corporate Governance Mechanisms

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
Executive Compensation
• Use of salary, bonuses, and long-term incentives to align managers’ interests with
shareholders’ interests

External Governance Mechanism

Market for Corporate Control
• The purchase of a company that is underperforming relative to industry rivals in order to
improve the firm’s strategic competitiveness

10–28
 BOARD TASKS

Accountability Strategic Thinking

• Reporting to • Setting corporate
External shareholders direction
• Ensuring compliance • Reviewing strategy

Supervision Corporate Policy

• Reviewing business • Review senior
Internal results executives
• Reviewing executive • Approve capital budgets
performance

Short Term Long Term

10–33
 Constitution of the Board of Directors in
India

• https://www.mca.gov.in/Ministry/reportonexpertcommitte/chapter4.htm
l

34
LEGAL OBLIGATIONS OF THE BOARD OF DIRECTORS IN THE
US

The American Bar Association Guidebook (ABA, 2007) outlines the six
main legal obligations for a U S. corporation ' s Board of Directors:
In General:
The baseline standard for director conduct is that every director must
discharge director duties in good faith and in a manner that the director
reasonably believes to be in the best interests of the corporation.
The six main obligations are:
1. Duty of Care: This duty relates to the overall responsibility of a director
to be informed when making decisions and to oversee the decision making
of the management of the corporation.
 CONSIDERATIONS WITH REGARD TO THE DUTY OF CARE:

Time commitment and regular attendance at board meetings. Directors are expected to
regularly attend and actively participate in board meetings.

Need to be informed and prepared. While directors can rely on management to supply
needed information, it is incumbent on the board member to carefully review the information
supplied, and to request additional information if needed.

Right to rely on others. Board members are entitled by law to rely on the information supplied
by management and others for information regarding the corporation.

Inquiry. Directors are obligated to inquire about potential problems or issues when alerted by
circumstances or events.

Disclosure among directors. Directors are obligated to disclose to other member of the board
any information that may be material to the decision making of the board.
(2) Duty of Loyalty:
The duty of loyalty requires a director to act in good faith and in
the best interests of the corporation.
• Considerations with regard to the duty of loyalty:
• Acting in good faith. Directors must act in a way such that they believe that they are acting in the
best interests of the corporation.
• Conflicts of interest. Board members are prohibited from using their position for personal gain.
• Fairness to the corporation. Decisions made by the board are obligated to ensure that decisions
made by the board are fair to the corporation.
• Independent advice. Directors should seek outside counsel and advice when necessary to make
decisions.
• Corporate opportunity. Business opportunities related to the business of the corporation should be
reviewed by the board first before being pursued by an individual director for their own interest.
(3) Business Judgment Rule: The legal standard for board decision-making is
the business judgment rule. In legal reviews of board decisions, courts will
examine whether: directors were disinterested in the matter, appropriately
informed themselves before making the decision, and acted in good faith
belief that the decision that they made was in the best interest of the
corporation. Breaches of this standard may expose a director to personal
liability for decisions made on behalf of the board.
(4)Duty of Disclosure: Directors have a duty to report to shareholders all
relevant material information known to the directors when they present
shareholders with a voting or investment decision.
(5) Confidentiality: Directors must keep confidential all information not
reported to the general public.
(6) Risk and Oversight Compliance: Directors are also charged with
assuring that the corporation employs proper risk management and complies
with appropriate laws and regulations.
Considerations with regard to risk and oversight
compliance :

Risk Management. The board should receive regular reports that describe
and assess the firm 's risk profile and risk management.

Compliance with Law. The board is also responsible for overseeing

management's activities in ensuring that the firm is in compliance with all
appropriate law and regulations in the firm's appropriate legal
jurisdictions.

Quality of Disclosure. The board is responsible that the corporation's

disclosure documents are well prepared and ensures proper and timely
disclosure of significant business information.
Employee Safety, Health and Environmental Protection, and Public Safety.
The board is also responsible for oversight in these areas as well.

Political Activity. The board and legal counsel are tasked with overseeing and
monitoring political activity by corporate officers and employees .

Crisis Management. The board also takes an active role in the crisis
management contingency planning of the corporation.
Governance Mechanisms (cont’d)

Ownership
• Composition of Boards:
Concentration • Insiders: the firm’s CEO and other
top-level managers
Board of Directors
• Related Outsiders: individuals
uninvolved with day-to-day
(b)
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

10–41
Governance Mechanisms (cont’d)
Ownership
• Criticisms of Boards of Directors
include:
Concentration
• Too readily approve managers’ self-
serving initiatives
Board of Directors
• Are exploited by managers with
(c)
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.

10–42
Governance Mechanisms (cont’d)
Ownership
• Enhancing the effectiveness of boards
and directors:
Concentration
• More diversity in the backgrounds
of board members
Board of Directors
• Stronger internal management and
(d)
accounting control systems
• More formal processes to evaluate
the board’s performance
• Adopting a “lead director” role.
• Changes in compensation of
directors.

