Introduction to corporate governance

Firm Theory and Corporate Governance

Aleksandra Gregorič

Associate Professor
Department of Strategy and Innovation
Copenhagen Business School
ag.si@cbs.dk

Lecture 1, Copenhagen, 30.1.2023

ALEKSANDRA GREGORIČ
ASSOCIATE PROFESSOR, PhD.
E-mail: ag.si@cbs.dk
Research topics:
Department of Strategy and Innovation • Gender inequality in the upper echelons
Center for Corporate Governance • Labor participation in corporate governance and decision making
Copenhagen Business School • Nordic corporate governance model
• Corporate governance and firm internationalization

Aleksandra Gregorič works as Associate Professor at Department of Strategy and Innovation, Copenhagen Business School (CBS). She is also affiliated with
the Center for Corporate Governance at CBS. Aleksandra holds a PhD in Economics from University of Ljubljana (Slovenia) and a Master degree in Economics
and Banking from University of Siena (Italy). During her studies she spent two semesters at European Center for Advanced Research in Economics and
Statistics (ECARES), Universite Libre de Bruxelles, and one semester at Stockholm School of Economics (Sweden). Her research focuses primarily on the
design and functioning of corporate governance mechanisms. In her work, she often adopts a sociological perspective to these issues, thus looking at how
corporate governance mechanisms and their impact on corporate outcomes (firm internationalization and labour relations in particular) depend on the
characteristics of the wider societal context in which firms operate. Her current research involves various topics concerning board of directors and director
labour market, such as workers’ participation on corporate boards and gender inequality in the upper echelons.

https://www.cbs.dk/en/research/departments-and-centres/department-of-strategy-and-innovation/staff/agrsi-0
Aim of the Course

• Objective of the course:

֍ provide the students with the knowledge such they will be able to contribute to the business decisions
concerning decision and governance structures in a corporation, as well as to detect potential agency
problems in an economic transaction and the solutions to these problems

֍ give a thorough understanding of the theory and develop ability to apply theory in practice

• This is an applied economics course that builds on and complements the courses in Corporate Finance,
Industrial Organization, and Applied Econometrics
 Learning Objectives
• to be able to discuss the concepts of incomplete contracts,
moral hazard, asymmetry of information etc. and critically
analyse the agency issues and their solutions in private
corporations
• to be able to identify the opportunities and potential pitfalls
in the use of incentive based remuneration as a tool to
motivate managers and to critically asses the efficiency of
various incentive schemes
• to be able to identify the benefits and downsides associated
with various types of structures, such as corporations with
concentrated ownership, family firms, etc. and to be able to
critically assess the specifics of these governance structures
in comparison to firms with dispersed ownership and control
• to be able to critically assess the structure of corporate
boards and discuss its implications for board behaviour and
firm performance
• to be able to identify and elaborate on the main barriers to
efficient functioning of the board of directors and other
corporate governance mechanisms (incentives, large owners,
legal rules, cognitive biases and emotions,..)
• to be able to critically discuss the influence/role of other
stakeholders the subsequent implications for the decision-
making in private corporations
• to be able to compare and evaluate the specifics of the
corporate governance systems across the world, to critically
assess selected elements of governance codes, and to be able
to apply these recommendations and the acquired
knowledge of corporate governance to real world cases
 Readings

• The course is based on academic papers and business cases

• The list of readings is provided in the syllabus, separately for
each session

• For introductory readings, you can consult for example

Goergen M. (2012), International Corporate Governance,
Pearson Education Limited

• 4 hour exam, including a HBS case

Case work, exam and feedback

• Cases and course feedback (course back TBA):

֍ During the course, we will discuss 3 business cases with the aim to apply the acquired
knowledge to business practice (2 are group presentations)
֍ Last 15 minutes for each class will be reserved for questions and answers
֍ Study questions will be provided for some of the readings
֍ One exam-type question as a homework after every lecture
֍ Active interaction in the discussion of the topics and applications to real examples in class
Agenda: Introduction to Corporate Governance

