1

Global Business

Issue Dossier

Corporate Governance Dossier

Group Members:

César Marnoto Martins – 324184

Daniel Rosenthal Ayash - 324109

Sofia Almeida Peres Feria - 324141

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1. Executive Summary 3

2. Introduction 3

3. Characteristics 4

3.1. Definitions 4

3.2. Dimensions 5

3.3. Causes: Scientific Research 11

3.4. Trends 14

3.5. The stakeholders 17

4. Consequences 18

4.1. Existing Scenarios 19

4.2. Issue ownership 22

4.3. Expectational gaps 25

4.4. Regulation possibilities and impact on stakeholders 26

4.5. Link with other issues 27

5. Analysis of phase in the issue life cycle 27

6. Firms part of the problem 29

6.1. Primary Responsibilities and Interfaces 29

6.2. Dominant Sector Effect 30

6.3. Dominant Business Model 30

7. Firms part of the solution 31

7.1. Responsibilities 31

7.2. Sector effect 31

7.3. Plea for regulation? 32

8. Leadership issue 33

9. Sustainable corporate story 34

9.1. Interface challenges 34

9.2. Strategic/operational choices 34

9.3. Tools: codes, reporting, labels, chain strategies, issue advertisement 35

9.4. Processes 35

10. Conclusion 35

10.1. Further Research & Research Limitations 35

10.2. Evaluation of Group/Individual Development 36

11. Bibliography 37

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1. Executive Summary

The term “corporate governance” has become a key discussion topic in the wider business,

legal, and investment communities. However, corporate governance standards and

compliance vary significantly between countries due to differences in financial markets,

ownership structures, legal framework and cultures (Japanese companies emphasize the

importance of the employee, while American companies prefer to please shareholders).

Nevertheless, the corporate finance paradigm that shareholders’ and managers’ interest

should be aligned has been broadened to include other stakeholders as well. Moreover,

corporate social responsibility including environmental and societal considerations has entered

corporate governance agendas.

A clear interaction between companies, the government and civil society concerning this issue

has surfaced. Corporate scandals related to managers’ malpractice and earnings manipulation,

such as Enron and WorldCom, have caught the attention of the media and numerous

academics which in turn pressure the government to intervene.

After these scandals, several NGO´s were created. They work closely with academic

universities, promoting further research concerning polemic corporate governance issues and

developing best paper contests, inducing a continuous debate about this topic and creating

guidelines for good corporate governance practices.

Additionally, recent newspaper articles criticizing the lack of transparency regarding Lehman

Brothers financial condition have pressured legal authorities to investigate possible white-

collar crimes such as fraud or financial reports’ manipulation.

Nonetheless, either in order to build a strong reputation or for ethical purposes, companies

have taken an active role in corporate governance considerations. Many multinational

companies spread through different industries, have created internal corporate governance

departments in order to address this issue.

A sustainable corporate story is still tricky to find, but given the current financial crisis and its

repercussions, companies will feel an increasing eagerness to pressure governments for

further regulation.

As Sir Adrian Cadbury, one of the fathers of UK’s corporate governance model, so vigorously

defended, ethical principles and corporate governance considerations should be part of firms’

strategies.

However, there is still a lot of disagreement regarding good corporate governance practices

and their effectiveness. It is undisputable the need for further research regarding this topic.

As the markets dangle at the verge of financial collapse, the need for sound and strong

corporate governance models is now more important than ever before.

2. Introduction

Our analysis is supported by several research papers, newspaper articles and books already

available on corporate governance. The overall objective of our work is to understand how

corporate government became such a prominent issue. First, we start by stating the main

characteristics of corporate governance, including the definition, its dimensions, main causes,

current trends and their impact on the topic, and stakeholders related to this issue. Second,

we mention the consequences of the issue discussion, encompassing the existing scenarios,

the issue ownership, the existence of expectational gaps, the importance of regulation and its

impact on stakeholders. Third, we analyze the issue life cycle, followed by a discussion on the

responsibility of the firm concerning this issue, their role in its settlement and the main drivers

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of a sustainable corporate story. Then, we present a leadership style necessary to address this

subject. Finally, we summarize other areas of research.

3. Characteristics

3.1. Definitions

The term “corporate governance” has become a key discussion topic in the wider business,

legal, and investment communities.

Corporate Governance

The separation of ownership and control in modern corporations has given rise to ever-

increasing agency conflicts between owners (shareholders) and managers. That is,

shareholders delegate decision-making responsibility to managers, but managers have

incentives to make decisions in their own best interests rather than those of the shareholders

(Jensen and Meckling, 1976).

Even Adam Smith perceived that conflicts of interest might arise due to the separation of

ownership and control:

“The directors of companies being managers of other’s 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 co-partnery frequently watch over their own.”

Basic Definitions of Corporate Governance

“Corporate governance is the system by which companies are directed and controlled. Boards

of directors are responsible for the governance of their companies. The shareholders’ role in

governance is to appoint the directors and the auditors and to satisfy themselves that an

appropriate governance structure is in place.” (Committee on the Financial Aspects of

Corporate Governance and Gee and Co., 1992)

“Corporate governance deals with the ways in which suppliers of finance to corporations

assure themselves of getting a return on their investment.” (Shleifer and Vishny ,1997)

“It is the relationship among various participants in determining the direction and

performance of corporations. The primary participants are (1) the shareholders, (2) the

management (led by the Chief Executive Officer), and (3) the board of directors.” (Monks and

Minow, 2001, p. 1)

“Corporate Governance is concerned with the resolution of collective action problems among

dispersed investors and reconciliation of conflicts of interest between various corporate

claimholders.” (Becht, 2005, p. 1)

“The system of checks and balances, both internal and external to companies, which ensure

that companies discharge their accountability to all their stakeholders and act in a socially

responsible way in all areas of their business activity.” (Solomon, 2007, p. 14)

It is quite straightforward the natural evolution of the corporate governance definition. The

oldest definitions only took into account shareholders or creditors interest while the most

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recent one considers all stakeholders interests and demands a socially responsible attitude

from companies.

3.2. Dimensions

Basic Dimensions of Corporate Governance

Figure 1 – Corporate governance top 10

There are several corporate governance mechanisms which can be classified into two

categories, internal or external to the firm.

The main internal corporate governance mechanisms are the Board of Directors, the

Ownership Structure and Executive Compensation.

The primary external corporate governance mechanisms are the market (mainly through

takeovers) and the regulatory framework.

The influence of each corporate governance mechanism differs substantially from one country

to another. Market characteristics, regulatory frameworks, institutional differences and

ownership structures play an obvious role on the mechanisms’ success.

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Active Mechanisms for Corporate Governance

External Mechanisms Internal Mechanisms

Board of Directors

The owners have some important rights which help minimize the agency problem. One of

them is the appointment of the Board of Directors, to which is assigned the responsibility of

monitoring managers and their performance as well as enhancing it through hiring, firing or

compensating. Additionally, board members are also required to vote on important strategic

decisions such as mergers and acquisitions, changes in executive compensation, changes in the

firm’s capital structure, etc. (Becht, Bolton & Roell, 2005, p.22). Ultimately, boards of directors

are responsible for the governance of companies.

In the US, boards are mainly dominated by managers, which have the complete autonomy and

authority over companies. Therefore, it is undisputable that the above mentioned roles of

boards will be highly biased, compromising its quality and integrity. In fact, usually the CEO of

the company is also the Chairman. This means that it will be extremely difficult to fire the CEO

in case of poor performance. As it is mentioned in the academic paper Corporate Governance

and Control, “in particularly dispersed ownerships the board is more of a ‘rubberstamp

assembly’ than a truly independent legislature checking and balancing the power of the CEO”

(Becht, Bolton & Roell, 2005, p.23).

UK is considered to be on the forefront of corporate governance reforms mainly due to the

increased interest in these issues within the boardroom, the institutional investment

community and the Government (Solomon, 2007, p.49). Boards play a crucial role in the UK’S

corporate governance system, where it is possible to find a clear separation between

governance and management. According to the Cadbury Report (1992) (the foundation of the

UK’s Corporate Governance model), the effectiveness of Boards was crucial in establishing

UK’s competitive position.

Several decisions have to be taken regarding the Board of Directors such as the board’s

structure, composition, independence and resources.

Regarding the Board’s structure, there are two general models, a unitary board or a two-tier

board. The unitary board is predominant in the UK and US, while the two-tier board structure

is more common in certain European countries such as Germany.

