International Corporate Governance

Slide 1.
International Corporate
Governance
Defining Corporate Governance and
Key Theoretical Models
Goergen, International Corporate Governance, 1st Edition Pearson Education Limited 2012
Slide 1.2
Lecture Aims
This lecture aims to introduce you to the subject area of
corporate governance.
The lecture discusses the various definitions of corporate
governance, reviews the main objective of the
corporation and explains how corporate governance
problems change with ownership and control
concentration.
The lecture also introduces the main theories
underpinning corporate governance.
While this course focuses on stock-exchange listed
corporations, this lecture also discusses alternative forms
of organisations such as mutual organisations,
cooperatives and partnerships.
Slide 1.3
Learning Outcomes
By the end of this lecture, you should be able
to:
1. Contrast the different definitions of corporate
governance
2. Critically review the principalagent model
3. Discuss the agency problems of equity and debt
4. Explain the corporate governance problem that
prevails in countries where corporate ownership
and control are concentrated
5. Distinguish between ownership and control.
Slide 1.4
The Basics
In what follows, we focus on stock-exchange listed
firms.
These firms are typically in the form of stock
corporations that have equity stocks or shares
outstanding.
Stocks or shares are certificates of ownership that
frequently confer control rights, i.e. voting
rights.
Voting rights enable their holders, the
shareholders, to vote at the annual general
shareholders meeting (AGM).
Slide 1.5
The Basics (Continued)

Voting shares confer the right to appoint the
members of the board of directors.
The board of directors is the ultimate governing
body within the firm.
Its role, in particular that of the non-executive
directors, is to look after the interests of all the
shareholders.
It may also look after the interests of other
stakeholders such as the employees and the
firms creditors.
Slide 1.6
The Basics (Continued)

More precisely, it is the non-executives role to
monitor the firms top management, including
its executives.
Slide 1.7
Defining Corporate Governance

Most definitions are based on implicit or explicit
assumptions about the main objective of the firm.
However, there is no universal agreement as to
what this objective should be.
For example, Andrei Shleifer and Robert Vishny
define corporate governance as the ways in
which suppliers of finance assure themselves of
getting a return on their investment.
This definition assumes that the main objective of
the firm is to maximise shareholder value.
Slide 1.8

(Continued)
They justify this focus by the argument that
investments in the firm by the shareholders
(as well as the debtholders) are sunk funds.
In contrast, the other stakeholders can easily
walk away from the firm without losing their
investments.
Hence, the shareholders are the residual risk
bearers or the residual claimants to the
firms assets.
Slide 1.9

(Continued)
If the firm enters financial distress, the claims
of all the other stakeholders will be met first
before the claims of the shareholders can be
met.
Slide 1.10

(Continued)
In contrast, Marc Goergen and Luc Renneboogs
definition allows for differences across countries
in terms of the main objective of the firm:
A corporate governance system is the
combination of mechanisms which ensure that
the management runs the firm for the benefit
of one or several stakeholders... Such
stakeholders may cover shareholders, creditors,
suppliers, clients, employees and other parties
with whom the firm conducts its business.
Slide 1.11

(Continued)
For example, German corporate law explicitly
includes other stakeholder interests in the
firms objective function.
The German Co-determination Law of 1976
requires firms with more than 2,000
employees to have half of the supervisory
board seats held by employee representatives.
Slide 1.12
Figure 1 Whose company is it?
Notes: The number of firms surveyed is 50 for France, 100 for Germany, 68 for
Japan, 78 for the UK and 82 for the USA.
Source: Yoshimori, M. (1995), Whose Company is It? The Concept of the
Corporation in Japan and the West, Long Range Planning 28, p.34.
Slide 1.13

(Continued)
A more neutral definition is that corporate
governance deals with conflicts of interests
between
the providers of finance and the managers;
the shareholders and the stakeholders;
different types of shareholders (mainly the large
shareholder and the minority shareholders)
and the prevention or mitigation of these

conflicts of interests.
This is the definition adopted by this module.
Slide 1.14
Corporate Governance Theory

