Week 1: International CG. Executive compensation
1. Core idea of corporate governance
Corporate governance exists because in large firms there is a separation of ownership and control: shareholders provide capital,
managers run the firm. That creates a principal-agent problem because managers may not always act in shareholders’ best
interests.
Why governance is needed
Shareholders want firm value maximized. Managers may instead pursue:
• shirking or the quiet life
• perks or perquisite consumption
• empire building
• risk aversion
• desire to stay in power
• misuse of free cash flow
Definition
A good definition is: corporate governance is the system of controls, incentives, and regulations used to reduce agency costs and
limit self-interested managerial behavior. Economically efficient governance reduces agency costs by more than it costs to
implement.
2. Main governance mechanisms
• Board of directors
• Executive compensation
• Large shareholders
• Threat of takeover
• Legal protection
• Transparency/disclosure
• Payout policy
• Debt
• Shareholder voting
• Product market competition
These mechanisms can work as substitutes or complements. A country or firm does not need the exact same mix everywhere.
3. Board of directors
The board is the central internal governance mechanism. It monitors and advises management. In the US framing from class,
directors owe fiduciary duties of: loyalty, candour and/or care
Important board issues:
• board size
• independence
• CEO-Chair split or combined role
• staggered board
• busy directors
• diversity
• financial and industry expertise
• tenure, age, background
• political or banking connections
Director types
• inside/executive directors: employees, former employees, family-linked
• gray/linked directors: have business ties to the firm
• outside/independent directors: no material ties to the company
,Board independence
Independence matters because it reduces conflicts of interest and improves monitoring. But fully independent directors may also
have weaker incentives than insiders because their wealth is less tied to firm performance. So independence helps, but it is not
automatically sufficient.
Important nuance
There is no one universally perfect board structure. Small boards may be faster and more effective in some settings; larger
boards may help in big, complex firms. This “no one-size-fits-all” point matters a lot later for empirical work too.
4. Executive compensation
Executive compensation is meant to align managers with shareholders, but it can also create distortions.
Main idea
In theory, pay should be the minimum amount needed to attract and retain a qualified executive. It should reward value
creation without overpaying from shareholder money.
How CEO pay is set
• Compensation committee recommends pay
• Independent directors approve it
• Consultants, HR, finance, peer groups may be used
• Shareholders often must approve equity-based compensation
• “Say on pay” gives shareholders a vote, though evidence on effectiveness is mixed
Main components of pay
• salary: fixed cash
• annual bonus: short-term, often tied to ROE, EPS, ESG, etc.
• stock options
• restricted stock / performance shares
• perks
• golden parachutes
• benefits
• clawbacks
• stock ownership guidelines
• deferred payouts
Why equity pay is attractive
Equity ownership aligns incentives because managers benefit if share price rises. That is the core logic behind stock-based
compensation.
But equity pay also creates problems
This is examinable conceptually:
• can encourage excessive risk-taking
• can encourage earnings manipulation
• can distort information release
• can create incentives for option timing
• can weaken incentives if executives are allowed to hedge
• pledging shares creates margin call risk
• insider trading concerns arise when executives trade with private information
Know these terms:
• spring loading: granting options before good news
• bullet dodging: delaying grants until after bad news
• hedging: reducing downside risk, but also reducing incentives
, • pledging: using shares as collateral
• repricing/exchange offers: resetting underwater options to restore incentives
Benchmarking problem
Compensation is often benchmarked against peers. This can create a ratcheting effect: everyone targets median or above-median
pay, which keeps pushing pay up even without clear value creation.
5. International corporate governance
A firm’s governance system is shaped by its environment. Governance must fit the country and institutional setting.
Determinants of governance systems
1. Capital market efficiency
Efficient markets help set prices properly and discipline firms through the stock price. If markets are inefficient or underdeveloped,
firms depend more on families, banks, or governments, so governance relies more on alternative mechanisms.
2. Legal tradition / shareholder protection
Strong legal protection, especially for minority shareholders, reduces agency problems. Common-law systems were presented as
generally more shareholder-protective than civil-law systems. Stronger legal protection is associated with stronger governance and
often higher valuations.
3. Accounting standards
Reliable accounting standards reduce information asymmetry and improve monitoring. Good standards help only if they are
actually credible and implemented properly. Transparency is central to governance.
4. Enforcement of regulation
Rules on paper are not enough. Enforcement builds investor confidence. Weak enforcement means shareholders may need to
monitor more directly.
5. Societal and cultural values
Governance also reflects culture. Some systems are more shareholder-centric, others more stakeholder-centric. Cultural norms
shape what behavior is acceptable and what governance mechanisms are needed.
The same governance mechanism can work differently across countries because institutions, enforcement, accounting quality,
market development, and culture differ. Therefore, there is no one-size-fits-all governance model.
6. What counts as “strong governance” and how to measure it
How governance can be measured:
1. single mechanisms, such as board independence, board size, CEO ownership, pay-for-performance sensitivity
2. indices, which combine several governance provisions into one score, such as the G-index or other broader governance
measures
A “strong” governance system is not just one with more rules. It is one that is effective for that firm’s context. Measurement is
hard because:
• one measure may capture only one channel
• indices can be noisy or arbitrary
• governance is context-dependent
• “good” governance for one firm may not be optimal for another
So in an exam answer: mention specific governance proxies, mention indices, and add the caveat that governance quality is
difficult to observe directly.
Scandals like Tyco, Occidental, FTX serve as illustrations of governance failure: weak oversight, poor controls, conflicts of
interest, no functioning board, poor transparency.