“Unitary boards include both executive and non-executive directors and tend to make

decisions as a unified group.” This way, the company will be able to combine the intimate

Corporate

Governance

Ownership Structure

Executive

Compensation

Market for Corporate

Control

Board of Directors

Regulatory

Framework

Figure 2 – Mechanisms for Corporate Governance

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knowledge of the business brought by executive board members with a broader and

independent view of the company’s activities brought by the non-executive board members.

“On the other hand, two-tier boards have two separate boards, a management board and a

supervisory board.”(Solomon, 2007, p.78). According to Solomon, the two-tier board structure

allows a clear separation between the management and the monitoring roles. Managers’ will

be able to focus on operational issues, while the supervisory board will be focused on key

strategic decisions.

Concerning the Boards composition and independence, the most relevant decisions regard the

number of non-executive board members, the creation of independent audit, compensation

and nomination committees and the separation between the role of chairman and CEO.

According to Byrd and Hickman (1992, p.196), “the inside directors provide valuable

information about the firm’s activities, while outside directors may contribute both expertise

and objectivity in evaluating the manager’s decisions. The corporate board, with its mix of

expertise, independence and legal power, is a potentially powerful governance mechanism.”

Furthermore, the Cadbury Report (1992) suggests that the board should have a minimum of

three non-executive directors who are able to influence strategic decisions.

Executive compensation

Executive compensation is usually defined by the board (or an independent Compensation

Committee) and it aims to align the individual interests of managers with the value-creation

goal of other stakeholders. Executive compensation instruments include a fixed amount, a

variable amount correlated to short-term financial indicators such as EBITDA margin and Net

Income, and a stock-related amount correlated to the firm’s long-term performance, usually

through stock-options.

Executive remuneration in the US is known to be far more excessive than in other countries.

Ownership Structure

There is an important trade-off concerning the ownership structure. While highly concentrated

ownership structures provide the necessary financial incentives to monitor management, it

compromises the optimal risk diversification obtained through dispersed ownership.

Since ownership is, particularly in the U.S. corporate model, so diffuse, no individual owner has

any incentive to monitor managers because he/she will incur all the costs and other

shareholders will also reap the benefits from that monitoring. This is a clear example of the

classic “free-rider” problem and of positive externalities for the economy which are not taken

full advantage of because monitoring will be less than socially optimal. Only with concentrated

ownership will we have a large shareholder for whom it is more profitable to monitor, since

the increased pay-off from this activity will outweigh the associated costs.

Monitoring will always be, however, less than socially optimal per si because of the free-riding

problem; in order to solve it such that monitoring occurs in equilibrium, there must be either

economies of scale to investment management or an institutional framework that encourages

pooled investments to diversify risk. Both conditions hold in today’s financial markets. With

economies of scale to investment management (e.g., improved diversification or reduced

transaction costs), the equilibrium size of a portfolio will be determined such that the

transaction costs savings are exactly offset by the cost of monitoring (Admati et al., 1994).

Furthermore, institutional investors usually face a trade-off between the need to have larger

positions and increase monitoring of management (in order to be able to force changes and so

increase the value of their holdings) and the need to have exit solutions that protect the

redemption of the fund subscribers’ money. If institutions take large controlling positions

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there is an inevitable sacrifice of liquidity, and so this trade-off leads to lower monitoring

efforts than optimal.

In fact, according to Becht, Bolton and Roell (2005, p.17) corporate governance could be

improved under concentrated ownership, if the regulatory framework provided the necessary

subsidies to blockholders, increasing the incentives to engage in monitoring.

However, highly concentrated ownership structures also have a downside. They give room for

expropriation, self-dealing or collusion with management at the expense of minority

shareholders.

Despite its low presence in the UK and the US due to regulatory restrictions on blockholder

actions, semi-concentrated ownership structures are common in certain European countries.

Market for corporate control

When internal mechanisms fall short in improving the company’s performance – which means

that the company’s market value is lower than its fair value – the market for corporate control

mechanism comes into place.

Hostile takeovers are one of the most effective ways of disciplining and replacing managers.

The simple threat of a takeover creates an incentive for “good management”, preserving a

high company value.

If managers have been delivering poor company performance, a corporate raider will find an

opportunity to earn high returns through the company’s acquisition and the replacement of

inefficient management.

“Under such circumstances, other management teams are likely to offer themselves to the

shareholders as alternatives to the incumbent management. The market for corporate control,

then is the competition among these management teams for the rights to manage the

corporate resources.” (Fama, 1980)

So, when a bidding firm acquires a company the controlling rights are transferred to the

acquiring firm.

Furthermore, takeovers also reduce the informational monopoly of the inside managers about

the company’s actual situation.

However, this mechanism presupposes a good performance of the stock market as well as

some market liquidity.

Nevertheless, regulatory intervention limiting anti-takeover defenses such as super-majority

amendments, mandatory bid rule, poison pills and golden parachutes is important for the

effectiveness of this mechanism.

Regulatory Framework

Why regulate?

Analyzing the regulatory framework regarding corporate governance is not a simple task, since

each country can have entirely different legislations. Also, we have to acknowledge that many

countries actually use a combination of legislative, regulatory and self regulatory processes

(Waring, 2005).

In most underdeveloped countries, there is a clear lack of enforcement of the regulatory

systems. In developed countries, however, the Sarbanes Oxley act of 2002 is facing large

repercussions, setting a new agenda of discussions.

According to Denis & McConnel (2003), several studies show evidence that a better legal

protection stimulate growth. While it is very hard to analyze corporate governance effects

within a country, since most companies will follow similar practices, comparing different

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countries can bring evidence that legal protection has a positive relation with different positive

effects, such as growth, profits and growth in dividends.

LaPorta, Lopez-de-Silanes, Shleifer, and Vishny (2000) suggest that in countries where investor

protection is stronger, the dividend payouts are higher than in countries with weak legal

protection. Rajan and Zingales (1998) argue that in countries with a developed financial

sector, economic growth is facilitated. Several studies (although not all of them) indicate

positive effects such as the above mentioned. Most of them rely on the argument that with a

better legal system, there is less risk, and with less risk, access to international capital is easier,

thus stimulating growth. Even though the conclusion is somewhat logical, proof is not so easy.

If proving the advantages is not so easy, proving the disadvantages is. According to Forbes

magazine (Forbes, 2003), costs of complying with the Sarbanes-Oxley approximately doubled

previous costs of compliance. Most of this money is spent on control systems, compliance

executives and audit committees. Betch (2002) argues that despite the costs, regulation is

necessary since even firms which begin with a good set of rules, will tend to break them later,

on a clear case of agency problem. Forbes magazine itself states that even though it may be

costly, regulation is necessary to avoid much bigger losses such as the Worldcom and Enron

cases.

How is it actually done?

In this section we will make a brief description on how the legal framework is organized today

in the main developed countries, namely the United States, UK, and EU and Developing

countries. Most of the data for specific countries were extracted from Green (2005) and

Waring (2005).

United States

Figure 3 – Company interfaces -.Source: McLuhan, One Issue, Two Voices, Woodrow Wilson Center, 2006

Following the Enron and WorldCom scandals, Washington passed the Sarbanes Oxley Act.

Major SARBOX guidelines include:

• Certification by the CEO and CFO of the accuracy and completeness of the company’s

financial reports (corporate and criminal fraud accountability and white collar crime

penalty enhancement);

• External auditor independence is mandatory;

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• Board audit committee that oversees all internal audits, defines the specific processes

and procedures for compliance audits, inspects and enforces compliance with the

specific mandates of SOX;

• Public accounting firms are prohibited of doing consulting work for audit clients;

• Prohibition of loans from the company to executives;

• Enhanced Financial Disclosures.

The Sarbanes Oxley Act acts as an overall framework, while the SEC (Securities & Exchange

Commission) is generally responsible for the details. Other known regulators are the state

courts and the Stock Exchanges (NYSE and Nasdaq, for example).

United Kingdom

The Cadbury Report (Committee on the Financial Aspects of Corporate Governance and Gee

and Co.,1992) was the first written document on corporate governance which elucidated the

corporate governance systems that where implicit in many British companies (Solomon, 2007,

p.49). This document became the foundation of further developed policy documents,

principles, guidelines and codes of practice in the UK. The Cadbury code was the beginning of

discussions regarding Corporate Governance in the UK. Since then, several contributions were

made, resulting in the Combined Code, which regulates the trading in the London Stock

Exchange. The main characteristic of the code is the “Comply or explain” system, which was

also used by other European countries.

EU

Unlike the United States, the EU is taking a little longer in their reform for the corporate

governance regulation. The European Commission has issued two communications addressing

issues such as modernization of corporate law and improvement and standardization of audits.

