What is corporate governance?
– A system of principles, policies, procedures, and clearly
defined responsibilities and accountabilities used by
stakeholders to overcome the conflicts of interest inherent
in the corporate form.
– the ways in which suppliers of finance assure themselves
of getting a return on their investment
Why is it needed?
– In most corporations, the owners (shareholders) do not
manage the company’s operations. Corporate governance
is needed to ensure that the managers are compelled to
return some of the firm’s profits to investors, or that
managers do not steal the capital or invest it in bad
projects.
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Two major objectives of corporate governance:
– To eliminate or mitigate conflicts of interest, particularly
those between managers and shareholders
– To ensure that the assets of the company are used
efficiently and productively and in the best interests of its
investors and other stakeholders
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Most common sources of conflict in agency
relationships within a corporation:
– Manager-Shareholder conflicts
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Management may use funds to increase their job security, power,
and salaries
Managers may give themselves a lot of perks (e.g. use of
corporate jet, $200,000 bathroom, etc)
Managers may take on risky ventures that benefit themselves, but
not necessarily the shareholders
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Duties of the Board of Directors:
– Establish corporate values and governance structures for
the company
– Ensure that all legal and regulatory requirements are met
and complied with fully and in a timely fashion
– Establish long-term strategic objectives for the company
with a goal of ensuring that the best interests of
shareholders come first
– Establish clear lines of responsibility and a strong system
of accountability and performance measurement
– Hire the CEO, determine the compensation package, and
periodically evaluate the officer’s performance
– Ensure that the management has supplied the board with
sufficient information
– Meet frequently enough to adequately perform its duties,
and meet in extraordinary session as required by events
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– Director-Shareholder conflicts
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Boards are supposed to represent the interests of the
shareholders, by monitoring managers and making sure their
actions are in the best interests of shareholders.
Conflicts arise when directors come to identify with the managers’
interests rather than those of the shareholders. This can happen
when:
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Board members are not independent (e.g. they are employees of the firm,
they have business dealings with the firm as consultants, lenders, suppliers,
etc., they are family members or friends of the managers)
Board memberships are inter-linked, e.g., CEOs serve on other companies’s
boards
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Evaluating Corporate Governance
Evaluating the power of the CEO
– Is the CEO the chairman of the board?
– Does the CEO have ownership in the company? In what
form (stocks, options)?
– How long has (s)he been CEO?
– How much is the CEO’s compensation?
• Difference between the next highest paid officer?
• Difference between the average compensation of other top
management?
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Evaluating Corporate Governance
Evaluating the board of directors
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Board composition and independence
Independent chairman of the board
Qualifications of directors
Annual election of directors
Annual board self-assesment
Separate sessions of independent directors
Audit committee and audit oversight
Nominating committee
Compensation committee
Board’s independent and legal counsel
Statement of governance policies
Disclosure and transparency
Insider or related-party transactions
Responsiveness of the board to shareholder proxy votes
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Evaluating Corporate Governance
Assessing shareholder power
– Voting rights (i.e., are there different classes of shares with
different voting rights? Who owns the shares with the
voting rights?)
– Is the top manager a founder/owner?
– Institutional shareholders
– Stockholders with competing interests (e.g. employee
ownership)
– Corporate cross-holdings
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Other corporate governance issues
– Conflict between shareholders and bondholders
– Environmental, social, and governance issues
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Sources:
Clayman, Fridson, Troughton. Corporate Finance.
Damodaran. Applied Corporate Finance, 2nd ed.
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