1. Defining corporate governance (CG)

• Traditional view of Corporate Governance
• Corporate governance and sustainability

2. Reconciling interests through CG: Key mechanisms

3. How should good corporate governance look like?

4. Current issues and Conclusion

Couse Overview
Main Course Topics

1. Agency issues and governance

2. Governance mechanisms: Rational-economic and
a. Incentives Behavioral approach
b. Ownership
Theory, empirical evidence and
c. Owner identity
cases
d. Board of directors
Shareholder value
3. Beyond the governance of large public corporations: Sustainability
a. Governance and financing of entrepreneurial firms

b. Corporate governance and the theory of the firm

What is corporate governance about?

“We define corporate governance as the control and direction of companies by

ownership, boards, incentives, company law, and other mechanisms. […]

It means setting the direction in which the company is going, its goals and
objectives, as well as controlling the implementation of theses goals.”
(Conyon and Thomsen, 2012)

DanskeBank_CEOreplacement

Family A.P. Møller Mærsk

Wirecard
 Corporate Governance: Introductory Discussion Enron

• What were the problems in Enron?

• What (other) factors contributed to the downfall of Enron?
• How would you describe J. Skilling?
• Who could have challenged then and how? Who ended up challenging them and
discovering the fraud?
• Why were top-level employees in Enron unchallenged by banks, investors, etc.?
• Can you think of a similar recent examples of companies or industries?
Corporate Governance: Introductory Discussion

• What are shareholders given voting rights and other

stakeholders not?

• Should companies have a social purpose?

• What do you understand by the world ‘governance’?

Agenda: Introduction to Corporate Governance

1. Defining corporate governance (CG)

• Traditional view of Corporate Governance
• Corporate governance and sustainability

2. Reconciling interests through CG: Key mechanisms

3. How should good corporate governance look like?

4. Current issues and Conclusion

Traditional View: Shareholders provide capital but they delegate control of these funds to the management
…act as providers of capital (i.e. have funds available to invest)
Shareholders …by being investment specialists, they diversify their investments, which results in a lower cost of capital
…are able to finance large projects
…reduce the risk exposure of managers and entrepreneurs ( more projects become valuable)

Capital

…have ideas and capabilities

What do shareholders really know
about what is going on within the firm Executives (managers)
they have invested in?

FIDUCIARY DUTY
BUSINESS JUDGMENT RULE
Dividends?

and Information?
A standard representation of a situation with conflicting interests
and asymmetric information is the principal-agent model

• Principal (shareholders) hires the agent (manager) to fulfill a certain task based on a contract

• CONFLICT OF INTERESTS:
֍ The agent dislikes effort although higher effort leads to higher outcome, which is beneficial for the principal
֍ The agent might also prefer suboptimal level of risk, or follow specific types of investments that provide some
private benefits to the agent

• INFORMATION ASYMMETRY: The principal cannot fully observe agent’s behavior and the agent holds superior
information

• INCOMPLETE CONTRACTS AND OPPORTUNISTIC BEHAVIOR: The principal knows that the agent might exploit
information asymmetries to their own benefit but also cannot write a contract that would instruct/restrain the agent
in every future instance
Conflicting Interests?
Examples of the managers behaving against the
interest of the shareholders:

Adam Smith, The Wealth of Nations (1776): • value-destroying investments and other
strategic decisions,
“The directors of joint-stock companies, however, being the managers
rather of other people’s money than of their own, it cannot well be • insufficient effort
expected, that they should watch over it with the same anxious • managerial theft
vigilance with which the partners in a private co-partnery frequently • empire building
watch over their own. Like the stewards of a rich man, they are apt to
• financial misreporting, fraud
consider attention to small matters as not for their master’s honor, and
very easily give themselves a dispensation from having it. Negligence
and profusion, therefore, must always prevail, more of less, in the
management of the affairs of such a company”.
The assumption that managers don’t have the same interests as the
shareholders still holds… https://www.bbc.com/news/business-46321097
 Summary: In settings with diverse interest, asymmetric information and principals’ inability to
write and enforce complete contracts, the principals are exposed to the agency problem