It is important to remember that there are still different laws in each country, so this

discussion is mainly for the long term, since implementing these changes may take some time.

Developing Countries

In most developing countries, regulation is still very weakly enforced. In 2003, the OECD issued

a white paper on corporate governance (OECD, 2003) on an attempt to standardize and

improve regulations in Latin American companies. Most of these countries have failed to turn

these guidelines into regulations, but have improved their governance practices through self-

regulatory actions. The São Paulo Stock Exchange, for example, categorizes companies in

different corporate governance levels, according to standards defined by the Brazilian Institute

of Corporate Governance.

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Summary of countries Legal Framework

United States UK Germany

Code Sarbanes-Oxley and NYSE

Code

Combined Code Cromme

Mandatory? Combination of

mandatory and non-

mandatory

Comply or explain Comply or explain

Independent Board Independent Board

Majority

At least half the

board should be

non-executive

One third to one half may

be employee

representatives

Chairman and CEO Not compulsory

separated, but there is a

trend towards separation

Separated Two tiered structure

(further explained in the

Board of Directors section)

Committees Audit committee Nomination,

remuneration and

audit committee

Audit committee

Auditor

Independence

Other services are

restricted for auditors;

Rotation is required

Audit committee

monitors auditors

independence

Supervisory board must

determine auditor’s

independence

3.3. Causes: Scientific Research

Causes – Theories in Literature

There are some theories in literature that aim to explain the current importance and existence

of the corporate governance issue.

The Principal-Agent Problem theory is the foundation of corporate governance. Several

centuries ago, the market was mainly characterized by small family companies, meaning that

there was no separation between ownership and control. However, market developments and

growth requirements led to the increasing need for external financing. In addition, huge

Corporate

Governance

Causes

Stakeholder Theory

Transaction-Cost

Theory

Short-Termism

(Investors and

Managers)

Principal-Agent

Problem

Figure 4 – Corporate Governance Causes

Source: Solomon (2007), p.17

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company’s growth called for more experienced and knowledgeable managers, increasing even

further the separation between decision and risk-bearing functions.

The shareholder, who is the owner (principal), delegates the decision-making in the company

to the managers (agents). The agency theory presumes a conflict of interests between

shareholders and directors, meaning that managers will act in their own benefit instead of

pursuing shareholders profit-maximization goals.

Additionally, literature theories also suggest that the short-termism of managers also

underline the need for good corporate governance models. That is, the increased focus of

managers in short-run profits to the detriment of maximizing long-run shareholders’ wealth

emphasizes the conflict of interests between both. Furthermore, there is an increased concern

regarding the short-termism of shareholders themselves, looking for quick returns instead of

long-term sustainable ones. Corporate Governance is crucial in order to deal with these

conflicts.

The transaction costs theory assumes an increasing influence of companies in resource

allocation due to their high growth and complexity. Inside a company, market transactions are

removed, which creates an incentive for managers to internalize transactions as much as

possible in order to reduce price quality uncertainties. This theory also assumes managers

bounded rationality and opportunism. Thus, the theory advocates that managers organize

transactions in their best interest sometimes in detriment of the market. This demands a

higher control.

Finally, stakeholder theories support corporate accountability to a larger number of

stakeholders, including shareholders, employees, suppliers, creditors, customers, the

environment, local communities and the society as a whole. Social and environmental groups

have targeted several companies demanding ethical practices.

It is fair to say that all these theories insist on better and more effective corporate governance

practices that align and balance stakeholders’ interests.

Causes – Economic and Financial Developments

Corporate Governance

Causes

De-regulation

and Capital

Markets

Integration

Mergers and

Takeovers Wave

1980’s and 1990’s

Financial Crises

Corporate Scandals –

Enron/WorldCom

/Parmalat

Globalisation

Privatisation

Pension Funds

and Active

Investors – Carl

Icahn & TIAA-

CREF

Figure 5 – Causes – Economic and Financial Developments

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Privatization

Most countries in Western Europe, Latin America, Asia and the former USSR experienced in

the 1990’s what was called a privatization wave. This wave is extremely important since it

brought up new questions regarding how these new listed companies would proceed

regarding their investors. The need for corporate governance emerged in companies where it

was not an issue before. This certainly helped the growth of the Corporate Governance Issue.

It is also of concern for the academics interested in the topic, since it gives us a clear before-

after scenario, where it is possible to try to relate performance indicators with governance

practices.

Denis and Mcdonnel (2003) again provide a series of research results about the privatization

wave trend. Studies such as Megginson et al (1994), Boubakri and Cosset (1998) and LaPorta

and Lopez-de-Silanes (1999), all report increased profitability, efficiency and employment

levels.

Although not all of the benefits can be entirely credited to the increase in corporate

governance, most studies above acknowledge the important role that governance has in these

improvements.

Mergers and Takeovers Wave 1980’s and 1990’s

The takeover wave is also of interest to the rise of Corporate Governance as an issue. During

the 80’s and 90’s, and especially after the privatization wave, hostile takeovers have been

commonly seen in developed countries’ stock markets.

These takeovers have generated heated discussions, which in some countries resulted in new

regulation regarding mergers.

Financial Crisis & Globalization

In the end of the 90’s, several crises shook the globalized financial market. Namely the ones in

Russia, Brazil and East Asia created a large impact even in the developed countries exchange

market. In an increasingly globalized market, large impacts in one country quickly affect other

players.

These crises brought with them new worries concerning the developing countries’ attitudes

towards corporate governance and legal enforcement.

Another characteristic of the globalized market is that every company now competes for

financing with every other company in the world. Simply complying with their own countries’

regulation is not enough to attract international capital. To attract international investors’

interests, companies should adopt practices similar as the ones practiced by the world’s most

globalized companies. This leads to a continuous improvement in governance practices.

Capital Market Integration

This phenomenon works very similarly as the above mentioned globalization of financial

markets.

With the advent of companies cross-listing their stocks in different exchange markets, stock

markets requirements have continuously converged. Brazilian companies listed in the NYSE,

for example, serve as a role model for other Brazilian companies in terms of governance, which

leads to a certain informal standardization. Even though these companies era not required by

law to certain practices, they are competing for capital with companies who present a high

level of governance. In face of this competition, they improve their practices, and so the

market as a whole also improves its governance level.

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Corporate Scandals

One of the most notable triggering events of our issue was the series of corporate scandals in

the late 1990’s and beginning of the decade.

The cases of Enron, Worldcom, Arthur Anderseen and several smaller ones made the American

congress to realize that something had to be done before individuals stopped trusting the

capital markets.

Some argue that the Sarbanes-Oxley act was already being prepared and discussed by the time

these scandals happened, but they certainly rushed the theme to the top priorities.

Besides targeting accounting irregularities (the main cause of these scandals), the Act also

tackles other issues previously mentioned.

These scandals may not have been the main events that triggered the rise of the issue of

corporate governance, but they were certainly decisive in its growth phase, bringing great

awareness to common people.

Active Investors

In the 1990s, many North American pension funds experienced a sharp decline in their asset

value due to a decrease in the share prices of their equity investments which, compared to the

European stocks, were having a poor performance. Furthermore, their equity investments

were indexed to reflect the composition of the Fortune 500 companies, which means they

were locked into holding the entire market. US pension funds such as CalPERS felt the urge to

intervene and pressure management in order to improve major U.S. companies’ performance.

Their role will be further explained in the trends section.

3.4. Trends

Economic and financial markets integration, along with the harmonization of regulation and

technological diffusion created new management challenges such has higher complexity

(products, procedures and financial markets) with management and control implications,

higher pressure for better change management (technology, competitive landscape and

regulation), increasing competition, industries’ consolidation, higher consumers’ demands,

increasing pressure from investors for good corporate governance practices and new

regulation.

The Mckinsey study A premium for good governance (Newell and Wilson, 2002) shows that

investors are willing to pay a premium for companies in emerging markets that have

implemented good corporate governance systems.

Growing Stakeholder

Demands – Shareholder

Activism

Global implementation

of International

Accounting Standards

Corporate

Governance

Trends

Government

Intervention

Figure 6 – Corporate Governance Trends

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One of the global trends presented by the IMD stated the growing stakeholder’s demands on

business, namely the increase in shareholder activism.

The rationale for shareholder activism is to intervene when the Board of Directors fails in its

primary duty, that is, when shareholders are dissatisfied with the performance of the Board of

Directors and of the firm. There are, broadly speaking, three lines of action that shareholders

follow in that case: sell their shares (‘vote with their feet’), hold their shares and voice their

dissatisfaction, or hold their shares and do nothing. Hirschman (1971) has called these three

activities: exit, voice and loyalty. Shareholder activism takes mainly the second form: activist

blockholders acquire a relevant minority (in most cases) control in underperforming

companies with the purpose of inducing management changes with impact at the profitability

and share price levels of the target.

