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IBU5GW

Governance

in a Globalising World

Week 2

Corporate governance theories

This week

• Introduction to different models of corporate

governance

– Theoretical

– Practical

• Consider regulatory and international

frameworks

Ch.2 Theories of

Corporate Governance

Thomsen, S., Conyon, M., 2012,

Corporate Governance; Mechanisms and

Systems, McGraw Hill.

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Introduction

• Chapter reviews corporate governance theories

• Market model of standard microeconomics

• Agency theory

• Related non-governance disciplines with applications in corporate governance

The market model

• The firm is a black box characterised by a technology and profit maximisation

• The economy works by itself under the price mechanism

– Based on pre-industrial society

– Buyers and sellers compete prices down

– Centralised exchange

– Full information

– Complete markets

– No transaction costs

Agency theory

� Different parties have different interests

� potential risk of people acting in their own interest on the other party’s expense

� Agents and principals

� Principals = owners, or anyone who hire someone else to do a certain job at their expense

� Agents = managers, a person hired to do a certain job in exchanged for an agreed compensation

� Whenever in a contract, one party therefore needs to

1) monitor the other party

2) find ways to ensure that interests are aligned

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RULE OF MAN

INTEREST DIVERGENCE

AGENCY PROBLEMS

AGENCY COSTS

CONTROL MECHANISMS

Agency theory

The owner-manager problem

• Separation of ownership and control give rise to

the need for professional managers

• Owners employ managers to run the firm in the

best interest of the investors – and most managers do

• However, some managers act criminal and embezzle shareholder funds

• Another classical agency problem is excess

expenditure: what expenses are business motivated and what is the manager’s private

consumption (consider a private company jet)?

Assumptions in agency theory

� Homo Economicus is rational, individualistic and opportunistic

� Always seeks to maximise own benefits and personal utility

� Moral responsibilities to act in someone else's interest are second priority

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Assumptions in agency theory

• Agency theory operates

when two Homo Economicus

meet, for example owners

and managers

• In firms the conflict of

interest becomes especially

important since only one

party bears the cost for

running the firm

Types of agency problems

• Type I agency conflicts most common in firms/nations with dispersed ownership

– Collective action problems and free rider problems (no one has incentive to monitor)

• Type II agency conflicts most common in firms/nations with concentrated ownership

– Private benefits

• Type III agency conflicts in both dispersed and concentrated ownerships

Information problems

• Information problems concern primarily two

types of asymmetric information between owners and managers

• Adverse selection occurs before the

manager makes a decision, while moral hazard occurs after a decision has been

taken

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Moral hazard

• “Hidden action”

• Occurs when the activity of the agent (manager) cannot be observed by the principal (owner)

• Moral hazard illustrates the trade-off between risk and incentives: if you don’t carry any risk you

loose your incentives to protect yourself against it

• Managers can be given incentives to share some of the shareholders’ risk, for example by being

remunerated with stock options or bonuses for excellent firm performance

Adverse selection

• “Hidden knowledge”

• Owners know less about the state of

the firm than managers, and they know less about a the capabilities of a new

manager than the manager herself

• Consider the example with Monday cars – ‘lemons’

• Adverse selection can partly be solved through monitoring

Extensions to agency theory

� We can imagine three types of extensions

1. With additional layers of agency relationships, as ownership

shifts to institutional. Portfolio managers are not the ultimate

owners of the invested capital. Thus, also the portfolio manager

requires monitoring in the same way as the firm manager.

2. Most firms have several owners; principals might not share the

same objectives and aims

3. Agency problems have a time dimension. Bad decisions lead to

bad reputation for the manager which provides incentive to

improve.

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Incomplete contracts

• Incomplete contracts theory provide that whoever has asset ownership possesses the residual right of control

• Residual right of control means the right to control in all situations not already covered by contracts

• Explains why large corporations cannot replicate the incentives of small entrepreneurial firms. As employees do not have the residual right of control they lack incentives to make an effort as the employer can act in his own interest whenever he’s not covered by a complete contract

Transaction costs

• Transaction cost lead to many deviations from the market model

• The existence (and size) of transaction costs affect

firm decisions to trade or produce

• Thus, transaction costs can explain vertical

integration and why firms grow large, thus causing the need for external finance which makes ownership separate from control

Psychology

� Behavioural economics rise with the recognition that underlying assumptions of agency theory might be incorrect

� Human beings are not completely rational or selfish

� Several streams of research can be applied to corporate governance settings: � Deviations from rationality

� Managers looking for information that coincides with their personal ideas and preferences

� People consider their own mistakes as a result of bad luck

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Sociology

• The relevance of sociology concerns mainly:

– Social networks theory that describes connections between companies, boards and investors

– The study of social norms, values, and cultures

– Social networks can be considered as a set of agents connected through various ties (boards, ownership etc)

which can be clustered to measure the size of a network

– Norms and values have obvious bearing on corporate governance as attitudes of honesty and fairness reduce

agency problems

Political science

• Politics is highly important because it shapes the law

• Parallels can also be drawn between models of democracy and corporate governance

– One share, one vote principle: shareholders vote by the size of their holdings and dual-class shares significantly affect voting outcomes

– Free rider problems make it disadvantageous for smaller

investors to engage in voting procedures

Law

� Five core characteristics across jurisdictions:

1. Legal personality: company is independent from its owners, and thus, shielded from personal creditors of the owners

2. Limited liability: risk can be shared with creditors who

have no recourse to the shareholders

3. Transferable shares: allows the firm to continue business independently of changes in ownership structure

4. Centralised management: company is run by the board that is formally separate from both management and

shareholders

5. Investor ownership: right to control and right to profits

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Philosophy

• Relevant primarily when discussing business ethics

• Stakeholder theory emphasises that the purpose of

a corporation is to create value for its stakeholders (customers, employees, creditors etc)

• Based on the argument that this is “the right thing to do”, and thus highly philosophical

• Others argue that profit is significantly dependent on close relationships with your stakeholders

Enlightened agency theory

• Starts with the basic agency problem and expands by taking the psychology of individuals into

account

• Egoistic objectives might lead controlling investors

and managers to actions

– Extraction of private benefits by blockholding families

– Imperial construction by CEOs

• This cannot be calculated for in mathematical agency theory

Summary

• Agency theory is the most influential theory in

corporate governance

• It has been challenged with perspectives from a wide variety of academic fields

• Basic assumptions of agency theory, particularly

concerning the human nature, can be questioned on the basis of psychology, sociology and other

alternative perspectives

• Different approaches to corporate governance should be considered complementary

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Divergence and convergence

“The polarisation of corporate governance

may have arisen from differences that exist between cultural and legal systems. However,

in general, countries attempt to reduce the differences to facilitate international co-

operation and trade.”

[Solomon]

���� ���� and ���� ����

Global Convergence of Systems

• International harmonisation now becoming common due to:-

• International investment, foreign subsidiaries • Accounting and financial reporting within

International Accounting Standards • OECD [Organisation for Economic Co-operation and Development]

• ICGN [International Corporate Governance Network] • European Union • World Bank

• Global Corporate Governance Forum

Variation in Systems

• Corporate ownership structure;

• State of the economy;

• Legal system;

• Government policies;

• Culture;

• History;

• Extent of capital inflows from abroad;

• Cross-border investment.

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Demands of Capital

• Effective legal and regulatory systems to minimise

capital being stolen or wasted;

• Boards of Directors who protect shareholder

interests;

• Properly audited accounts;

• Accurate corporate reporting – transparency;

• Fair shareholder voting system;

• Freedom to sell shares to highest bidder;

• Rights of stakeholders.

Organisation for Economic Co-operation

and Development [OECD]

“A forum for governments to discuss, develop

and enhance economic and social policies.”

“A global model for corporate governance.”

“Formulate minimum standards of fairness,

transparency, accountability, disclosure and responsibility for business practice.”

OECD

• Membership of 34 countries

• Principles are basic requirements of good governance

• However – no legislative power

• But – reference point for self-assessment and for developing own standards

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OECD Principles

• Corporate governance frameworks promote transparent and efficient markets, be consistent with rule of law;

• Facilitate shareholder rights;

• Ensure equitable treatment of all shareholders;

• Recognise rights of stakeholders;

• Timely and accurate disclosure of all relevant matters

ICGN Principles

An international organisation for corporations

and individuals interested in corporate governance reform.

• Promote discussion on governance issues;

• Annual conference;

• Promotes OECD principles;

• Provide guidance on how to implement OECD principles

European Union

• No attempts at harmonisation best practice;

• 42 governance codes exist;

• Harmonisation will be by evolution not revolution;

• Convergence at the margins but no one model;

• Standards issued in 2004 by European Commission – transparency, shareholder rights, disclosure, functions of the Board

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World Bank

International financial institution that provides loans to developing countries for capital programmes.

• Official goal to reduce poverty; • Measures to improve governance world-wide;

• Offers technical and expert assistance; • Knowledge sharing; • Loans tied to corporate governance reform.

Research

• “Countries that pursue privatisation without putting good governance structures in place experience worse economic growth.”

[James Wolfensohn – Past President World Bank]

Global Corporate Governance Forum

• Established 1999 by World Bank and OECD

• Established “Centres of Excellence” across Africa

• Sponsored a project to promote role of media as a watchdog

• Regional roundtables

• Partnerships with regional private sector groups

International Monetary Fund

• 188 countries working to encourage global

monetary co-operation, secure financial stability, facilitate international trade, promote high

employment, sustainable economic growth and to reduce poverty.

• Monitors world economies and lends to members in economic difficulty;

• Promoters exchange rate stability;

• Members represented through quota system based on relative size.

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Two Types of Systems

• Insider-dominated systems – publicly listed companies owned and controlled by a small

number of major shareholders – e.g. France, Germany, Japan.

• Outsider-dominated systems – large firms controlled by managers but owned by outside shareholders – e.g. Australia, UK, USA

Insider-Dominated Systems

• Shareholders are family, banks or

government.

• Advantages – management and shareholder interests aligned; hostile takeovers rare; shareholders have a strong voice.

• Disadvantages – abuse of power, little transparency, misuse of funds, lack of knowledge by minority

shareholders, excessive control by small group of shareholders, weak investor protection in law.

Outsider-Dominated Systems

• Separation of control and ownership

• Advantages – management actions accountable to shareholders, transparency, shareholders vote, strong investor protection in law.

• Disadvantages – managers not always work for shareholder interests, hostile takeovers, shareholders not loyal can sell shares anytime

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Next week

• Mechanisms of governance

• Individual assignment workshop

– Understand assessment criteria!

– Come prepared with questions!

– Share ideas!