8. Final exam-ready takeaways
1. Core idea of corporate governance
Corporate governance exists because in large firms there is a separation of ownership and control: shareholders provide capital,
managers run the firm. That creates a principal-agent problem because managers may not always act in shareholders’ best
interests.
Why governance is needed
Shareholders want firm value maximized. Managers may instead pursue:
• shirking or the quiet life
• perks or perquisite consumption
• empire building
• risk aversion
• desire to stay in power
• misuse of free cash flow
Definition
A good definition is: corporate governance is the system of controls, incentives, and regulations used to reduce agency costs and
limit self-interested managerial behavior. Economically efficient governance reduces agency costs by more than it costs to
implement.
2. Main governance mechanisms
• Board of directors
• Executive compensation
• Large shareholders
• Threat of takeover
• Legal protection
• Transparency/disclosure
• Payout policy
• Debt
• Shareholder voting
• Product market competition
These mechanisms can work as substitutes or complements. A country or firm does not need the exact same mix everywhere.
3. Board of directors
The board is the central internal governance mechanism. It monitors and advises management. In the US framing from class,
directors owe fiduciary duties of: loyalty, candour and/or care
Important board issues:
• board size
• independence
• CEO-Chair split or combined role
• staggered board
• busy directors
• diversity
• financial and industry expertise
• tenure, age, background
• political or banking connections
Director types
• inside/executive directors: employees, former employees, family-linked
• gray/linked directors: have business ties to the firm
• outside/independent directors: no material ties to the company
,Board independence
Independence matters because it reduces conflicts of interest and improves monitoring. But fully independent directors may also
have weaker incentives than insiders because their wealth is less tied to firm performance. So independence helps, but it is not
automatically sufficient.
Important nuance
There is no one universally perfect board structure. Small boards may be faster and more effective in some settings; larger
boards may help in big, complex firms. This “no one-size-fits-all” point matters a lot later for empirical work too.
4. Executive compensation
Executive compensation is meant to align managers with shareholders, but it can also create distortions.
Main idea
In theory, pay should be the minimum amount needed to attract and retain a qualified executive. It should reward value
creation without overpaying from shareholder money.
How CEO pay is set
• Compensation committee recommends pay
• Independent directors approve it
• Consultants, HR, finance, peer groups may be used
• Shareholders often must approve equity-based compensation
• “Say on pay” gives shareholders a vote, though evidence on effectiveness is mixed
Main components of pay
• salary: fixed cash
• annual bonus: short-term, often tied to ROE, EPS, ESG, etc.
• stock options
• restricted stock / performance shares
• perks
• golden parachutes
• benefits
• clawbacks
• stock ownership guidelines
• deferred payouts
Why equity pay is attractive
Equity ownership aligns incentives because managers benefit if share price rises. That is the core logic behind stock-based
compensation.
But equity pay also creates problems
This is examinable conceptually:
• can encourage excessive risk-taking
• can encourage earnings manipulation
• can distort information release
• can create incentives for option timing
• can weaken incentives if executives are allowed to hedge
• pledging shares creates margin call risk
• insider trading concerns arise when executives trade with private information
Know these terms:
• spring loading: granting options before good news
• bullet dodging: delaying grants until after bad news
• hedging: reducing downside risk, but also reducing incentives
, • pledging: using shares as collateral
• repricing/exchange offers: resetting underwater options to restore incentives
Benchmarking problem
Compensation is often benchmarked against peers. This can create a ratcheting effect: everyone targets median or above-median
pay, which keeps pushing pay up even without clear value creation.
5. International corporate governance
A firm’s governance system is shaped by its environment. Governance must fit the country and institutional setting.
Determinants of governance systems
1. Capital market efficiency
Efficient markets help set prices properly and discipline firms through the stock price. If markets are inefficient or underdeveloped,
firms depend more on families, banks, or governments, so governance relies more on alternative mechanisms.
2. Legal tradition / shareholder protection
Strong legal protection, especially for minority shareholders, reduces agency problems. Common-law systems were presented as
generally more shareholder-protective than civil-law systems. Stronger legal protection is associated with stronger governance and
often higher valuations.
3. Accounting standards
Reliable accounting standards reduce information asymmetry and improve monitoring. Good standards help only if they are
actually credible and implemented properly. Transparency is central to governance.
4. Enforcement of regulation
Rules on paper are not enough. Enforcement builds investor confidence. Weak enforcement means shareholders may need to
monitor more directly.
5. Societal and cultural values
Governance also reflects culture. Some systems are more shareholder-centric, others more stakeholder-centric. Cultural norms
shape what behavior is acceptable and what governance mechanisms are needed.
The same governance mechanism can work differently across countries because institutions, enforcement, accounting quality,
market development, and culture differ. Therefore, there is no one-size-fits-all governance model.
6. What counts as “strong governance” and how to measure it
How governance can be measured:
1. single mechanisms, such as board independence, board size, CEO ownership, pay-for-performance sensitivity
2. indices, which combine several governance provisions into one score, such as the G-index or other broader governance
measures
A “strong” governance system is not just one with more rules. It is one that is effective for that firm’s context. Measurement is
hard because:
• one measure may capture only one channel
• indices can be noisy or arbitrary
• governance is context-dependent
• “good” governance for one firm may not be optimal for another
So in an exam answer: mention specific governance proxies, mention indices, and add the caveat that governance quality is
difficult to observe directly.
Scandals like Tyco, Occidental, FTX serve as illustrations of governance failure: weak oversight, poor controls, conflicts of
interest, no functioning board, poor transparency.
8. Final exam-ready takeaways