If the pattern of intervention persists in time, expands its reach, and maintains the present

high level of governance success, then the separation of ownership and control and associated

agency costs will become a less acute problem for corporate law. But such a change will occur

only to the extent that clear cut financial incentives encourage an expanded field of

intervention.

To measure the impact of shareholder activism on the target’s performance is a complex task,

especially because it is difficult to determine cause-effect relationships. One can see, for

instance, whether firms remove their antitakeover amendments, change their compensation

plans or change the structure of their board of directors after shareholder proposals have been

submitted, but there will be the problem of determining whether the changes are actually due

to the activism. An additional problem is that much of the activism takes place “behind the

scenes”, by means of private negotiations/settlements, which make the access to information

more difficult.

There are several investors that engage in shareholder activism. In fact, their particularities

define their activist initiatives and therefore their performance.

Prominent names such as Carl Icahn, Daniel Seth Loeb, Warren G. Lichtenstein and CalPERS

are known for their enthusiastic activism against poor performing companies.

Another important trend related to this subject is the integration of accounting standards. The

International Financial Reporting Standards that were adopted by the European Union

countries highlight the increased importance of corporate governance today. Through the

international harmonization of reporting standards it will be easier to compare and analyse the

quality and integrity of financial reports, simplifying the auditing process.

Further regulation is also a relevant trend. Financial crises allow governance problems to

surface and government intervention becomes necessary. A great example is the current

financial crises in the US. Lack of control and monitoring over management seriously affected

companies’ performance, and was the main driver in this crisis.

Actually, Monk (2005, p.109) mentioned that governance practices in North American

companies still failed to address important issues such as non-executive director

independence, long-term shareholding, institutional investors as “responsible owners”, the

independence of auditors, and executive remuneration.

However, one should mention that corporate governance problems and criticism only arises in

times of economic distress. During economic expansions, the topic is never brought up

(Frentop, 2002).

The current financial crisis has put corporate governance practices under the microscope. The

media and government are the primary overseers.

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As it is mentioned in the Forbes article Subprime: The Next Wave of Corporate Fraud Probes?

(2007-03-19) “The recent free-fall in the subprime mortgage market has captured the public's

attention and sparked the interest of law enforcement and regulators.” and “The recent

announcements of investigations by the Department of Justice, the SEC and the Massachusetts

Secretary of State may mark the beginning of a long series of inquiries into one of the largest

and most complex financial markets.”

In fact, the following extract from an article in the Guardian website highlights the need for

government interference in corporate governance matters, proving that this is an institutional

issue which, according to Van Tulder (2007, p.157), means that there is “considerable room for

interpretation due to a relatively poorly developed framework.”

“The aim must be to rebalance the relationship between the City and society, not out of

revenge or a disavowal of all markets, but to protect people, which is surely the basic duty of

the state. There is a near unity of opinion that rules must be changed; that regulation has been

weak; that the supposed masters of the universe in New York and London have been exposed

as enfeebled spins. The price of trusting too much in financial markets has been an intolerable

volatility. Reform must aim to put in its place greater security. The knocking down of old

barriers - on credit, on speculation, on what City firms are allowed to do - produced an artificial

enrichment. Not all the consequences were bad. But finance has been indulged as other

sectors of the normal economy have not been. It should not exist as a world in itself.” (The

Guardian, After the firestorm, 2008-09-19)

Actually, the US central bank has just released a Policy Statement on equity investments in

banks and bank holding companies that directly affects corporate governance guidelines.

According to this statement, regulation tying control and responsibility together “ensures that

companies have positive incentives to run a successful banking organization but also bear the

costs of their significant involvement in the banking organization’s decision making process,

thus protecting taxpayers from imprudent risk-taking by companies that control banking

organizations.” (Board of Governors of the Federal Reserve System, 2008-09-22)

The statement makes explicit the possibility of board representation of minority shareholders.

“The Board has reexamined its precedent in this area and, based on its experience with

minority investors and director representation, believes that a minority investor generally

should be able to have a single representative on the board of directors of a banking

organization without acquiring a controlling influence over the management or policies of the

banking organization.” (Board of Governors of the Federal Reserve System, 2008-09-22)

Additionally, the US central bank raised the stake minority shareholders could take in a bank

holding company from 25% to 33%.

In Europe, corporate governance models adopted by companies are evolving. The following

diagram illustrates the main adjustments to corporate governance practices.

17

Previous “Models”

- Exclusively oriented for shareholders

- Bundle of the executive and supervisory

functions, usually at the same person: “CEO +

Chairman”

- Model of “unitary” power (all centered in a single

body – the Board of Directors)

- Lower transparency, “non independency” of the

elements with supervisory functions and poor

protection of smaller shareholders and remaining

stakeholders

- Takeover defense mechanisms

New “Models”

- Oriented for all stakeholders

- Clear separation of the executive and supervisory

functions (CEO and Chairman)

- Higher transparency and participation of

independents in the supervisory function

- Increasing focus in the implementation of

corporate governance and management models

that takes in consideration the demands of the

“Sustainable Growth” (Sustainability)

- Abolishment of anti-takeover devices

- Growing pressure of institutional investors on

corporate boards to perform and on governments

to install good corporate governance legislation

- Cross-holdings of shares in other sectors (very

common in Spain and Italy)

We conclude that this issue is still being strongly discussed. Moreover, there has been a

tightening of accountability and surveillance by the shareholders and media and civil society,

respectively.

3.5. The stakeholders

GOVERNMENT

MARKET CIVIL SOCIETY

Figure 7 – Corporate Governance Models

Figure 8 - Stakeholders Diagram

18

The above diagram separates the stakeholders involved within the Corporate Governance

realm into three spheres, these being the government, the market and the civil society.

Government

• Legislators – Ministry of Finance/Economy;

• Financial Services Authority – UK; Security Exchange Commission – USA.

Civil Society

• European Corporate Governance Institute

• International Corporate Governance Network

• Shareholders

• Consumers

• Society as Whole

Market

• Employees

• Managers

• Suppliers

• Creditors

4. Consequences

The business paradigm that companies should focus in profit-maximization is shifting. Given

different accounting standards, financial reports manipulation, different profits definitions and

focus on short-term profits in detriment of long-term sustainable ones, the profit-

maximization paradigm has become outdated. Today, following an ethical conduct has become

the new business paradigm. Through benchmarking against top performers, corporate

governance issues have become part of companies’ daily agenda.

Good corporate governance practices improve perceptions and transparency regarding what a

company says it is and what it really is. This increases society’s confidence in financial markets

which leads to economic prosperity.

19

4.1. Existing Scenarios

Figure 9 - Corporate Governance ratings in Europe

Source: Heidrick & Struggles International, Inc., 2007. (Maximum rating of 16)

It is fairly easy to see a substantial improvement in countries corporate governance ratings.

The United Kingdom is on the forefront of good corporate governance practices, followed by

the Netherlands, Switzerland and France.

20

Figure 10 - Average Governance rating for all countries 1 (Maximum rating:10)

Source: Governance Metrics International, September 2007

Figure 11 - Average Governance rating for all countries 2 (Maximum rating:10)

Source: Governance Metrics International, September 2007

21

Australia, the UK, Ireland, Canada and the US are the countries with the highest corporate

governance ratings, meaning that their companies apply the best practices regarding board

structure and board committees (nomination, auditing and remuneration), board’s

independence, transparency and executive compensation.

Asian and South American countries have the worst corporate governance ratings. Their

corporate governance systems are still underdeveloped but reforms are being implemented.

(Green, 2005)

It is possible to see the divergent views on good corporate governance practices by these two

institutions, presenting different rankings to European countries.

Country Legal Framework

Market for

Corporate

Control

Executive

Compensation

Ownership

Structure

Board of

Directors

USA Sarbanes-Oxley,

NYSE

Powerful

disciplinary

mechanism –

market sanction

Overpayment to CEO

Dispersed

ownership

structure

Dominated by

managers - All-

powerful

Chairman/CEO

UK Combined Code

(Comply or Explain)

Powerful

disciplinary

mechanism

Compensation

Committee composed

by non-executives

Dispersed

ownership

structure

Strong role of

the Board

Importance of

Board’s

independence

Continental

Europe Comply or Explain

Family-Owned

Companies limit

legislative

capacity – golden-

shares

Governance and

management are the

same which means

that “managers define

their own salaries”

Semi-concentrated

Ownership

Structure

“Active

ownership"

leaving little

space for Board

intervention

There has been an increased convergence of corporate governance regimes between 1999 and

2003, namely regarding a greater degree of transparency (Van Tulder, 2007).