Divergence of interest P (A) (dis)likes efforts of A

Financing & Delegation of AGENCY PROBLEM: the

tasks principal cannot ensure that
the agent will perform the task
P A as stipulated in the contract
Information asymmetries P cannot observe actions of A

Implications: Output is lower

than in a setting where actions
are fully observed and
enforced

Inability to write “good” contracts Actions of A are not enforceable

A misalignment between manager and shareholder interests affects firm value…
Cash flows Balance Sheet of a Firm Cost of capital

Debt  Cost of debt

 Assets produce  Cost of

The (fundamental) cash flows, but this
Preferred Stock
preferred stock

WACC
comes the cost of Assets
firm value is financing these Retained
assets earnings
determined by…  Cost of equity
Paid-in capital

E[FCF1 ] E[FCF2 ] E[FCF3 ]

Basic Valuation Equation: V0 = + + + ...
(1 + WACC ) (1 + WACC ) (1 + WACC )3
1 2

Direct: reducing cash flows for investors Indirect: higher cost of capital
due to due to
Agency costs • suboptimal risk-sharing • external monitoring activities (done by
• suboptimal investment decisions shareholders)
affect firm value • tunneling or even theft
by… • costs of internal monitoring and controlling • the inability to attract “cheap” outside
activities (activities of the supervisory capital
board, but also hiring a rating agency to
signal creditworthiness)
 Corporate Governance in the Contractual View of the Firm
Traditional view assumes that the contracts with other parties perfectly insulate these groups from any change in the firms’ production decisions
Building blocks:
Self-interested and opportunistic agents with potentially
conflicting interests, information asymmetries, bounded
rationality
• Corporate governance view the FIRM AS A NEXUS OF CONTRACTS
• Contracts between the various self-interested parties are
incomplete information asymmetries and bounded rationality
• We need mechanisms that govern the behaviour of the parties, so
that control is allocated in cases not predicted in the contract and
the incentives of the various parties are aligned towards the
realization of the set goals
• TRADITIONAL VIEW: The other parties in the nexus are protected
by their contracts (regulation), and the shareholders are the only
residual risk-bearers
• Increasing shareholder value = doing good to the society
The traditional view of CG focuses on shareholder protection following the
assumption that only the shareholders are the ones that bear residual risk

Capital is the starting point and a key resource

of every economic activity, shareholders get paid after everyone else
and bear the residual risk
Agent’s misbehavior is only costly for the shareholders

The rights/returns of the other providers of resources are

secured through regulation (government) and
possibility of sanctioning through class actions

“Corporate governance deals with ways in which suppliers of finance to corporations assure
themselves of getting return on their investments” (Shleifer & Vishny, 1997)
 Traditional view only holds in the world with no externalities, complete markets
and perfect competition
Should Board incorporate Sustainability in
• Certain types of owners (e.g., workers) might push for policies that
their Corporate Governance Practices?
benefit a specific group of stakeholders and do not align with
INSEAD Video
shareholder value maximization
• Common ownership and imperfect competition: (some) shareholders
will push other policies and shareholder value maximization

• Regulatory constrains are not fully efficient in making the corporations

bear the costs of the externalities (negative effects) that they cause to
the society
• Business firms are often pivotal actors in contributing to social misery
and environmental disasters rather than contributing to find solutions
for global world challenges
 Addressing Externalities/Imperfections: Not the responsibility of the firm?
• Friedman (1970): Individual shareholders should themselves individually engage in public welfare activities
if they are socially responsible or care about harming others, while the firm should keep maximizing profits

֍ Firm’s damage-inducing (benefits generating) activities are often inseparable from the production activities
(e.g. DuPont’s waste; Costco’s use of antibiotics in raising chickens, etc.), in which case the separation theorem
does not work, i.e. shareholders cannot easily replicate or undo the firm’s decision

֍ Not all shareholders my favor the shareholder-maximization policy, some might care about the externalities or
are directly affected by them

֍ Is there really a conflict between doing good and making profit? Alex Edmans TED talk

֍ https://ecgi.global/: Conversation with Alex Edmans

 Addressing Externalities: Shareholder Welfare Maximization?

