Corporate Governance

Kenneth Kim & John Nofsinger 2th Edition Pearson Prentice Hall
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Chapter 1
Corporations and Corporate Governance

Chapter overview:
Forms of Business Ownership Separation of Ownership and Control Can Investors Influence Managers? An Integrated System of Governance International Monitoring

Forms of Business Ownership

Three general types of business ownership:

Sole proprietorship
Partnership Corporation

Comparison of three forms

Sole proprietorship Business owner Owners liability Easy access to capital market? Is management and ownership separate? Are business owners exposed to double taxation? Single owner Unlimited No No Partnership Partners Unlimited No No Corporation Shareholders Limited Yes Yes

No

No

Yes

Pros and Cons of Corporations

Pros: Easy access to capital markets Infinite life unless go bankrupt or merged by others Owners have limited liability Liquid corporate ownership Cons: Shareholders are exposed to double taxation Costs of running a corporation is relatively high Corporations suffer from potentially serious governance problems.

Separation of Ownership and Control

The thousands, or more, investors who own public firms could not collectively make the daily decisions needed to operate a business. Therefore:
The shareholders are owners of the firm The officers (or executives) control the firm

Principal-agent problem

Principalshareholders Agentmanagers Principal-agent problem represents the conflict of interest between management and owners. For example if shareholders cannot effectively monitor the managers behavior, then managers may be tempted to use the firms assets for their own ends, all at the expense of shareholders.

Solutions to Principal-agent problem

Incentivesaligning executive incentives with shareholder desires.
e.g. stock, restricted stock, and stock options.

Monitoringsetting up mechanisms for monitoring the behavior of managers.

Can Investors Influence Managers?

Some inactive shareholders will go along with whatever management wants. Some active shareholders have tried to influence management, but they are often met with defeat.

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Monitors

Monitors are called for because managers may not act in the shareholders best interest. Figure 1.1 shows that monitors exist:
inside the corporate structure
Board of directors

outside the structure

Auditors, analysts, bankers, credit agencies, and attorneys

in government

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SEC, and IRS

Figure 1.1

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Inside monitors-Board of directors

Oversee management and are supposed to represent shareholders interests. Evaluates management and design compensation contracts to tie managements salaries to the firms performance.

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Outside monitors

Interact with the firm and monitor manager activities

Auditors Analysts Bankers Credit agencies Attorneys

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Government monitors

The SEC regulates public firms for the protection of public investors The SEC also makes policy and prosecutes violators in civil courts. The IRS enforces the tax rules to ensure corporations pay taxes. The Sarbanes-Oxley Act of 2002

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Other monitors

Market forces Stakeholders Creditors Employees Society

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An Integrated System of Governance

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International Monitoring

Important differences occur between the types of monitoring and incentive used in other capitalist countries and the U.S. due to:

Different compensation contracts Different accounting standards Different institutional investing environment Bank-oriented or capital markets-oriented Different legal environment

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Summary

The corporations, probably the most important business form, generate approximately 90 percent of the countrys revenue. Separation of ownership and control causes the agency problem. Possible solutions to Principal-agent problem are incentives and monitoring. The corporate system has interrelated incentives.

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