However, corporate reforms in North America companies such as the separation of the roles of

CEO and Chairman and the re-structure of executive compensation have been difficult to

implement mainly due to CEO resistance to share power. (Felton, 2004)

Executive compensation in the US is still despicable, showing substantial increases from 2004

onwards.

22

Figure 12 - Executive Compensation in the US - CEO

4.2. Issue ownership

It is extremely difficult to identify a single entity concerned with the corporate governance

structure of companies. However, it is possible to name the ones most engaged in this topic.

After the 2001 scandals of Enron and Worldcom, it became obvious the active role of the

media concerning good corporate governance practices, namely regarding the financial reports

integrity. The BBC News and The Economist are good examples of media vigilance over

organisations’ malpractices. Articles such as “The banks that robbed the world” (BBC News,

2004-06-9), are crucial in shaping public opinion concerning the issue.

Academics are not only an important source of information about this topic, but also the most

reliable. However, their impact is limited since most people do not have either knowledge or

interest to thoroughly investigate this issue. Moreover, the existing academic papers are

usually extensive and conflicting, making it hard for common people to understand them.

Nevertheless, the ever-growing interest of academics in this subject will eventually lead to an

increased understanding of the subject. Academics such as Marco Becht (ECARES, Université

Libre de Bruxelles and ECGI), Patrick Bolton (Professor of Business and Professor of Economics

at Columbia University, NBER, CEPR and ECGI), Ailsa Roell (Professor of Finance and Economics

at the School of International and Public Affairs at Columbia University, CEPR and ECGI), Viral

Acharya (London Business School and CEPR) and Paolo Volpin (London Business School, CEPR

and ECGI), have written several papers on this topic. In fact, we have read some for this issue

analysis, namely “Corporate Governance and Control” (Becht, Bolton & Roell, 2005),

“Corporate Governance Externalities” (Acharya & Volpin, 2007) and “International Corporate

Governance” (Denis & McConnell, 2003).

Other important sources of information about corporate governance are the NGOs, namely

the ECGI (European Corporate Governance Institute), the CCGI (Canadian Corporate

Governance Institute), the Global Corporate Governance Forum, the Millstein Center for

23

Corporate Governance and Performance at the Yale School of Management and theArthur and

Toni Rembe Rock Center for Corporate Governance at Stanford University. It is important to

mention that most of these non-profit institutions work closely with academic organizations,

further spreading their knowledge.

According to Jones and Chase (1979), “an issue is an unregulated question or matter that is

about to be straightened out”. Van Tulder, extends this definition by saying that “such matters

are yet to be institutionalized, regulated or settled.” Therefore, as previously mentioned,

despite its late intervention, governments play an indispensable role on the issue

settlement/closure. A known example of this is the Sarbanes-Oxley Act in 2002 after the

outrageous corporate and accounting scandals affecting Enron and WorldCom.

Investors are one of the most notorious owners of the corporate governance issue. Through

shareholder activism, they are able to force companies to implement good governance

practices that emphasize the monitoring of managers. Below, we list some of the most

renowned activists regarding this matter.

CARL ICAHN

Arguably the most famous (and one of the most successful) raider in the world, this American

investor has, since 1978, taken considerable or even controlling stakes in an impressive 36

companies, including TWA, Texaco, Marvel Comics, Revlon, RJ Nabisco, Time Warner,

Motorola or, most recently, Yahoo. He built his reputation for fiercely tackling

underperforming companies after his hostile buy-out of TWA in 1985, after which he stripped

the company’s assets and sold them separately. This and other transactions were substantially

financed by junk bonds before this market collapsed. Other remarkable actions have been the

2004’s successful proxy fight against Mylan Laboratories’ take-over bid for King

Pharmaceuticals and Mylan’s board over-compensation, or the use of a 3.3% stake at Time

Warner to press for a number of value-enhancing measures. These included a $20 billion share

repurchase, sizeable operating cost-cutting, the nomination of more independent non-

executive board members and, most strikingly, the spin-off of Time Warner Cable which is to

be completed later this year. During the process there has been some level of cooperation

with the management, with Icahn eventually supporting the re-election of the firm’s board

members in exchange for those measures being taken.

There is a recurrent playbook in Icahn’s approach to the companies he targets: he starts by

threatening the management and initiating a proxy contest, then tries to lead the target to

pour out significant cash, and finally he quickly sells, benefiting from the fact that the target’s

share price normally appreciates with the news of him holding a stake. Unlike other raiders,

there are usually no accusations of misconduct in the process. He is not a greenmailer: the

payouts are shared pro rata with the other shareholders. His motivations and battle ground

have changed greatly over the years, but mergers and acquisitions have consistently

represented the most prominent occasions for his activist-like intervention. He may oppose a

firm in the process of acquiring another firm, with the objective of preventing the transaction

from happening, just as he can tackle a firm being acquired, with the objective of securing a

higher price. Often, a deal is not reached and so intervention often will come with the

objective of forcing the target to put itself up for sale. Finally, sometimes Icahn decides to

make himself an offer to buy the target. Icahn denies that his intentions are to rip companies

apart for short-term gain, but instead, is eager to rid poorly performing companies of

ineffective managers (enjoying excessive perks) in order to make the assets more productive.

He deeply dislikes conglomerates, whose concept, in his view, has never promoted efficiency

and considers that poison pills would make “Machiavelli blush”. He buys companies at a low

price and analyses both the firm's structure and operations to find the reasons for any

disconnect between the company's stock price and the true value of its assets, like

24

management missteps or excess costs. In a country where there is a long-standing tradition of

an almighty, unaccountable management, Icahn has always been a fierce critic of the way U.S.

companies are run, trying to force management to take responsibility and be efficient for the

welfare of the company and of its owners. We believe it is worth reading, in his own words, his

very peculiar view on the issue: “It's kind of a reverse Darwin's Theory. The survival of the

dumbest, if you will. And the famous investor has this theory to thank for his multi-billion

dollar net worth. The theory goes like this: Many college kids seek refuge in their fraternities or

clubs (when Icahn tells it, "sorority" is conspicuously omitted) for a friendly face. Without fail,

the president of the club, who never seems to open a book, is there to cheer them up. He's a

nice and friendly guy, the kind of guy you want around to make you feel better with a beer or a

game of pool. Not surprisingly, that guy goes into business. He's never the smartest guy in the

room, but he's likable and he's a survivor. He moves up the corporate ladder, without a single

original idea that might make his boss feel threatened by his potential. Eventually, he gets to

be the #2 guy at the company. He's a little dumber than the CEO, but the board likes him, so he

eventually gets to be CEO. Of course, he assigns a #2 who is a little dumber than he is. And

eventually, we're going to have all morons running our companies. We might not be that far

off from that right now. And that is how your incompetent boss got the corner office.”

To those who criticize activists’ long-term harm to economic growth, he replies by claiming

that the market will never penalize a good manager for investing in capital equipment because

if it is the right choice there will eventually be little impact on earnings after depreciation has

been accounted for. Research expenditures are also valued in the share price. Overall, Icahn

strongly believes that increased monitoring and performance will benefit the economy as a

whole. If there is a change in accountability, assets will perform better, ensuring business

sustainability in the long run.

CalPERS

The California Public Employees’ Retirement System (CalPERS) was the pioneer of institutional

activism and has remained ever since a leading activist in corporate governance issues. It is

currently the public pension fund with most assets under management and reported a total of

$232 billion in assets as of January 31, 2007 (Choi and Fisch (2007)). Over time, CalPERS

gradually shifted its focus from more technical issues related to corporate control to

fundamental issues of long-term corporate performance. The overall objective of CalPERS’

investment program is to provide beneficiaries with benefits as required by law. It executes a

long-term investment program that allocates and manages the assets of CalPERS.

Consequently, CalPERS investments will be broadly diversified to minimize the effect of short-

term losses. CalPERS current strategy encompasses identifying underperforming companies

with poor governance practices and working to change those governance practices and

improve performance, in order to increase the firm’s long-term market value and profit from

this increase. The fund chooses its target companies and publicly releases them in its Focus

List. Besides making a constant effort to meet with the management and directors to discuss

performance and governance issues, it focuses on reforming the company's governance

practices, mainly on accountability, transparency, independence, and discipline. CalPERS

generally files shareholder proposals to seek changes in the company's bylaws in order to

improve not only the governance structure of the company, but also its performance. In order

to evaluate the success of CalPERS activism, one must compare ex-ante and ex-post stock

returns on the announcement of the Focus List. Actually, one of the criteria to be selected as a

target is poor stock performance. Therefore one would expect negative returns prior to the

announcement.