10–43
Governance Mechanisms (cont’d)
 Forms of compensation:
Ownership
 Salaries, bonuses, long-term
Concentration
performance incentives, stock
awards, stock options
 Factors complicating executive
Board of Directors
compensation:
 Strategic decisions by top-level

Executive managers are complex, non-routine

Compensation (a) and affect the firm over an
extended period.
 Other variables affecting the firm’s
performance over time.

10–44
 INCENTIVE COMPENSATION
Oldest form of incentive pay. Board can evaluate executives’ performance
Annual bonus plans
along multiple dimensions and allocate a year-end cash award

An employee receives the right to buy a set number of shares of company

Stock options
stock at a later date for a predetermined price

More recent forms of incentive compensation. Long-term bonuses linked to

Other long-term
performance over several years. May help executives avoid short-term myopia
incentives
and focus on long-term

45
Governance Mechanisms (cont’d)

Ownership
Concentration
 Individuals and firms buy or take
over undervalued corporations.
 Ineffective managers are usually
Board of Directors replaced in such takeovers.
 Threat of takeover may lead firm to
operate more efficiently.
Executive
Compensation  Changes in regulations have made
hostile takeovers difficult.
Market for
Corporate Control (a)

10–47
Governance Mechanisms (cont’d)

Ownership • Managerial defense tactics increase

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

10–48
Managerial Defense

Managerial Defense

49
 Takeover Defence Strategies
Defence Strategy Description Success as a Effects on
Strategy shareholder
wealth
Capital Structure Dilution of the target firm’s stock, making it more costly for an Medium Inconclusive
Change acquiring firm to continue purchasing the target’s shares. Employee
stock option plans (ESOPs), recapitalization, issuance of additional
debt, and share buybacks are actions associated with this strategy.
Corporate charter An amendment to the target firm’s charter for the purpose of Very low Negative
amendment staggering the elections of members to its board of directors so that all
are not elected during the same year. This change to the firm’s charter
prevents a potential acquirer from installing a completely new board
in a single year.
Golden parachute A lump-sum payment of cash that is given to one or more top-level Low Negligible
managers when the firm is acquired in a takeover bid.
Greenmail The repurchase of the target firm’s shares of stock that were obtained Medium Negative
by the acquiring firm at a premium in exchange for an agreement that
the acquirer will no longer target the company for takeover.
Litigation Lawsuits Antitrust charges and inadequate disclosure are examples of the Low Positive
that help the target grounds on which the target firm could file.
firm stall hostile
takeover attempts
Poison pill An action that target firm takes to make its stock less attractive to a High Positive
potential acquirer.
Standstill agreement A contract between the target firm and the potential acquirer Low Negative
specifying that the acquirer will not purchase additional shares of the
target firm for a specified period of time in exchange for a fee paid by
the target firm.

50
 EXAMPLES OF CODES OF GOVERNANCE
What is the Can the same Is disclosure
recommendation executive be both required if the
on director CEO & Is auditor rotation company does not
Country independence? chairperson? required? comply with the
recommendations?
Brazil CVM As many as Split recommended Not addressed No
Code (2002) possible

Russia CG At least one- Split required by Not addressed No

Code (2002) quarter law

Singapore CG At least one-third Split recommended Not addressed Yes

Committee
(2001)
The UK
Corporate Majority Split recommended Periodic rotation of Yes
Governance lead auditor
Code
United States Separation is one
Substantial
Conference of three acceptable Recommended3 No
majority
Board and alternatives
CalPers (2003)2

1. Just one of several codes in existence in the United States 51

2. The Sarbanes-Oxley Act requires that the lead audit partner be rotated every 5 years; changing audit firm after 10 years of continual relationship or if
former audit partner is employed by the company
 Corporate Governance in India
CG movement in India began in 1996 with a voluntary code framed
by the CII.

SEBI in 2000 specified principles of CG and introduced a new

clause 49 in the listing agreement of the stock exchanges

Kumar Mangalam Birla committee report 2000

Narayana Murthy committee report 2003

J.J. Irani committee report 2005

Indian Companies Act 2013

10–52
 Agency Theory
Agency theory proposes two solutions to the
diverging interests between principal and
agent: monitoring and incentive alignment
(Eisenhardt, 1989). Boards of directors, in
this context, act as agents of shareholders;
their agenda is to monitor the actions of
management with the goal of maximizing
shareholder value.
 Shareholder Theory
Shareholder Theory regards the firm as a system of shareholders
operating within a larger system of the host society. The
purpose of the firm in this view is to create wealth or value for
all of it’s stakeholders(Clarke, 1998).
 Network Theory

Network governance for an industry is characterized by informal

social systems rather than bureaucratic structures and formal
contractual relationship in order to coordinate complex
products or services in an uncertain and competitive
environment(Powell, 1990).
 Stewardship Theory

Stewardship Theory argues that man is self-actualizing and,

under the right circumstances, collective serving (Davis,
Schoorman & Donaldson, 1997).