• https://ecgi.global/
• Conversation with Oliver Hart
 Addressing Externalities and Imperfections? (Hart & Zingales, 2022)
• Hart & Zingales (2022): Firms should pursue SHAREHOLDER WELFARE
MAXIMIZATION (SWM) and not shareholder value maximization (SVM)

• Implementation challenges:

֍ Basic agency problem remains: how to make managers act in the interest
of (prosocial) shareholders?
֍ Is commitment to socially responsible investments restricting the
investors (funds’) access to financing?
֍ Different shareholders might have different social preferences: when will
the vote lead to social efficient outcome?
֍ When does a company have a comparative advantage in achieving social
goals? Unique technology of production that cannot be easily reversed;
market power; political pressure
֍ What issues should the shareholders be allowed to vote on?
֍ Too many proposals directing attention away from ordinary business?
Social Preferences of Key Stakeholders
Addressing Externalities: Activist CEOs, Activist Investors or Active State?

https://www.blackrock.com/americas-
offshore/en/literature/publication/blk-sustainability-mission-
statement-web.pdf

• Failure_GreenInvesting
ESG Investing Strategies and Challenges
• Negative Screening: excludes certain • How can we measure the human, environmental and social impact of
securities from investment critical investment decision?
consideration based on ESG criteria  Economist_ESGmeasures

• Divesting: removing stocks from a

portfolio based on mainly ethical, non-
financial objections to certain business
activities of a corporation
• Shareholder activism: efforts attempt to
positively influence corporate behavior
• Positive/Impact Investing: is the new
generation of socially responsible
investing making investments in
activities and companies believed to
have a positive social impact

• Inclusive Capitalism's Embankment Project

Broad View of Corporate Governance: CG is also about reconciliation of conflicts of
interests of ALL those contributing relevant resources to the firm, directing them towards
the strategic direction of the firm
• Corporate governance deals with the determination of the broad uses to which
organizational resources will be deployed and the resolution of conflicts among
the myriad participants in the organization (Daily et al., 2013).
• This task encompasses two main responsibilities:
֍ Setting the purpose of the corporation and the organization’s strategic direction
֍ Striking a dynamic equilibrium between the interests of the firms’ dominant coalition
and those of the other stakeholders who provide essential resources to the firm
֍ Proving incentives for firms to actively contribute to the solution of today’s world
problems ? (Scherer & Voegtlin, 2020)
Corporate Governance and Responsible Innovation (Scherer & Voegtlin, 2020)
Corporate Governance: Discussion Questions

1. What role does corporate play for businesses and society?

2. Why is it important for you to understand corporate

governance?
Who is interested in CG?
Interest group Interests

• Identifying possible corporate governance problems

Investors • Understanding the trade-offs of governance mechanisms

• Identifying different interest groups within and outside the firm

Managers and other • Understanding the trade-offs of governance mechanisms
Corporate Governance is of key employees • Identifying governance issues in other firms (clients, suppliers)
interest for…

• Understanding the trade-offs of governance mechanisms

Regulator • Addressing market failures
• Anticipating potential problems of regulatory initiatives

• Understanding the functioning of firms, the role of incentives, information

„Interested“
• Understanding the concept of agency, moral hazard, information asymmetry for
observers
other internal and external relationships, and the role of motivation (incentives)
and supervision
Indeed, CG is often a topic of debate…
Agenda: Introduction to Corporate Governance

1. Defining corporate governance (CG)

• Traditional view of Corporate Governance
• Corporate governance and sustainability

2. Reconciling interests through CG: Key mechanisms

3. How should good corporate governance look like?

4. Current issues and Conclusion

 Self-interested managers (entrepreneurs) might behave opportunistically when
managing investors’ money …

The action is not

observable by the investor
(information asymmetry)

Assume A=0 and the project NPV>0 only when manager (entrepreneur) puts high effort (phR>I)
The investor can motivate the manager to choose high level of effort by sharing part of
the returns with him ..