The Wilshire study considered the 128 companies listed on CalPERS’ Focus List from the

beginning of 1987 through mid-2005. It shows that CalPERS’ good governance campaign has

25

added value to the share prices of targeted companies. For the five years prior to the initiative

date, the Focus List companies had produced an annualized excess return of –13.3% per year,

whereas, for the first five years after the initiative date, they produced an excess return of

2.3% per year. However, according to recent studies, one should notice that the post-initiative

date five-year cumulative excess return for the targeted firms has steadily decreased overtime

(54% in 1995 vs. 8.1% in 2004).

More recently, Barber (2006) found that, in the short-term, CalPERS shareholder activism, on

average, improves shareholder value by 35 basis points (value-weighted), in a typical year.

Over the last fourteen years, the improvement in shareholder wealth was nearly $3.1B, which

translates in an annual wealth creation of $224M. The conclusion is that, overall, the benefits

outweighed the costs of CalPERS activism. However, in the long-run, Barber (2006) did not find

statistical significant positive results and so he could not conclude that they were unusual.

Concerning changes in governance structure, Smith (1996) found that 72 percent of firms

targeted by CalPERS between 1988 and 1993 either adopted CalPERS’ proposed changes or

made changes resulting in a settlement with the fund. Actually, Huson (1997) found that after

being targeted by CalPERS firms engage in more divestitures, fewer acquisitions, and more

joint ventures. Furthermore, he found that upon the announcements of these changes, the

market response was, on average, greater than before the targeting, revealing a positive

wealth effect of the applied changes. Regarding social activism, Barber (2006) argues empirical

evidence only supports governance-based activism.

The Children’s Investment Fund

TCI is a London-based hedge fund founded in 2003, regulated by the Financial Services

Authority (UK). TCI theoretically makes global long-term investments in companies. A portion

of TCI’s profits goes to The Children’s Investment Fund Foundation. Like most hedge funds, TCI

requires investors to commit their capital for multi-year periods. This supposedly long-term

horizon allows the fund greater flexibility when trading and investing capital independent of

any potential unplanned time constraints. Ironically, TCI has a reputation for aggressive

shareholder activism, since it has taken an active role in most situations to promote its own

agenda under the appearance of sound corporate governance and increase shareholder value.

A well-known case of TCI’s activism was the ouster Deutsche Börse CEO after he had refused to

abandon his plan to take over the London Stock Exchange. Recently, in 2007, after acquiring

just 1 percent of the shares of ABN AMRO, TCI forced the bank to split up or sell to the highest

bidder, in order to increase shareholder value. However, in June 2007, after acquiring a 10

percent stake, TCI failed to get the Japanese utility J-Power to boost its dividend. The general

meeting of shareholders rejected the proposal, prompting a severe selloff in the stock. In many

places, like in Japan, funds like TCI remain unwelcome and unsuccessful in unlocking value,

since they are seen as trying to make a "quick" buck in a society that highly values long-term

investments. TCI is also one of the most feared funds in boardrooms, particularly in Europe,

but it is also very respected and regarded as a role model by other investors, which often

imitate the fund’s investment strategies.

4.3. Expectational gaps

According to Van Tulder (2007, p.158), “issues exist particularly as a result of expectational

gaps.” He believes that expectational gaps arise when people have different perceptions about

acceptable corporate behaviour regarding societal issues.

26

Since most corporate governance practices are not mandatory generally problems surface

because there is a conformance gap. That is, companies may have a corporate governance

model but choose not to follow it.

A well-known example of a large conformance gap is Enron. Enron’s corporate malfeasance

and fraudulent behaviour led to its bankruptcy in 2001. The lack of transparency of accounting

reports along with inaccurate and weak auditing allowed a severe market misguidance

concerning the company’s performance (Solomon, 2007, p.36).

Essentially, transparency is a key ingredient for a robust system of corporate governance.

4.4. Regulation possibilities and impact on stakeholders

Congress responded to the financial reporting fraud crisis by passing the Sarbanes-Oxley Act of

2002. The Act requires listed companies to adopt and disclose a code of ethics for key

executives or explain why they have not done so. It encompasses board’s structure (including

auditing, nomination and compensation committees) and composition, corporate governance

disclosure, code of ethics and CEO accountability and certification.

The main disadvantage of this regulation is the cost of compliance which sometimes

discourages companies from public sale. Moreover, the high demand for compliance shifts the

board’s focus from the company’s development. In addition, its requirement for clear

separation between the consulting and auditing businesses severely affected auditing

companies which obtained most of their profits from the consulting business.

Despite the disadvantages, the Sarbanes-Oxley Act has increased the transparency in

accounting and financial reports.

Main North American enforcement institutions are the securities plaintiff bar (responsible for

class action suits), the Securities and Exchange Commission (SEC), and the U.S. Department of

Justice (Enriques and Volpin, 2007).

The UK has the most comprehensible corporate governance system. In fact, the Cadbury

report was the foundation of the following reports on corporate governance. The Combined

Code, currently effective in the UK, works on a voluntary “comply or explain” basis which

means that a company has the freedom to comply but it has to explain if it chooses not to.

Actually, the countries’ corporate governance rating presented above shows the effectiveness

of the UK’s model. Companies’ incentives to comply rely on reputation. Investors will be favour

companies with the best corporate governance structures.

The European Union has also made some reforms in order to enhance corporate governance

at companies:

“The main objectives pursued by the Commissions' Action Plan are:

1. to strengthen shareholder rights and third party protection, with a proper distinction

between categories of companies, and

2. to foster efficiency and competitiveness of business, with special attention to some

specific cross-border issues.” (European Commission website, 2008)

However, as it was previously mentioned, the current financial crisis emphasizes society’s

demands for further regulation regarding corporate conduct and transparency in order to

avoid further market abuses. The extension of government regulation will improve society’s

confidence in financial markets and therefore in companies.

It is fair to say that there is still lack of transparency in financial markets. “As recently as June

2008, Richard S. Fuld Jr., the chairman and chief executive of Lehman Brothers, said he was

confident that Lehman was sound even as the bank posted a second-quarter loss of $2.8

27

billion, caused by bad mortgage investments. But on Sept. 16, Lehman filed for bankruptcy and

began sliding toward an eventual liquidation.” (New York Times website, 2008)

Consequently, during the past few months we have witnessed the build up of class action suits

against major Wall-Street listed companies such as Wachovia, Lehman Brothers and Schwab,

demonstrating a higher pressure for ethical compliance from stakeholders.

Recently, there has been a huge pressure for law enforcement concerning corporate fraud.

The F.B.I. and the Justice Department in the U.S. have started to investigate white-collar

crimes likely committed by important financial institutions.

“The F.B.I has now opened preliminary investigations into possible fraud involving the four

giant corporations at the center of the recent turmoil – Fannie Mae and Freddie Mac, Lehman

Brothers and the American International Group, The Associated Press reported.” (New York

Times, 23-09-2008)

Senator Patrick J.Leahy, the Vermont Democrat who leads the Judiciary committee

commented “And if people were cooking the books, manipulating, doing things they were not

supposed to do, then I want people held responsible. And I suspect every American taxpayer –

I don’t care what their political background is – would like them held responsible.” (New York

Times, 23-09-2008)

To sum up, as we previously mentioned, regulation and strong law enforcement are crucial to

improve stakeholders’ confidence in companies which supports economic prosperity.

Stakeholders will feel protected. As a result, creditors will lend money more easily, investors

will invest more money, consumers will be keen to buy products, employees will feel

motivated to work and society as a whole will prosper.

4.5. Link with other issues

It is quite straightforward to link corporate governance with issues such as rogue trading,

executive pay, insider trading, fraud, money Laundering, bribery and tax evasion since they are

all connected to business ethics which is the foundation of a corporate governance system.

However, if we take into account the stakeholder’s theory, it is also possible to link corporate

governance to societal issues such as hunger, poverty, environmental protection, gender

equality and human rights.

5. Analysis of phase in the issue life cycle

According to Van Tulder (2007) issues have cycles of rise and decline, known as the “issue life

cycle”, and this cycle can be primarily divided in four main phases. These phases are the birth,

growth, development and maturity of the issue. Some also consider the post-maturity phase,

where the issue may come back to the discussions table.

The Corporate Governance issue follows the rule. We can clearly identify these four stages of

development, and will describe generically each one, with links to our specific issue.

