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Corporate Governance: The Role of

Boards and Institutional Investors

Prof. Igor Filatotchev

Session 2

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Aims and Objectives

• To introduce main concepts of the agency

framework

• To outline basic elements of various corporate

governance practices

• To link this discussion to the topics of subsequent

sessions and case analyses

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Incomplete Contracting• some issues that parties may face are not

predictable at the contracting date;

• even if all issues could be foreseen, there may be

too many issues to write into the contract;

• monitoring the behaviour of others may be costly;

• enforcing the contracts may involve considerable

legal costs;

• it is difficult to make a full account of different

factors linked to human behaviour

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Principal-Agent Relationship and

the Firm

• The Principal (shareholders) delegates to the

Agent (managers) the responsibility for selecting

and implementing an action (production of goods

and services). The Agent is compensated by the

Principal, with the Principal being the residual

claimant to the outcome of the Agent’s act (profits).

Berle, A.A. & Means, G. C. (1932) The Modern Corporation and Private Property.

NY: Macmillan

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“Agency Problem”• The bulk of the profits goes to the outside

shareholders

• All major decisions are taken by the corporate

officers (CEOs)

• The outside shareholders are unable to control the

corporate officers

• The interests of CEOs and shareholders may

diverge widely. Senior managers are in a position

to enrich themselves at the expense of the

shareholders

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Basic Problems of Information

Asymmetry

• Moral Hazard: the principal and agent share the same

information up to the point at which the agent takes an action, but thereafter the principal is only able to observe

the outcomes.

• Adverse Selection: the principal does not know some

information which is relevant to the action, whereas the agent can make use of this information to his own

advantage.

The essence of the Agency Theory is that the Principal has inferior information to the Agent.

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Agency Costs and the Firm

• CEOs may derive non-pecuniary benefits from their actions:

- managers’ perquisites

- maximisation of growth versus profits

- mergers and acquisitions

• Different risk attitudes:

- shareholders maintain a diversified portfolio of assets

- manager’s wealth is tied to a particular firm

- managers may be more risk-averse and, for example, under-invest in R&D and innovation

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“The directors of companies, being managers of other people’s money than their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own”

Adam Smith, “The Wealth of Nations”, 1776

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Case example: ‘Free Cash Flow’ and

big oil companies in the USA in the

1980s

Free Cash Flow: ‘Liquid financial assets for which investments in current businesses are no longer economically viable’

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Corporate Governance and Control

• Regulatory system (insider trading, ban on anti-

competitive activities, etc.)

• Product and factors markets

• The internal control system (Corporate Boards,

managerial hierarchy, etc.)

• The external control systems (take-overs, board

participation by banks, etc.)

Corporate Governance is the process by which society exerts some control on the corporation and corporate

managers through markets or regulatory system.

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• Annual General Meeting of Shareholders

• Board of Directors that include the representatives of the

owners and has the responsibility to oversee the direction of the organisation chosen by the CEOs

• Internal control is the process by which the Board

oversees the management of a corporation

• Incentive clauses in managers’ contracts (ESOs; LTIPs)

Shareholder activism - shareholders take an active role in

the firm’s operations and attempt to secure drastic changes in the organisation when performance declined.

“Shareholder Activism” and the Role of

Boards

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Principles of “Good Corporate

Governance“

• Separate the roles of Chairman and Chief Executive Officer.

• Not less than one half of the Board should be Non

Executive (Independent) Directors, and their independence and effectiveness should be strengthened.

• Establish committee dominated by Non Executive Directors and independent of management (e.g.,

nomination, audit and remuneration committees).

• Short-term contracts for executive directors, etc.

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• Nomination committee is responsible for

recruitment of executive and non-executive board

members. Should be independent from the

executives.

• Remuneration committee determines director’s

remuneration packages, including bonuses, ESOs

and LTIPS

• Audit committee oversees internal audit

processes and relationships with external auditors.

Board Committees

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• “CEO duality” is when the roles of CEO and

Board Chairman are combined

• Non-executive (UK) or independent (USA)

directors board members who are not employed

by the firm in any executive position, do not have

business links with the firm and not involved in any

long-term relationships with the executives

(friends, family, etc.)

• Senior Independent Director (SID) oversees the

relationships with main shareholders.

Board Independence

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Corporate Governance and “Market

for Corporate Control”

• accumulation of shares by a ‘core’ investor

• corporate take-over is initiated when the managers of one firm, the raider, make an offer for another firm, the target,

that is resisted by the management of the target

• leveraged buy-out (LBO) occurs when investors acquire a

relatively large proportion of the outstanding stock of a firm using debt.

Corporate governance through ‘exit’: shareholders can sell their shares in the company to someone else.

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“Does it Really Work?”

• AGM attracts a very small fraction of

shareholders (vote by proxy);

• Gathering of information is expensive and

time consuming

• Why to bother if you can benefit from the

result in any case?

The effectiveness of shareholder activism is generally reduced by a ‘free rider’

problem:

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Managerial Incentives

• Lack of complete information about the manager’s abilities

• Management is a team work, recognising the influence of a

single manager may be difficult.

• Performance-related pay and misrepresentation.

• There may be other personal utility-creating activities which seem to the manager superior to seeking performance

improvements in the firm.

The salary a potential manager can command is assumed to reflect performance

to date, but:

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Market for “Corporate Control”

• Anti-take-over strategy:

- ‘poison pill’

- ‘golden parachutes’

- ‘greenmail’, etc.

• Market for Corporate Control is an expensive and

ethically controversial mechanism of governance.

Most managers fear take-overs because of the implied or direct thereat to their

jobs, but:

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New Perspectives on

Corporate Boards• Monitoring and

control

• Resource and ‘legitimacy’

• Strategy/Service

• Access to resources

• Strategic leadership

• Strategic restructuring expertise

• Corporate venturing

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Corporate Governance and ‘Entrepreneurial Leadership’

• “Wealth protection” and “wealth creation” roles of corporate governance

• Resource and strategy roles of corporate boards

• Boards as a “knowledge pool”

• The new roles of non-executive directors

• Individual entrepreneurship, corporate venturing and

innovation

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From Board Structure to Board Processes

• Are structural characteristics (% of

independent directors, CEO/Chairman, etc)

really important? Conflicting evidence

• Emphasis on board processes (engagement,

involvement, support and advise)

• What should a Chairman do?

• Strategic roles of internal and external audit

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Learning Outcomes

• Corporate Governance theory is underpinned

by agency framework which is focused on

potential costs of the ”principal-agent” problem

• Information asymmetries and managerial

opportunism may destroy shareholders’ values,

and corporate governance is there to protect

shareholders’ interests

• However, there are other roles of corporate

governance that may include resource,

strategy and knowledge aspects.

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Reading

• Filatotchev & Wright (2005) various

• Monks, R.G. and Minow, N. (2004) various

• Cadbury, A. 2002 Corporate Governance and

Chairmanship: a Personal View. Oxford: OUP.

• Shleifer, A. and Vishny, R. 1997. ‘A Survey of

Corporate Governance’, Journal of Finance, Vol

52, No 2, June.

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Questions?