Corporate Governance

Corporate Finance Detailed Notes: Corporate Governance
Created By: Andrew Bubbs
Corporate Finance (FIN 401)
Creation Date: December 1, 2003

Corporate Governance: set of mechanisms—both institutional and market-based—that induce the self interested controllers of a company (those that make decisions regarding how the company will be operated) to make decisions that maximize the value of the company to its owners (the suppliers of capital).

Two Basic "Systems" of Governance:

Market-Based: system of corporate governance in which board of directors (supervisory board) represents a greatly dispersed group of shareholders

--U.S. and U.K. systems are good examples of this system of corporate governance
--Banks play minimal role except during times of financial distress

Bank-Based: system of corporate governance in which board of directors (supervisory board) is dominated by bankers and other corporate insiders

                --Japan and Germany systems are good examples of this system of corporate governance
                --Recall the "Keiretsu" system in Japan where bank is in the center surrounded by producers that are related
                   in some way. It would be expected that the bank would hold one (if not more) director positions with those
                   companies.

Ownership Trends Vary Greatly from Country to Country:

U.S. and U.K. ownership is generally diluted in comparison to many other industrialized nations
Ownership in German companies tend to be blocks of owners (many cross-holdings)--ie: Daimler-Benz (1990)--owned by blocks of investors [Deutsche Bank (28.3%); Kuwait Government (14%); Mercedes Automobil Holding AG (25.23%); Widely Held (32.37%)]
As mentioned before, Japanese system is quite similar to German system.
China is moving toward the U.S./U.K model but it is taking some time. They have begun to move toward this model, but the government still maintains majority ownership (and therefore control) over these companies that are being partially privatized.

Ownership Trends and Basic Corporate Structure in the United States (by no means exhaustive):

Diluted and dispersed ownership
Great number of publicly traded firms (most of which are widely held)
Market-based system of governance
Great deal of management influence on the board of directors (either by direct membership or through indirect methods)
Very active (external) market for takeovers
Much less influential role of banks as opposed to some other industrial countries (ie: Japan and Germany)
Single-tier supervisory board (board of directors)
Management compensation often tied greatly to stock and stock options (to align incentives)
Block holdings and cross-holdings are rare in U.S. system (where they are prevalent elsewhere)
Management compensation is greater in the U.S. than anywhere else

Proxy Contests:

Proxy--a ballot used to allow shareholders to vote on proposed corporate actions without actually attending the annual meeting

                --The proxies that are not used are automatically voted in favor of management's recommendations
                --Extremely difficult to successfully attempt a proxy contest against management's wishes
                --Management has company resources to fight proxy contest while outsiders must fund any attempts to exert
                  their control over management

(Very generally) a situation where a group of people try to exert control over the actions that are taken by the board of directors and/or management
Often attempted by another firm that wishes to attempt a hostile takeover--trying to solicit the support of the target company's shareholders so as to allow it to effectively acquire company control without having to pay a premium for that control
Studies have found that companies that are involved (in one way or another) with proxy contests (generally) see share prices rise

Reasons for Corporate Governance:

There is a great potential for conflicts of interest between owners and management
It is not efficient for (most) individual shareholders to monitor the company on their own. It is much more efficient for there to be a system in place that is doing that for them.
Great possibilities for fraud which can lead to investor skepticism
Corporate Governance decreases agent costs and cost of capital for firms.

Forms of Governance are both Internal and External:

Internal Governance:

Board of Directors (in the U.S.) are specifically charged with representing the interest of shareholders

            --Exists primarily to hire, fire, monitor, and compensate management (while working to maximize
               shareholder value)
            --Many U.S. Boards of Directors include numerous insiders (who are the ones that should be monitored)
               or members who are sympathetic toward management (management often plays active role in selecting board
               members.
            --It is not uncommon to see the CEO also acting at the Chairperson of the Board (this presents a great possibility
               for conflict of interest)

Ownership Structure (with primary focus on the U.S.)

            --It is rarely the case that ownership and control are completely separate
            --Controllers frequently have some degree of equity in the firms they control (manage)
            --Others effectively have control due to the sheer size of their equity position (ie: CalPERS)
            --Ownership by company's management can better align manager's incentives with those of shareholders
               (However, when management acquires a high equity share they may be allowed greater freedom to pursue
               own objectives without fear of reprisal); in other words: they may become entrenched
            --Due to its sheer size and equity share in many corporations, CalPERS can often exercise control over management
               and increase shareholder wealth for all
            --Problems with typical U.S. corporate structure (with widely dispersed ownership, individual stockholders have
               little incentive to expend significant resources needed to monitor managers or seek influence within the firm)
            --Another Problem arises when significant block holders use their powers to influence management to take some
               action that might not be beneficial to all shareholders

External Governance:

The Takeover Market

            --When the gap between actual firm value and potential firm value is large enough, there is an incentive for outside
               parties to seek control
            --The takeover market (market for corporate control) is very active in the US
            --When a change in corporate control occurs it is almost always at a premium (therefore immediately creating value
               for the target firm's shareholders)
            --Management Incentives in this case is to keep the firm's value high (to keep the gap between actual and potential
               value from growing large enough to warrant a takeover)
                    *Dark side of active takeover market (for shareholders) is the potential for managers of firm that's looking to
                       acquire other firm may be interested more in maximizing the size of their business empires by wasting
                       corporate resources (overpaying for the acquisition) rather than paying out dividends