Birth phase

The birth phase is characterized by the beginning of concern about the issue itself. Society

starts to recognize that there is a gap in regulation and starts to create awareness about it. We

can link this to the 80’s and beginning of the 90’s, when the first huge takeovers and mergers

began, as well as the privatization wave. Some visionaries, such as Sir Adrian Cadbury in 1992,

start acting about the issue. Most companies are still inactive towards the issue.

28

Growth phase

Van Tulder (2007) describes the Growth phase as one of growing discontent, especially

because the entities in command have failed to correctly address the issue on the birth phase.

He also identifies as characteristics of the growth phase the presence of triggering events and

the attention of the media. These characteristics can be clearly perceived in the end of the 90’s

and beginning of the current decade, with the corporate scandals involving Enron, WorldCom,

Parmalat and others. These scandals were the triggering events for a deeper discussion,

receiving media’s full attention. The public became highly aware of the issue and started to

demand better governance practices. NGO’s such as the European Corporate Governance

Institute, the International Corporate Governance Network, the National Association of

corporate Directors and the OECD were created or started activities regarding corporate

governance. Several governments, mainly US and UK governments, started to take a better

look at what was happening, in a certain reactive attitude. Companies started to realize that

they needed to do something about the problem.

Development phase

The development phase starts when stakeholders begin to more aggressively demand

changes. Campaigns can begin, and governments will probably attempt to take action. This is

the phase in which we believe our issue is today. It started in the beginning of the decade,

clearly characterized by the Sarbanes-Oxley act of 2002, and is still happening today.

Governments world-wide have realized that a better legal enforcement was needed, and have

started taking action. Society has pressured both government and businesses to adopt better

practices and legal protection. Companies have changed their structures and processes in

order to attend societies and legal demands. All these changes are still very recent though, so

the effects are yet to be clearly felt.

Maturity phase

The maturity phase normally involves the settlement of the issue. Solutions are provided and

accepted by governments, civil societies and businesses. This phase is yet to be reached

concerning the corporate governance issue, since there is not yet a clear settlement by the

parts involved.

Issue Life Cicle

Birth MaturityDevelopmentGrowth

Takeoverwave(80’s and 90’s)

PrivatizationWave(90’s)

IncreasingGlobalization

and Financial

MarketsIntegration

Financial Crisis(end of 90’s)

CorporateScandals

worldCom, Enron,

Parmalat...

Sarbanes Oxley

Review of Regulation

Companies creating

Corporate GovernanceCodes and Practices

?

29

6. Firms part of the problem

6.1. Primary Responsibilities and Interfaces

According to the classification present in Van Tulder (2007, pg 173), the corporate governance

issue has managers and firms as source of the problem. Even though civil society and

governments play a major role, the firms are the ones who can actually take action. The

primary responsibilities are certainly in the hands of managers.

Still analyzing Van Tulder’s classification, we can further classify the Corporate Governance

topic as a “personal and company internal: involving abuse of fiduciary powers”.

The problem has fiduciary duty written all over it. Since Smith’s declaration in 17761, as we

have previously quoted , one of the main interests of investors is knowing if managers are

acting in the best interests of stakeholders.

Regulation can go only so far, and as we have also stated before, a very strict regulation can

also bring problems . Civil society can also play a limited role on investigating firms actions if

public information is not available.

Van Tulder (2007) recognizes this “The discussion focuses on the separation of ownership and

control, and in increase in transparency, control and accountability”.

The figure below explains some of the interface situations that can be observed regarding the

subject.

Corporate

Governance

Issue

Government

Business Civil Society

Pressure for betterpractices – Activism

New practices –Creation of corporate

governance divisions

Although we have identified managers as primary responsible, the issue lays in the interface of

businesses with governments and society, equally weighted.

The interface with governments is done mainly through regulation. Governments legislate and

firms comply, or not. The problem here is not mainly about compliance, since most firms do

comply. The problem is of how far should regulation go, since a strict regulation becomes too

1 “The directors of companies being managers of other’s peoples 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.” (Smith, 1776)

30

expensive to comply, bringing inefficiency. And if regulation is not strict enough, managers can

“explore the boundaries of their fiduciary duties” (Van Tulder, 2007), and yet not be

accountable, since they are not actually breaking the rules.

The interface with civil society goes back to the concept of activism. Society is actually

demanding better business practices, regarding themes such as accountability, transparency,

and information publication. Businesses have reacted, although quite reactively, by creating

Corporate Governance structures in their divisions. Most public companies throughout the

world are now concerned, and publish their financial information as much as possible. Some

firms publish more than what law requires from them. Some of these companies have been

more proactive than others, and publish annual reports with extensive information regarding

company activities.

6.2. Dominant Sector Effect

As we have stated before, the main responsibilities rely on the business sector of the pyramid.

The other sectors participate in the issue by applying pressure on the business sector. So it is

natural that businesses assume a certain dominance regarding the issue.

So, even though society claims for changes, these will only really happen when managers

assume their roles.

This has been a problem until now, since without the triggering events that culminated in the

massive media around the issue, the common people would not get involved. So without the

participation of society, managers had a high level of freedom, and the corporate scandals

have shown that they had more power than they should.

6.3. Dominant Business Model

The main problem with the business model is actually a matter of wrong incentives. This is

better explained in the diagram below.

Profits

Good performanceClear

communication ofgood performance

High Rewards

Bad Performance

MisleadingFinancial Reports

High Rewards

Clearlycommunicating

bad performanceLow Rewards

Managers actions and performance Managers Rewards

As we can see, there is a clear incentive to act in a way to mislead shareholders about the real

situation of the company. This normally happens through accounting irregularities, misleading

31

financial reports, concealing of huge amounts of debts, or whatever means that directors find

to show results better than they really are.

These incentives have been responsible for most of manager’s misconducts, and they still have

not been corrected by legislation. Being the root of the problem, we believe that stronger

attention must be paid to this kind of adverse selection of behaviour. Regulation must

intervene to create negative incentives in acting in such a way.

7. Firms part of the solution

7.1. Responsibilities

Even though we have identified firms as source of the problem, there is also the possibility that

they can be part of the solution, or at least some firms can be part of the solution.

According to Van Tulder (2007) we can classify companies in four groups, Inactive, Reactive,

Active and Pro-active. Some of the characteristics of firms presented as being source of the

problem in section 5.a clearly define these companies as reactive, or sometimes even inactive.

But we can also find companies that have a pro-active attitude, and can be considered part of

the solution. These companies have been incorporating corporate governance issues in their

daily agendas even though these issues may be not in the specific interest of the firm’s profits.

Companies from completely different industries such as Cadbury, Shell, BP, Unilever,

Mckinsey, Starbucks and Inditex are have a Corporate Governance section in their websidtes,

including a company code of conduct.

Take the example of Cadbury, which we have largely quoted and will better explain in the

Leadership section. On 1992, Sir Adrian had been Chairman of the Cadbury group, and was a

director for the Bank of England and also a director of the IBM Corporation. This however, did

not stop him from taking the lead in proposing discussions and raising awareness about the

Corporate Governance issue, and finally chairing the Committee that resulted in the Cadbury

code.

So it is indeed possible that members of the business world, and the firms they represent, can

be part of the solution.

7.2. Sector effect

As we have stated before, the sector effect can be a problem if firms fail to fulfill their primary

responsibilities. But if these firms and managers correctly fulfill their duties and play an active

role, they can generate a positive reinforcement cycle by acting as role models.

32

Firms set the agenda Introducing new practices,

raising discussions

Society Awareness

Society becomes aware ofthe issue – Demands for

regulation and betterpractices

GovernmentAwareness

Governmentsacknowledges the

demands for regulation

and introduces newlegislation

Image improvement

Pressure from both societyand governments lead to

better image of companieswho are setting up the

agenda

Keep up the pace

Companies who initiallywere not “proactive” try to

keep up the pace. Theyacknowledge the benefits ofbeeing the “agenda setter” and start ther own actions

The diagram above shows this positive reinforcement cycle. Some visionary leaders may have

a proactive attitude towards the issue, and set the agenda. In the specific issue of corporate

governance, some firms have taken the lead and stated their position before regulation was

passed on. Society acknowledges this, “rewards” these companies and starts demanding that

other companies adopt the same practices. In some cases, society will also plea for regulation.

The government, in the appropriate time, will also recognize these new demands and will ask

the question: “if some companies, are doing it, is it possible that others should also do it?

