Corporate Governance

Chapter 2

1
 Learning Objectives
1. Understand the financial
implications of the different forms of
business organizations.

2.Understand the conflicts of interest

that can arise between managers and
owners.

3.Understand the institutional

governance factors that influence
corporate behaviour.
2
 Overview of Lecture
1. Forms of Business Organization

2. Agency Theory

3. International Corporate Governance

4. Bringing it all Together

3
 1. The Corporate Firm
Sole Proprietorship Partnership Limited Corporation

Owned and Managed by Easy to form Articles and

one person Requires a partnership Memorandum of
Very easy to form agreement Incorporation Required
Profits taxed as personal Limited and unlimited Limited Liability
income partners Profits taxed at
Unlimited liability Partnership is corporate tax rate
Life of company linked terminated when a Board of Directors
to life of owner partner dies or leaves Life of company
Amount of funding is the firm hypothetically unlimited
limited by owners Difficult to raise cash
personal wealth Profits taxed as personal
income
Controlled by general
partners sometimes
votes are required on
major business decisions
4
 1. The Arts and Mems
Articles of Incorporation Memorandum of Association

Name of the corporation. The rules by which the corporation

Intended life of the corporation (it is organized
may be forever).
Business purpose.
Number of shares that the
corporation is authorized to issue,
with a statement of limitations and
rights of different classes of shares.
Nature of the rights granted to
shareholders.
Number of members of the initial
board of directors.

5
1. The Board of Directors Single Tier
Countries
Chairman/
Chief
Executive

Non-
Directors Executive
Directors

6
1. The Board of Directors Two Tier Countries

Supervisory
Board

Chairman/Chief
Executive

Directors

7
 1. Unitary vs Dual Board Structures

Two-Tier
Unitary
Board Reports to Board reports to
Shareholders supervisory board
Shareholders elect Supervisory board elects
directors at AGM directors
Supervisory board consists
of representatives from
banks, government, trade
unions, other stakeholders

8
 1. Partnerships vs Corporations
Liquidity and Partnership: Restricted Trading
Corporation: Traded easily sometimes on
Marketability exchange

Partnership: Partners have control

Voting Rights Corporation: Each share gives a voting right

Partnership: Profits taxed at personal tax rate

Taxation Corporation: Profits taxed at corporate tax rate

9
 1. Partnerships vs Corporations
Partnership: All profits allocated to partners
Reinvestment and Corporation: Total freedom in dividend decisions
Dividend Payout

Partnership: General Partners have unlimited

liability
Liability Corporation: Shareholders have limited liability

Partnership: Limited life

Continuity of Corporation: Unlimited life
Existence

10
 2. Agency Theory

Relationship between
Type I
managers and shareholders

Relationship between
Type II majority shareholders and
minority investors

11
 2. Management Goals

Shareholders want
Managers want to
managers to
maximize their own
maximize the value
wealth and power
of the company

12
 2. Agency Costs

The costs of resolving problematic

agency relationships

13
 2. Type I Agency Costs

Direct Costs: Corporate expenditure that

benefits managers at the expense of
Shareholders
Indirect Costs: Corporate Expenditure to
monitor and control manager activities
Examples: Private Jet, Payment of
auditors, Large administrative tiers.
14
2. Do Managers act in Shareholders Interests?
Managerial Compensation
Performance based pay

Control of the Firm

Are shareholders powerful?

Shareholder Rights
Do shareholders have a facility to call managers to account?

Proxy Voting
A grant of authority by a shareholder allowing another individual to
vote his or her shares. 15
2. Highest Paid Executives in 2011

16
2. CEO Target Pay Mix in 2011
Long-term
incentive
e.g. stock,
options

Short-
term
incentives
e.g.
bonuses

Salary

17
2. Do Managers act in Shareholders Interests?
Classes of Shares
Some firms have more than one class of ordinary equity. Often the
classes are created with unequal voting rights.

Pre-Emptive Rights
A company that wishes to sell equity must first offer it to the existing
shareholders before offering it to the general public. The purpose is
to give shareholders the opportunity to protect their proportionate
ownership in the corporation.

Dividends
Payments by a corporation to shareholders, made in either cash or
shares. 18
 2. Dividends

Unless a dividend is declared by the board of directors of a

corporation, it is not a liability of the corporation. A
corporation cannot default on an undeclared dividend. As a
consequence, corporations cannot become bankrupt
because of nonpayment of dividends.
The payment of dividends by the corporation is not a
business expense. Dividends are not deductible for
corporate tax purposes. In short, dividends are paid out of
the corporations after-tax profits.
Dividends received by individual shareholders are taxable.
19
 2. Type II Agency Costs

Majority shareholder makes one of her

firms trade on attractive terms with
another of her firms. Known as a Related
Party Transaction.
Majority shareholder can force the
company to declare a large dividend
because they need the cash.
20
 2. Stakeholder

Someone, other than a shareholder or

creditor, who potentially has a claim on the
cash flows of the firm e.g. employees,
government, customers

21
 3. International Corporate Governance

Main areas of importance are:

Investor Protection
The Financial System
Control Mechanisms
Firm Corporate Governance Systems

22
3. Legal Systems around the world

23
3. Investor Protection: Shareholder Legal Protection

What are the country-level legal rights of shareholders?

Main characteristics:
Proxy vote by mail is allowed
Votes are not blocked before the annual general meeting
Cumulative voting or proportional representation exists
Oppressed minorities mechanisms exist
Pre-emptive rights exist and
There is a minimum percentage to call an extraordinary shareholders
meeting
24
3. Investor Protection: Law Enforcement

Many countries have strong regulations but very weak enforcement

To what extent does a government enforce its laws?
Two issues to consider:

The Efficiency of the Judicial System

Is the Rule of Law and Order followed?

25
 3. Corruptions Perception Index

Very
clean

Very corrupt

26
 3. The Financial System:
Bank and Market Based Systems
Bank Based Systems
Banks are central to the process
of moving funds between
demanders and suppliers of
capital
More active monitoring
Germany and Japan are
examples
Market Based Systems
Securities markets are as
important and can be
significantly more important
External market discipline
US and UK are examples
27
 3. The Financial System:
Financial Market Development

Banking Development Market Development

Bank Liquid Liabilities/GDP Market Capitalization/GDP
Bank Assets/GDP Total Trading Volume/GDP
Domestic Bank Deposits/GDP

28
3. Bank vs. Market Based Financial Systems

29
3. Control Mechanisms: Ownership Structure

Widely Held Firms Closely Held Firms

Separation between ownership
and control
Agency Issues between
managers and shareholders
Manager and shareholder
incentives aligned
Agency Issues between
controlling and non-controlling
shareholders

30
3. Ownership Structure of 20
Largest Companies in Each Country

31
3. Country Differences: An Overview
Regulatory Governance is extremely complex
Improving one aspect of governance is likely to make
another aspect much weaker
There is no one correct approach to regulatory governance
Different environments require different regulations
We are now having to rethink this area with the new approach to
government ownership in strategic industries
The west will need to consider more carefully the regulatory
governance approaches of Middle East and China
With additional funding from these places, we will see stronger
pressure to adapt our systems to be consistent with theirs

32
 4. Bringing it all Together

Controlling
Managers
Shareholders

Trust

Minority
Stakeholders
Shareholders

33
4. Relevant Codes of Corporate Governance

34