Introduction and Corporate Governance Theories
Introduction
What is a Corporation?
- Sole proprietorship → owner = firm
- Unlimited personal liability
- Partnership → all partners are liable for the debt, unlimited liability
- Limited liability companies → firm as a legal entity with contractual rights and obligations
- Limited liabilities
- Separate ownership & control
- Joint-stock
What is Corporate Governance?
Corporate governance → the processes, structures, and mechanisms that influence the control and direction of
corporations
- A set of relationships between a company’s management, its board, its shareholders and other stakeholders.
Provides the structure through which the objectives of the company are set, and the means of attaining
those objectives and monitoring performance are determined
- Provides the assurance that managers give the capital providers their money back
- The mechanism for decision making, about the residual control rights
Many disciplines have plenty to contribute - economics, accounting, finance, law, management, politics, psychology,
etc.
Why Does Corporate Governance Matter?
Corporate governance quality affects:
- Firm value
- In the 1990s, Russian firms worth 1% of their Western equivalents
- If management invests in positive NPV projects, then the firm’s value would increase
- Shareholder rights
- The average voting premium of 45.5% in Israel and 82% in Italy
- If investors don’t get adequate returns, would they invest? Voting rights in itself has their
economic value
Corporate Governance as a Global Challenge
- Governance and economic wellbeing
- Development and health of a country’s capital markets, economy
- When there is a secure governance structure (both for the government and the
corporations), the economy would thrive
- What makes an economy competitive or not?
- Governance and political wellbeing
- How are international organizations being governed?
- How to prevent the next global financial crisis?
- Governance of multinational corporations
- What are the common characteristics of successful corporations?
- How to win and maintain trust from investors?
Key Theories
Agency Theory
Separation of ownership and control
- Managers (the agents) controls the firm while shareholders (the principals) own the firm
- Similar situations:
- Citizens (principal) – politicians (agent) → political science
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- Democracy vs. dictatorship
Patients (principal) – doctors (agent)
Employers (principal) – employees/contractor (agent) → managerial accounting
Questions Arising
- Will investors get their money back? If so, when? How much?
- Will managers act in the best interests of the investors?
Who Controls the Company?
Residual control rights
- Residual control rights → the rights to make any decisions regarding an asset’s use that are not explicitly
assigned to another party in a contract
- Free cash flows
- Key resources
- Company strategy
- Management hire and fire
- Voting rights
- Do shareholders, creditors, managers, and regulators find the same things important
Key Conflicts of Interests
- Shareholder vs. manager
- Ownership and control
- Minority investor protection
- Voting rights
- Executive compensation
- Dividend policy
- Change of ownership, etc.
- Shareholder vs. creditors
- Optimal capital structure
- Cost of capital
- Debt overhang
- Risk taking, etc.
- Shareholder vs. stakeholders
- Corporate social responsibility
- Employee rights and regulations (national and international)
- Social and environmental externalities of business, etc.
- Institutional shareholders vs. individual shareholders → large shareholders may influence firms at the
expense of other shareholders
Main Challenges for the Investors to Ensure Their Financial Return
- Contract incompleteness → investors and managers can’t write contracts ex ante on all future
contingencies and specify all the potential solutions
- Information asymmetry → managers know more about the company than investors
- It’s costly for investors to effectively monitor managers’ efforts or verify the managers’ claims
Agency Theory Founder – Jensen and Meckling 1976
- Separation of ownership and control lead to agency problems
- Agency problems exist in all organizations and all cooperative efforts
- Corporation is a legal fiction that serves as a nexus of contracts among individuals
- Agency costs
- Monitoring costs by the principal
- Bonding costs by the agent
- Residual losses
Transaction Cost Economics
(Coase, 1937) Firm → a governance structure to allocate resources more efficiently, at a lower cost than the
operation of markets
- Firm size increases if the internal market is more efficient
- The choice of governance structure can reduce transaction costs internally
Stakeholder Theory
Firm Purpose
Shareholder theory (Friedman, 1970) → maximizing shareholder value would improve all the other stakeholders
welfare in the neo-classical model
- That responsibility is to conduct the business in accordance with the basic rules of the society, both those
embodied in law and those embodied in ethical custom
Stakeholder theory (Freeman, 1984) → an organization’s effectiveness is measured by its ability to satisfy not only
the shareholders, but also those stakeholders who have a stake in the organization
Shareholder Theory vs. Stakeholder Theory
The implied governance structure and monitoring mechanism of shareholder and stakeholder theories are different
- US & UK → one-tier board contains only shareholder elected executive and non-executive members
- France & Germany → labor union, local government, and banks have representatives on the supervisory
board of firms
Resource Dependence Theory
Corporations and their external environment interdepend on each other
- The relationship with stakeholders like employees, suppliers, customers, investors, and regulators must
be managed with care in order to ensure access to critical resources
Stewardship Theory
Managers are intrinsically motivated to act in the best interest of the corporation and its stakeholders
- Firm should run as a team with shared vision and strong sense of commitment from the managers
- Contrast with managers under agency theory, that needs to be monitored and incentivized
- Many corporate governance codes also require the stewardship role of managers
Institutional Theory
Corporations are embedded in a broader institutional environment
- Must confirm to the institutional norms and expectations to gain legitimacy to operate
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