Corporate Governance:

An Overview
FIN-6137
 What is Corporation?

A corporation is a legal business structure

that establishes the business as being a
separate entity from the owners.
 Corporate Governance

 Corporate governance relates to the

internal means by which corporations
are operated and controlled.

 It usually involves balancing the interests

of company’s stakeholders.
 It provides framework for attaining
company’s objectives.
 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. The responsibilities of the
directors include setting the company's strategic
aims, providing the leadership to put them into
effect, supervising the management of the business
and reporting to shareholders on their stewardship.
 (Sir Cadbury)
 Corporate Governance
 The corporate governance structure specifies the
distribution of rights and responsibilities among
different participants in the corporation, such as the
Board, managers, shareholders and other
stakeholders, and spells out the rules and procedure
for making decisions on corporate affairs.
 It also provides the structures through which the
company objectives are set, and the means of
attaining those objectives and monitoring
performance.
 (The OECD )
 Corporate Governance Parties
 Shareholders – those that own the
company

 Directors – Guardians of the Company’s

assets for the Shareholders

 Managers who use the Company’s assets

 Other stakeholders
 Four Pillars
of Corporate Governance

 Accountability

 Fairness

 Transparency

 Independence
 Accountability

 Ensure that management is accountable to

the Board

 Ensure that the Board is accountable to

shareholders
 Fairness

 Protect Shareholders rights

 Treat all shareholders

including minorities, equitably

 Provide effective redress for violations

 Transparency

Ensure timely, accurate disclosure on all

material matters, including the financial
situation, performance, ownership and
corporate governance
 Independence
 It is an ability to “stand apart” from
inappropriate influences and to be free of
managerial capture, to be able to made
the correct and uncontaminated decision
on a given issue. (e.g. NED. Auditors etc)
Elements of Corporate Governance
 Good Board practices

 Control Environment

 Transparent disclosure

 Well-defined shareholder rights

 Board commitment
 Why Corporate Governance?
 Better access to external finance
 Improved company performance –
sustainability
 Stakeholders’ trust
 Reduced risk of corporate crisis and
scandals
Corporate Governance System
 Self Interested Executives
 Executives that can take actions to benefit
themselves without detection and therefore
avoid the cost of punishment.

 Executives make investment, financing and

operating decisions that better themselves
at the expense of others parties related to
the firm.

 Agency problem arises due to such

executives
 Agency Problem
 A situation in which agents of an
organization (e.g. the management) use
their authority for their own benefit rather
than that of the principals (e.g. the
shareholders).

 Agency problem is the likelihood that

managers may place personal goals ahead
of corporate goals.
 Prevention of Agency Problem
 The agency problem can be prevented by:

1. Market Forces
2. Agency Cost

Market Forces
It is of two types:

 Behavior of security market participants

 Hostile takeovers
 Cont’d….
Behavior of security market participants
 The participants include institutional
investors (mutual funds, insurance etc.)
actively participate in management. They
use their voting right to replace more
competent management.
Hostile Takeovers
 It is the acquisition of the firm by another
firm that is not supported by
management. The constant threat of
takeover motivate management to work
for maximizing owners wealth.
 Agency Cost
These are the cost born by the
shareholders to prevent agency problem
as to maximize owners wealth.

They have to incur four types of cost:

 Monitoring
 Bonding
 Opportunity
 structuring
 Cont’d…
Monitoring Expenditures
 It relates to the payment for audit and
control procedures to ensure that
management is working for maximizing
owners wealth.

Bonding Expenditures
 The firm pays to obtain fidelity bond from
a third party bonding company to
compensate for financial losses due to
dishonest acts.
 Cont’d….
Opportunity Cost
 The cost which results from the inability of
the firm to respond to new opportunities.

Structuring Expenditures
 Relates to structuring managerial
compensation to maximize owners wealth.

It is of two types:
 Incentive Plans and

 Performance Plans
 Relationship with CG & Firms
Performance
 According to a 2002 survey by McKinsey &
Company, nearly 80 percent of institutional
investors responded that they would pay a
premium for a well governed company. The size of
the premium varied by market, ranging from 11
percent for a company in Canada to around 40
percent for a company in Morocco, Egypt, or
Russia. These results imply that investors perceive
well governed companies to be better investments
than poorly governed companies. They are also
consistent with the idea that governance systems
are more important in certain countries than in
others.
Best Practice or Best Practices?
Does one size fits for all?
 Applying a “one-size-fits-all” approach to
governance can lead to incorrect
conclusions and is unlikely to substantially
improve corporate performance.
 A set of governance mechanisms that
works well in one setting might prove
disastrous in another. This situation
becomes apparent when considering
international governance systems.
 For example, Germany requires labor
union representation on many corporate
boards. How effective would such a
system be in the United States? Japanese
boards have few outside directors and
many of those who are outside directors
come from banks that provide capital to
the firm or key customers and suppliers.
What would be the impact on Japanese
companies if they were required to adopt
the independence standards of the United
States?