It is in the interest of every man to live as much at his
ease as he can; and if his emoluments are to be
precisely the same, whether he does, or does not
perform some laborious duty, it is certainly his
interest, at least as interest is vulgarly understood,
either to neglect it altogether, or, if he is subject to
some authority which will not suffer him to do this, to
perform it in as careless and slovenly a manner as
that authority will permit.
Smith, A. (1776), An Inquiry into the Nature and Causes of the
Wealth of Nations, reprinted in K. Sutherland (ed.) (1993),
Worlds Classics, Oxford: Oxford University Press.
Slide 1.15
Corporate Governance Theory (Continued)

This quote illustrates the conflict of interests
that may exist between an agent and the
agents principal.
Michael Jensen and William Meckling
formalised these conflicts of interests in their
principalagent theory.
While the agent has been asked by the
principal to carry out a specific duty, the agent
may not act in the best interest of the principal
once the contract has been signed.
Slide 1.16

The agent may rather prefer to act in his own
interest.
Economists call this moral hazard.
Moral hazard is not just an issue in corporate
governance, but it is also a major issue for
insurance companies.
One way of addressing principalagent
problems is via so called complete
contracts.
Slide 1.17

Complete contracts are contracts which specify
exactly what
the managers must do in each future contingency of the
world; and
what the distribution of profits will be in each contingency.
In practice, contracts are unlikely to be complete as

it is impossible to predict all future contingencies of the
world;
such contracts would be too complex to write; and
they would be difficult or even impossible to monitor and
reinforce by outsiders such as a court of law.
Slide 1.18

A necessary condition for moral hazard to exist
and for complete contracts to be impossible is
the existence of asymmetric information.
Asymmetric information refers to situations
where one party, typically the agent, has more
information than the other party, the principal.
If both parties had access to the same
information at all times, then there would be
no moral hazard problem.
Slide 1.19

Moral hazard exists because the principal
cannot keep track of the agents actions at all
times.
Even ex post, it is sometimes difficult for the
principal to judge whether failure is due to the
agent or external circumstances.
Jensen and Mecklings principalagent model
also assumes that there is a separation of
ownership and control.
Slide 1.20

Adolf Berle and Gardiner Means were the first to
point out this separation in their 1932 book The
Modern Corporation and Private Property.
A firm starts off as a small business, fully owned
by its founder, typically an entrepreneur.
At this stage, there are no conflicts of interests
as the entrepreneur both owns and runs the firm.
As the firm grows, it becomes more and more
difficult for the entrepreneur to provide all the
financing.
Slide 1.21

Eventually, the entrepreneur will need to raise
outside finance.
Once outside finance has been raised, the
entrepreneurs incentives to work hard have
been reduced.
Ultimately, the entrepreneur will sell out and
the firm ends up being run by professional
managers on behalf of its shareholders.
Slide 1.22

Hence, there is a clear division of labour in the
modern corporation with
the manager, the agent, having the expertise to run
the firm, but not the funds to finance it; and
the shareholders, the principal(s), having the
required funds, but not the skills to run the firm.
In practice, control lies with the managers who

run the day-to-day operations of the firm
whereas the firm is owned by the shareholders.
Hence the separation of ownership and control.
Slide 1.23

However, the agent may prefer to run the firm in his
own interests rather than those of the principal.
This is the principalagent problem (agency
problem).
The main consequence of this problem is agency
costs.
These are the sum of
the monitoring expenses incurred by the principal;
the bonding costs accruing to the agents; and
any residual loss.
Slide 1.24
Agency Problems
The two main types of agency problems are
perquisites and
empire building.
Perquisites or perks consist of on-the-job

consumption by the managers.
While the benefits from the perks accrue to the
managers, their costs are borne by the
shareholders.
Examples of perks are CEO mansions financed
by the firm and personal usage of corporate jets.
Slide 1.25
Agency Problems (Continued)

The former CEO of Tyco International had his
company fund his wifes 40th birthday party in
Sardinia at a cost of US$1 million.
Former Merrill CEO John Thain spent $1.2
million to renovate his offices, including
installation of a $35,000 toilet.
Source: The Gazette, 28 March 2009, p. B1.
Slide 1.26

