Corporate Governance Summary

Lecture 1 – Corporate Governance

What is corporate governance?
- Deals with the relationships among various participants in determining the directions
and performance of corporations
- The system by which companies are directed and controlled
- Deals with the ways in which suppliers of finance to corporations assure themselves of
getting a return on their investment
- What corporate governance is not:
o Not about management, but about the control and direction of managers
o Not just regulation/code
o Not a faith/belief

Why corporate governance?
- Better corporate performance, economic efficiency and social welfare
- Ensure good decision making: good management, good investments
- Create checks & balances and prevent abuse of power
- Diminish corporate failures & scandals
- Better access to finance, lower cost of capital

How does governance take place – Corporate governance mechanisms
- Internal (firm-oriented)
o Ownership structure
o Board structure
o Compensation structure
- External (market-oriented)
o Capital market / Analysts, Auditors
o Takeover market
o Debt market / Creditors
o Product market / Competitors
o Labor market
o Regulation
- In addition to these formal mechanisms, some informal governance mechanisms also
exist:
o Codes
o Social norms
o Reputation & trust

Theories related to corporate governance
- Agency Theory



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, o Organizations are characterized by one party, the principal, delegating work to
another party, the agent
o In context of a corporation:
 Owners (principal) hire managers (agent) to run the firm in exchange for
an agreed compensation
o Parties join to do business but have conflicting interests: potential risk of
managers acting in their own interest at the expense of the owners
 Agency problems arise
o Conflict of interest becomes important because only one party bears the cost
o Owners therefore need to:
 Monitor the managers
 Find ways to align interests
o Since a corporation has stakeholders other than just owners and managers,
different types of agency problems arise
- Information asymmetry theory
o Agency theory cannot alone explain human behavior
o Owners and managers experience asymmetric information between them
o It creates two types of information problems:
 Adverse selection (i.e. hidden knowledge)
 Owner know less about the capabilities of a manager who knows
herself more
 Occurs before the principal takes the decision, i.e. employ the
manager  wrong managers might be selected
 Partly solved through screening or monitoring incoming applicants
 Moral hazard (i.e. hidden action)
 Activity of managers cannot be observed by owners
 Occurs after the decision, i.e. manager is employed
 Managers can be given incentives to share some of shareholders
risks
- Stakeholder theory
o Takes account of a wider group of constituents rather than focusing on
shareholders
 Focus usually on shareholders based on interest in resources being used
to maximum effect; should benefit society as a whole
o Stakeholder – any individual or group on which the activities of the company
have an impact  unclear protection of their rights
o Shareholder – entity that owns shares in a company  rights protected by law
 Can be part of the stakeholders
o Stakeholders (apart from shareholders) include:
 Employees
 Interest in company – provide their livelihood
 Concerned with pay/working conditions
 Customers

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