Corporate Governance and Board

Effectiveness by Kose John and Lemma

W. Senbet

Present by
Kamal Saeed
ID 5719580
Introduction and Objective of the paper

The paper emphasize on empirical and theoretical literature on the

mechanism of Corporate Governance (e.g corporate board of directors)
Directors role in solving various agency problem arising from conflict of
interest between equity holders and managers, creditors, capital contributor
Also emphasize on subsititue effect on internal and external mechanism of
market for corporate control.
Corporate governance deals with mechanism that deals with stakeholders
controls over corporate insiders and management such that equity holders
interest is protected.
Corporate insiders and management control key decision of the corporation ,
given that separation of ownership and control and how stake holders control
management is the main key of corporate governance.
Different types of capital contributor have different types of pay off structure
so as different of agency problem arises.
 Ongoing debate of relative efficiency of corporate governance such as UK and
US dispersed shareholding and prominent role for secondary market trading of
shares.
Japan and Germany concentrated more on share holding and prominent role
of Bank.
Share holders elect the directors who in turn select the top management.
Directors have prominent role of monitoring management for effective and
efficient performance of management.
Monitoring roles accounts for important component for corporate governance.
Board effectiveness depends on size, composition and independence.
Large share holder vs large creditor is now a new topic to cover on corporate
governance.
Agency probleman corporate governance
Corporate governance is viewed as context of control mechanism designed for
efficient operator of a corporation of behalf of stake holders.
Agency problem can be classified on the basis of conflicts among certain
particular parties to the firm e.g conflicts between stock holders and
management between stock holders and bondholders, between the private
sector and public sector (agent) also (social agency)
Deviation from effective investment strategy also affect firm performance
also hampers economic growth and development of the firm.
Important to outline two classes of agency problem first is managerialism
refers to self serving behavior by manager, ownership of the modern
corporation as manager lack in ownership they tend to undertake unefficient
or low profitable investment to keep their job safe.
Management firm and agecy conflicts
with the firms

Using debt may cause investment strategy risky and

also making less profitable venture taking more risky
investment.in respect to maximize the wealth of
shareholder.

Even in higher cash flow the debt obligation is fixed

and rest is carried back to equity holder .

May undertake risky investment in failure of risky

investment equity holder may walk free shifting risk to
creditors.
 High interest to compensate the creditor in case of
default.

Equity holder seeks for high risk activity such as

investment where profitable project maybe forgone in
exchange for high risk but inferior counterparts leading
to inefficient economy.
 Value at vertical axis depicted as concave
function of asset risk (variance of
terminal cash flow measured in horizontal
axis)mapping of value and risk possibility
of excessive risk taking cause destruction
of value at some point leading to risk
shifting agency cost.
Corporate Governance of board of directors
Board of directors is central to corporate governance mechanism in market
economics along with external market for corporate control and institutional and
concentrated shareholding
Primary means for share holder to exercise control on top management.
Monitoring function and board objective: Empirical literature gives enough
evidence boards play an important role on monitoring role. The board provides
effectiveness and performance of top management and also bring discipline such
as CEO turnover.
Board Composition: outside directorship and board independence
Board independence depends on board composition board presumed more
independent as outside directors increases.
Outside director played major role in bringing discipline and and maximizing
shareholder wealth.
Optimal board composition is still a ongoing research subject.
Performance affects shareholder wealth and cash flow
In previous research it is found announcement of outside director increases share
holder wealth using event methodology.
It is important to see if director seek interest of share holder.
Adoption of poison Pill (outside director) positive for firm if announce by outside
director also stock return is high.
Adoption of poison pill (inside director) cause negative return and adverse affect on
market or might be harmful to company.
Stock market reaction of adoption of poison pill is robust to various variable such as
firm size director ownership propotion,leverage,industry institutional ownership type.
Outside directors who effectively performs its duty able to generate high level of
sales, few employee turnover general and administrative expenses and higher return
on equity comparing with firm who have less discipline in management.
In aspect of board composition no positive relationship is found on board composition
and performance but positive relationship with ownership structure and performance.
 Regarding board composition its argued inside and outside directors have
their respective advantages and disadvantages from research it is found that
from 1% to 20% ownership have positive impact in top management.
Prolong CEO tenure might affect the performance of the firm.
CEO Turnover:Due to poor performance CEO is removed by outside directors
inside directors do not tend to remove ceo as it might think it may hampers
their interest.
Board size:Usuallay it is argued that larger board size more affective its
monitoring role but due to miscommunication, Yermack finds conclusive
results on board size that outside directors performs well and smaller the size
of board more efficient in monitoring and large scale improvement in
corporate governance.
 Committee structure: from previous research its found out that outside director
are more active in monitoring the performance of manager and productivity
oriented committee is are composed of inside director.
Monitoring committee ( audit,compensation, and nominating) are
disproprotiately compromised by director of outside and productivity
committee( finance investment and stragetic issues are vice versa of monitoring
committee).
Compensation structure: Compensation to stragetic interaction to top
management depends on substitute affect arises from when increase rivalry
decrease firms marginal profits stragetic complement affects when marginal
increases due to an increase in rivals action. Under stragetic substitute
management is asked to increase sales to trade off profit and hence for
substitute opposite affects takes places.
Governance structure and interior control mechanism is also a future topic to
look on.
 Board serves an important institution to resolve manager-share holder agency problem.
Passive dissent and strong monitoring.?
Board members have utility function that depends on firms value as well on retention of
their directorships.
Firm performances CEO tenure chages in market structure lead to changes in board
composition
Previous research shows firms tends to add inside director when their CEO approaches
retirement, inside director are more likely to leave and outside director more like to
join the board firms performs poorly and when it exist product market New Ceo leads to
departure of insiders
Board outsiders apparently have weak financial ties or have little information about the
firms operation it is important to increase awareness and have strong co-operation with
block holders
Interaction with outside Market.

Interplay between internal (board of directors and external (take over

market)
Williamson suggest board as corporate mechanism will be greater in market
where takeover are difficult.
In increase risk of take over inside director plays active role.
Board is responsive for poor performance and it succeds more in addressing
firm specific than industry wide problems.Top management turnover is
associated primariliy with poor performance of a firm relative to its industry
Higher equity stake of top executive reduces the likehood of complete turn
over and hostile takeover.
Takeover Market monitors the monitors.
Direction of future research

The ultimate goal should be maximize allocatinal efficiency

Debt problem and social agency problem
Higher incentive for directors
 Debt can act as mechanism for solving managerial agency problem.
Creditor have rights over company asset and also monitor the firms
performance
Creditor provides sets of rules for company to follow.
Corporate Governance and Social agency
cost.
Corporate governance also protects right of non-financial stakeholders
The claim holders includes customer warranty holders employees suppliers
etc.
Government agency also involve in non financial claim holder.

Corporate governance needs to reduce social agency cost.

Internal governance mechanism solves multiple agency problems (but need
further research).