While perks can cause public outrage, especially
when they are combined with lacklustre
performance, they tend to be modest compared to
empire building.
Empire building consists of managers pursuing
growth rather than shareholder-value
maximisation.
While there is a link between the two, growth does
not necessarily generate shareholder value and
vice-versa.
Empire building is also referred to as Jensens free
cash flow problem.
Slide 1.27

The free cash flow problem consists of managers
investing beyond the point where investment
projects earn an adequate return given their risk.
So why would managers be tempted by empire
building?
Managers derive benefits from increasing the size
of their firm.
Such benefits include increased power and social
status.
Managerial remuneration has also been shown to
depend on firm size.
Slide 1.28
Agency Problems of Debt and Equity

So far, we have focused on the agency problem of
equity, i.e. the agency problem between the
managers and the shareholders.
However, there also exists an agency problem of
debt.
When there is very little equity left (e.g. when the
firm is in financial distress), the shareholders may
be tempted to gamble with the debtholders money.
They may do so by investing the firms funds into
high-risk projects.
Slide 1.29

(Continued)
If the project fails, the major part of the costs
will be borne by the debtholders.
If the project is successful, most of its payoff
will go to the shareholders given that the
debtholders claims have a limited upside.
Slide 1.30
Figure 2 Firm value

Value of debt and
equity
Value of
equity
Value of
debt
Financial
distress
Firm value
Slide 1.31

Jensen and Meckling argue that, given that
there are agency costs from both debt and
equity, there is an optimal mix of debt and
equity which minimises the sum of the agency
costs of debt and equity.
Slide 1.32
Figure 3 Agency costs of debt and equity
Slide 1.33
The Expropriation of Minority Shareholders

The principalagent model is based on the BerleMeans premise that, as firms grow, ownership
eventually separates from control.
However, this is only an accurate description of the
Anglo-American system of corporate governance.
In the rest of the world, most stock-exchange listed
firms have large shareholders exerting significant
control over the firm.
Hence, the main conflict of interests is between the
large shareholder and the minority shareholders.
Slide 1.34

(Continued)
Minority shareholders may face the danger of
being expropriated by the large shareholder
via e.g.
tunnelling;
transfer pricing;
nepotism; and
Infighting.
Tunnelling consists of the large shareholder

transferring the firms assets or profits into his
own pockets.
Slide 1.35

(Continued)
The large shareholder may also expropriate the
minority shareholders via transfer pricing,
i.e. by overcharging the firm for services or
assets provided.
Tunnelling and transfer pricing involving the
large shareholder are also sometimes referred
to as related-party transactions.
Large shareholders may be even more tempted
to engage in related-party transactions in the
presence of ownership pyramids.
Slide 1.36
Figure 4 Expropriation of the minority

shareholders by the large shareholder
Large shareholder
51%
Firm A
100%
Firm B
Slide 1.37
Figure 5 Leveraging control and increasing

the potential for expropriation
Large shareholder
51%
Holding Co.
100%
Firm B
51%
Firm A
Slide 1.38

(Continued)
Other forms of minority shareholder

expropriation include nepotism and infighting.
Nepotism consists of the large family
shareholder appointing family members to top
management positions rather than the most
suitable candidates on the job market.
Infighting may not necessarily be a wilful form
of expropriating the firms minority shareholders,
but nevertheless is likely to deflect management
time as well as other firm resources.
Slide 1.39
Nepotism
Slide 1.40
Alternative Forms of Organisation and

Ownership
The main alternative to the stock corporation
is the mutual organisation.
A mutual organisation is owned by and run on
behalf of its members.
For example, a mutual bank is owned by its
savers and borrowers.
Both stock corporations and mutual
organisations are likely to suffer from the
principalagent problem.
Slide 1.41

Ownership (Continued)
However, this problem may be more severe in
mutual organisations given that stock
corporations benefit from a range of
mechanisms that mitigate agency problems.
These include
the threat of a hostile takeover
monitoring by large shareholders
ownership of stock options and stocks by managers
and employees
a market price for the stocks.
Slide 1.42