The Legal System

            --Acknowledged by Jensen's 1993 paper as being too blunt an instrument to be used in dealing with manager/
               shareholder agent problems
            --Two basic determinants of usefulness of legal system
                    *The extent to which laws protect investor rights
                    *The actual enforcement of laws on the books

Strong Accounting System

            --Without stringently audited financial statements, you might as well not even produce them at all
            --The SEC working along with the Financial Accounting Standards Board (FASB) establish and enforce an
               accounting system that allows for the thorough auditing of financial statements.
            --Many strict requirements established and enforced by these organizations (FASB establishes, SEC enforces):
                    *Which specific documents must be produced
                    *How many years worth of past data must be provided
                    *Certain items or actions that must be disclosed
                    *Standardized forms (such as the income statement, balance sheet, etc.)
                    *Must provide the compensation of corporation's top management
           --There are, however some areas that are not subject to strict requirements due to the differing needs from industry
               to industry (such as the depreciation method used)
            --Strong accounting system allows for the drastic reduction of the information asymmetry problem. It allows
               ordinary shareholders to much of the information that is available to management and large institutional
               shareholders.

Board Composition (and how it affects firm performance and management):

Higher proportion of outside directors on board is NOT associated with superior firm performance; however it has been associated with better decisions regarding acquisitions, executive compensation and CEO turnover
In the U.S.--Board size is negatively related to both firm performance and quality of decision making
Poor firm performance, CEO turnover, and changes in ownership structure are often accompanied with changes in board membership
Other countries often see different results when taking some of the same actions

Board Composition in (a Few) Foreign Countries:

European Countries--most often single-tiered (similar to U.S.)

            --There are, however some two-tiered structure (as is mandated by law) for example in Germany and Austria;
               some countries have option to utilize two-tiered structure if desired (ie: France and Finland)
            --Many countries do not recognize shareholder wealth maximization as a major (if even a goal) of the board.
                    *Exceptions to this include U.K, Swiss, and Belgian systems which place more emphasis on shareholder wealth
            --Many European countries have issued and adopted a "Code of Best Practice" (trend began in U.K. in 1992)
                    *Some require specified numbers or percentages of independent directors on boards of firms
                    *Specifies that position of CEO and chairperson of the board must be held by different people
                    *Typically voluntary in nature (with varying degrees of compliance)
                    *Some attribute non-compliance in continental Europe (much less prevalent in U.K.) to controlling
                       shareholders that don't want to see their influence reduced due to additions of independent directors
                    *London Stock Exchange requires that all companies listed on that exchange disclose if they are in compliance
                       with the code (and if not: provide an explanation as to why)

Russia--majority of firms are owned by insiders and employees. Therefore, most boards are solidly controlled by insiders (most of which are block holders)
Japan--many board members are "outsiders" (defined as being previously employed by banks or other corporations)

            --Outside board appointments increase following poor stock performance and earnings losses
            --More likely in firms with significant bank borrowings, concentrated shareholdings, and membership in a
               corporate group
            --Such appointments stabilize and modestly improve corporate performance

Germany--outside firms are largest block holders, but banks play important role in that they can vote the shares that they hold for their customers (unless told not to) due to their proxy rights
China--ownership split between private parties and the government (although the government does hold on to majority of voting right and the influence that accompanies)

Executive Compensation (both U.S. and World Trends):

In US--Sensitivity of executive pay to firm performance has increased

--Stock options are the fastest growing component of CEO compensation
--U.S. CEO compensation is more generous than anywhere else in the world

Studies have found that firms in countries that use more equity oriented capital markets (as well as firms with higher growth potential) use more equity based compensation
Japanese executive compensation tied to stock returns and earnings is increasing

Management Entrenchment:ability of management to insulate themselves from actions taken by shareholders and other stakeholders to take reactionary measures in response to their actions

Managers can become entrenched with lower percentage of ownership in the U.S than elsewhere (due to the dilution of ownership)
Study by Morck, Schleifer, and Dishny (1988) found that management entrenchment effects began to dominate management actions with only 5% of ownership in a U.S. firm (as opposed to 12% needed in the U.K.)

Sources:

Boyd, Brian K. and David Norburn. European Business Journal; 2000 3rd Quarter, Vol. 12 Issue 3, p116, 18p, 3 charts, 1bw. EBSCOhost, 12 November 2003 <http://search.epnet.com/direct.asp?an=3749584&db=bsh>.

Butler, Kirt C. Multinational Finance 2nd Edition. Ohio: South-Western College Publishing, 2000.

Chew, Donald H. The New Corporate Finance. New York: McGraw-Hill/Irwn, 2001.

Denis, Diane K. and John McConnell. International Corporate Governance. EBSCOhost. 12 November 2003 <http://search.epnet.com/direct.asp?an=10598341&db=bsh>.

Kumar, Rajeev. "Postseason Report: Proxy Battles Rise Again, and So Do Stock Prices" (August 22, 2003). 28 November 2003 <http://www.issproxy.com/articles/archived/archived78.asp>.

Meyers, Stewart C. and Richard A. Brealy. Principles of Corporate Finance. New York: McGraw-Hill/Irwin, 2003.

Monks, Robert A.G. and Nell Minow. Corporate Governance 2nd Edition. Massachusetts: Blackwell Publishing, 2001.

Rui, Oliver M., Firth, Michael and Fung, Peter, "Corporate Governance and CEO Compensation in China" (September 2002). http://ssrn.com/abstract=337841