Corporate Governance

Corporate Governance- guiding corporations to

protect the interests of stakeholders
Corporate governance is system by which business
corporations directed and controlled
Or
System of structuring operating and controlling a
company with a view to achieve long-term strategic
goals to satisfy primary stakeholders

Separation of Ownership and

Managerial Control
Basis of the modern corporation

shareholders purchase stock, becoming residual

claimants
professional managers are contracted to provide
decision-making

Modern public corporation form leads to efficient

specialization of tasks
risk bearing by shareholders
strategy development and decision-making by
managers

Agency Relationship: Owners and

Managers

Shareholders
(Principals)
Firm owners

Decision makers

Managers
(Agents)

Risk bearing specialist (principal) pays

compensation to
A managerial decision-making specialist
(agent)

An Agency
Relationship

Agency Theory Problem

The agency problem occurs when:

the desires or goals of the principal and agent conflict

and it is difficult or expensive for the principal to verify
that the agent has behaved inappropriately

Solution:

principals engage in incentive-based performance

contracts
monitoring mechanisms such as the board of directors
enforcement mechanisms such as the managerial labor
market to mitigate the agency problem

Agency Relationship Problems

Principal and agent have divergent interests and
goals
Shareholders lack direct control of large, publicly
traded corporations
Agent makes decisions that result in the pursuit of
goals that conflict with those of the principal
It is difficult or expensive for the principal to verify
that the agent has behaved appropriately
Agent falls prey to managerial opportunism
5

Managerial Opportunism
The seeking of self-interest with guile (cunning
or deceit)
Managerial opportunism is:
An attitude (inclination)
A set of behaviors (specific acts of self-interest)

Managerial opportunism prevents the

maximization of shareholder wealth (the
primary goal of owner/principals)
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Response to Managerial Opportunism

Principals do not know beforehand which
agents will or will not act opportunistically
Thus, principals establish governance and
control mechanisms to prevent managerial
opportunism

Examples of the Agency Problem

Possible Problems
Product diversification
Increased size, and relationship of size to managerial
compensation
Reduction of managerial employment risk
Fraud

Use of Free Cash Flows

Managers prefer to invest these funds in additional
product diversification (see above)
Shareholders prefer the funds as dividends so they control
how the funds are invested
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Agency Theory Conflicts

Principals may engage in monitoring behavior
to assess the activities and decisions of
managers
However, dispersed shareholding makes it
difficult and inefficient to monitor
managements behavior
Boards of Directors have a fiduciary duty to
shareholders to monitor management
9

Agency Costs and Governance Mechanisms

Principals may engage in monitoring behavior
to assess the activities and decisions of
managers
However, dispersed shareholding makes it difficult and
inefficient to monitor managements behavior

Boards of Directors have a fiduciary duty to

shareholders to monitor management
However, Boards of Directors are often accused of being
lax in performing this function
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Corporate Governance Mechanisms

The interests of the stakeholders are
protected through set of mechanisms
They are called corporate governance
mechanisms

Internal mechanism
Board of Directors
Top Managements Monitoring
Ownership Concentration

External mechanism

Regulatory Oversight (Financial market regulator)

Legal System (Company law, Bankruptcy law)
Corporate Control activity
Capital market access
Rating Agencies
Gatekeepers Analysts, External Auditors &
Underwriters

Board, Top Management and Shareholders

CEO &Management

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AGMs, Director Elections

Investors

Board
Grievance redressing mechanism

Types of Directors
Executive Directors
Non- Executive directors (Independent Directors and
Promoter Representatives)
Nominee Directors
Alternative directors

Top Management Monitoring

Top Management has the responsibility to
ensure proper internal control systems

Governance Mechanisms-Ownership
Concentration
Large block shareholders (often institutional
owners) have a strong incentive to monitor
management closely

Their large stakes make it worth their while to spend

time, effort and expense to monitor closely
They may also obtain Board seats which enhances
their ability to monitor effectively
Have the size (proxy voting power) and incentive
(demand for returns to funds) to discipline ineffective
top-level managers
Can affect the firms choice of strategies

Regulators and Legal Systems

Provide the norms for corporate governance
mechanisms and structures
Corporate Disclosures An important tool for
ensuring transparency

US Environment
SEC was formed in 1934
SEC is very active and the regulatory system was
well advanced
Managements Discussion and Analysis since
1960s
Regulatory norms were revised regularly by SEC

Sarbanes Oxley Act

Corporate failures in USA Enron, WorldCom
Failure of Internal and External mechanisms
Sarbanes-Oxley act- July 30,2002 also known
as Public Company Accounting Reform and
Investor Protection Act of 2002

Sarbanes Oxley Act

302- CEO & CFO need to certify the accuracy and
completeness of their company reports every
quarter
404 -Internal controls Internal Audit
Audit committee will get direct reports from internal
auditors
Accounting firms- Public Accounting Oversight Board
(PCAOB) - No consultancy works
Protect whistle blowers
No loan for top management personnel
Off-balance sheet transactions

Indian Regulatory Systems

SEBI Clause 49