As each member of a mutual organisation has only
one vote, this prevents the emergence of powerful
owners.
Through the 1980s/90s, a number of UK mutual
building societies went through a demutualisation.
They changed their legal status to a stock corporation
and applied for a stock exchange listing.
At the time, it was thought that this would result in a
major improvement in the efficiency of these
organisations.
Slide 1.43

However, roughly 20 years later several of the

demutualised building societies had to be
nationalised as a result of the subprime
mortgage crisis.
Northern Rock was the object of the first bank
run on a British financial institution for more
than 150 years.
Overall, it is still unclear which of the two
organisational forms is superior.
Slide 1.44

One of the potential benefits of the mutual

form is that it avoids conflicts of interests
between owners and customers.
These conflicts tend to be severe for long-term
products and services as the owners may be
tempted to expropriate the customers.
For these products and services the mutual
form is superior as it merges the functions of
owner and customer.
Slide 1.45

While mutual organisations are not subject to

the disciplining role of the stock market, they
have their own disciplinary mechanism.
The members of a mutual organisation are
allowed to withdraw their funds at any time.
Such withdrawals reduce the financial basis of
the mutual.
In contrast, stock corporations do not see their
funds shrink when shareholders sell their
shares.
Slide 1.46

Some commercial organisations are in the form of
partnerships and owned by their employees
Goldman Sachs
John Lewis Partnership.
Sanford Grossman, Oliver Hart and John Moores

theory of property rights predicts when
employees should have ownership of their firm.
Employees should be given property rights if they
have to make investments in their human capital
which are highly specific (idiosyncratic) to the firm.
Slide 1.47
Defining Ownership and Control

Ownership is defined as ownership of cash
flow rights.
Cash flow rights give the holder a pro rata
right to the firms assets and earnings.
Control is defined as ownership of control
rights.
Slide 1.48
Conclusions
The link between the objective of the firm and
the definition of corporate governance.
The principalagent model.
The expropriation of minority shareholders.
Conflicts of interests as the definition of
corporate governance adopted by this module.
Ownership versus control.

International Corporate Governance

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Slide 1.

The Basics (Continued)

The Basics (Continued)

Defining Corporate Governance

Defining Corporate Governance

Defining Corporate Governance

Defining Corporate Governance

Defining Corporate Governance

Figure 1 Whose company is it?

Defining Corporate Governance

and the prevention or mitigation of these

Corporate Governance Theory

Corporate Governance Theory (Continued)

Corporate Governance Theory (Continued)

Corporate Governance Theory (Continued)

In practice, contracts are unlikely to be complete as

Corporate Governance Theory (Continued)

Corporate Governance Theory (Continued)

Corporate Governance Theory (Continued)

Corporate Governance Theory (Continued)

Corporate Governance Theory (Continued)

In practice, control lies with the managers who

Corporate Governance Theory (Continued)

Perquisites or perks consist of on-the-job

Agency Problems (Continued)

Agency Problems (Continued)

Agency Problems (Continued)

Agency Problems of Debt and Equity

Agency Problems of Debt and Equity

Figure 2 Firm value

Agency Problems of Debt and Equity

Figure 3 Agency costs of debt and equity

The Expropriation of Minority Shareholders

The Expropriation of Minority Shareholders

Tunnelling consists of the large shareholder

The Expropriation of Minority Shareholders

Figure 4 Expropriation of the minority

Figure 5 Leveraging control and increasing

The Expropriation of Minority Shareholders

Other forms of minority shareholder

Alternative Forms of Organisation and

Alternative Forms of Organisation and

Alternative Forms of Organisation and

Alternative Forms of Organisation and

However, roughly 20 years later several of the

Alternative Forms of Organisation and

One of the potential benefits of the mutual

Alternative Forms of Organisation and

While mutual organisations are not subject to

Alternative Forms of Organisation and

Sanford Grossman, Oliver Hart and John Moores

Defining Ownership and Control

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