Should they be obliged to?” New regulations may be passed on. Society and governments may

then look at firms with a more critical view. The “agenda setters” may have an “image

improvement”, and this better image can bring advantages. As we have stated before, in the

corporate governance case these advantages may be such as lower debt payments, easier

access to investors money, or even more sales of their products, since the company gains in

“spontaneous marketing”. Other companies acknowledge these advantages – and start

thinking about how they can keep up. They will usually try to imitate what the agenda setters

are doing. But sometimes they will go even further, and also seek the benefits of being an

“agenda setter”. This seek will probably go back to the beginning of the cycle, leading to a

virtuous circle.

7.3. Plea for regulation?

There is also another way in which firms can be part of the solution. They can act directly with

governments demanding new regulation. Van Tulder (2007, pg 195) acknowledges this kind of

proactive corporate citizenship in the ERT case: “The ERT has actively lobbied the EU on

general interest issues that determine the environment in which they operate. ... European

33

industrialists have taken it upon themselves to define what they consider to be a public setting

in which they do business.”

Firms complying with strict standards involving governance will also have heavy costs

associated with this compliance. So it is just natural that they also want other companies to

incur in these costs, and lobby governments to regulate their demands.

8. Leadership issue

Sir Adrian Cadbury is a world leader and pioneer in Business

Ethics and Corporate Governance matters, being one of the

most esteemed businessmen in UK.

Cadbury graduated in economics at Cambridge University in

1952. He joined the Cadbury business in 1952 and became

Chairman and Managing Director of Cadbury Ltd from 1965

until 1989. During this time, he also served as Director of

the Bank of England (1970-1994) and IBM UK (1975-1994).

Upon retirement Sir Adrian Cadbury’s was appointed Chair

of the UK Corporate Governance Committee which aimed to

make recommendations to managers regarding good

corporate governance practices.

“Sir Adrian Cadbury was a visionary chair who energetically

promoted the committee’s recommendations.” (Solomon, 2007, p. 51)

The Cadbury Report developed under his chairmanship in 1992 constitutes the foundation of

the UK’S Combined Code, which was previously mentioned.

Cadbury was also an academic serving as Chancellor of Aston University between 1979 and

2004. In addition, he still makes speeches at the University in topics such as governance,

business ethics and corporate social responsibility. His academic paper Ethical Managers make

their own rules published in 1986 in Harvard Business Review won the HBR’s 1986 Ethics in

Business Prize. Furthermore, he has also written several academic books on the subject such as

The Company Chairman (1995), Family Firms and their Governance: Creating Tomorrow’s

Company from Today’s (2000), Corporate Governance and Chairmanship (2002) and Corporate

Social Responsibility (2006).

As a result of his dedication to these topics, Cadbury received several awards, namely

honorary degrees from several universities, an Albert Medal from the Royal Society of Arts, an

International Corporate Governance Award from the International Corporate Governance

Network and a Beta Gamma Sigma Business Achievement Award from the Aston Business

School.

Leadership Style

“The Quaker principles of respect for the individual and the importance of arriving at decisions

through reaching a ‘sense of the meeting’ have been very important to me. I have always

believed that everyone in the business has a useful contribution to make and that one should

look for each person’s strengths and attempt to build on them. Equally, we took participation

seriously and aimed to involve people at the point at which decisions affecting them were

taken.” (Adrian Cadbury)

Sir Cadbury statement shows clear evidences of a transformational leadership style. He

motivates and inspires people by focusing on individual strengths as well as integrating them

34

on the decision making process. Moreover, his devotion to high ethical and moral standards

also corroborates this conclusion.

In his quest for ethical conduct and good corporate governance practices diffusion, he took

advantage of his reputation as a business leader and led people to believe that “Values are

important because they play an essential part in attracting people to a company and in

retaining them … Tomorrow’s company has to be seen as a goal worth working for.” (Adrian

Cadbury). Moreover, commenting on the positive correlation between effective codes of

ethics and profits found by the Institute of Business Ethics, Cadbury emphasized that “There is

therefore no necessary contradiction between profits and principles.” (Adrian Cadbury).

Moreover, he believes that an effective leader should support the development his/her

employees in detriment of a coercive leadership style “Good leaders grow people, bad leaders

stunt them. Good leaders serve their followers, bad leaders enslave them.” In fact, his

statement “We escape from coercive leadership as soon as we may. We remain voluntarily

under leaders with whose values we identify.” confirms his skepticism about the success of

coercive leadership.

“Many who have met Sir Adrian will attest to his openness and warmth, and an interest in

people that is apparent despite a very busy lifestyle.” (Trusted Leadership website, 2008)

9. Sustainable corporate story

The sustainable corporate story, as defined by Schultz (2000) should present at least four basic

criteria: be realistic, relevant, responsive and sustainable.

Although these seem like simple criteria, meeting them all at the same time is not an easy task.

Being sustainable and realistic regarding corporate governance, for instance could mean that

you have to present complete and relevant financial information without letting the

competition know too much about your financial situation.

So to come up with a truly sustainable corporate story, we will analyze four different

dimensions, presented in the following items.

9.1. Interface challenges

As we have concluded before, the corporate governance issue lays on the interface between

Business, Governments and civil society. The main responsibilities are on managers hands, but

governments and society also play a major role. So what a sustainable corporate story needs

from this interface is that every part assumes it’s role. Society must continue to pressure

businesses for better practices, and government for better regulation. Activist stakeholders are

crucial in this role.

Government’s must continuously pursue better regulation (not stricter – better). The

Sarbanes-Oxley act was a major and radical change, but it is not yet the end of the way.

Continuous improvement must always be pursued.

Businesses must respond adequately to these demands – and come up with new and better

standards, with their own agenda-setting.

9.2. Strategic/operational choices

Firms will also be challenged with strategic and operational issues. A good example is the

Cadbury PLC adoption of the NYSE regulation, even though not being obliged to it (the rules

only apply to American companies). Cadbury’s Board has decided to do so as “Cadbury is

35

committed to maintaining good standards of corporate governance and ethical behaviour.”

(Cadbury.com).

Matters such as these will become increasingly common, and firms choices regarding

corporate governance practices will be determinant to how this story develops.

9.3. Tools: codes, reporting, labels, chain strategies, issue

advertisement

Some tools have already been developed, others are still being created. One good example is

an index created by Brazilian researchers Ricardo Leal and Andre Carvalhal (Carvalhal-da-Silva

& Leal, 2005) which ranks Brazilian firms according to their corporate governance practices.

Other indexes such as these are also used in other countries, and they create awareness and

advertisement for the issue.

Companies’ codes and reports also have their importance, especially in setting benchmarks for

other companies to also create their codes and even improve them.

9.4. Processes

All this can only be done by dialogue. NGO’s have an important role in this. Organizations such

as the ECGI (European Corporate Governance Institute) and the Global Corporate Governance

Forum should continue to stimulate debates in order to promote the convergence of

corporate governance thoughts. Businesses, governments and civil society must work

together.

To achieve a true sustainable corporate story, all these dimensions need to be correctly

addressed.

10. Conclusion

10.1. Further Research & Research Limitations

Due to the extension, complexity and controversy of academic studies concerning the

effectiveness of good corporate governance mechanisms it was difficult to reach a specific

conclusion. Specifically, further research could be conducted regarding the effectiveness of

different corporate mechanisms such as board structures, takeover threats, protection of

minority shareholders, CEO compensation, the role of institution investors, etc.

In addition, one could also exploit the cause-effect relationships between bad governance

systems and financial crises, especially in a time like this.

Additional research could be made regarding polemic elements of some corporate governance

models such as the control premia (premium paid for additional control), the overweight of

blockholders and related party transactions.

Under the executive compensation discussion, further research about self-dealing, results

manipulation, options backdating and golden parachutes could be conducted.

Another necessary discussion is regarding the board of directors compensations and

incentives. Further research is necessary about how incentives work for board members.

Finally, academic papers have also discussed the controversial topic of control enhancing

mechanisms such as golden shares and government veto rights, shares with different voting

rights, voting limits, holdings and sub-holdings (pyramids), and the case of one share, one vote.

36

10.2. Evaluation of Group/Individual Development

We believe that the time constraint improved our productivity. We learned how to focus on an

important subject while still addressing its main causes and implications.

Additionally, our research skills improved enormously including the referencing.

We also believe that this project aimed at improving our structuring capabilities, mainly the

research framework defined in Van Tulder’s Skill Sheets.

The most difficult part in this project was building the arguments from a large amount of

information. However, we strongly believe that given the limited time available main ideas

were presented and discussed.

As a group, we managed to follow the group contract and the previously agreed deadlines.

Furthermore, we overcome some of our individual weaknesses, namely time management,

building arguments and using research of others.

Finally, it is refreshing to see that even a short-length project can promote a “learning from

each other” environment.

37

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