Investor receives less than the full return R, as part of R is shared

with the manager
 Implication 1: Investors can align the agents’ interests by sharing part of profits
(INCENTIVES)
That is, managers’ earnings generally depend on how the return that the shareholder get from the firm:
• Variable compensation for executives
• Market for managers
• CEO replacement
Implication 2: Because of agency costs (and the need to align interests) some of the firms
with positive NPV projects might find it hard to obtain financing

Investors expected return ≥ Investments

(zero interest rates assumed)

Thus, although positive, where NPV does not exceed the amount
that needs to be paid to entrepreneur (manager) in order to align
incentives, the firm will not be financed
Implication 2 (cont.): Firms with lower agency costs (B) are more likely to obtain
financing

• The lower is the B, the lower the part of return that investors needs to give back to the entrepreneur/manager
and more likely the entrepreneur/manager will obtain financing will his positive NPV project

• What firms have a relatively lower B?

֍ Firms with good reputational capital, good track record

֍ Firms in industries with lower scope for consumption of private benefits

֍ Firms that have mechanisms in place that prevent opportunistic behavior

 Investors can introduce mechanisms that monitor firm managers and prevent them from consuming B
thereby reducing their motivation to choose low effort
 Examples of such mechanisms is the board of directors, direct supervision (challenging) by large owners,
etc. (CORPORATE GOVERNANCE MECHANISMS)
Implication 3: The presence of investors who can monitor management reduced B and
facilitates financing (although not without costs)
Investors holding large shares of firm equity (blockholders) are those willing and able to
CONTROL the agents to prevent misbehavior

• Large owners emerge through concentration of ownership by individuals, firms,

families, institutional investors etc. or though mechanisms (takeovers) that
allow for the transfer of control rights to investors when a firm is
underperforming

Family A.P. Møller Mærsk

Copyright The Financial Times Limited 2020. All rights reserved.
Agenda: Introduction to Corporate Governance

1. Defining corporate governance (CG)

• Traditional view of Corporate Governance
• Corporate governance and sustainability

2. Reconciling interests through CG: Key mechanisms

3. How should good corporate governance look like?

4. Current issues and Conclusion

Corporate Governance: Mechanisms of Incentives and Control
Market for Largest Blockholder
Corporate Control Shareholder
meeting
Minority Blockholder

Minority shareholder

Court decision
Non-Executive Directors

Labor/ Product
Market Competition
Incentives Annual reporting
Public (Codes of best Auditors (GAAP)
practice), Media
Non-profit Executives
Organizations
Court decision

Covenants Creditors
We will look more carefully into three of these mechanisms during lectures

• Legal rules
• Takeovers
• Incentives: Executive compensation
• Control: Large owners (family, institutional)
• Board of directors
And only briefly discuss some of the others…

• Legal rules
• Takeovers
• Internal Control Systems
 Legal rules regulate behavior but also facilitate the implementation of other
CG mechanisms

REGULATORY STRATEGIES GOVERNANCE STRATEGIES

Agent’s Affiliation terms Appointment Decision rights Agent Incentives
Constraints decisions
EX – ANTE RULES ENTRY SELECTION RATIFICATION TRUSTEESHIP

EX-POST STANDARDS EXIT REMOVAL VETO REWARD

The efficacy of the regulatory strategies depend on the

The efficacy of the governance strategies depends on
ability of external authority to enforce these strategies.
the ability of the principals to exercise control according
to them, and on the background legal rules
Examples of legal rules that are relevant for CG
REGULATORY STRATEGIES
GOVERNANCE STRATEGIES:
Rules:
Dividend restrictions, minimum capitalization requirements, takeover –rules, proxy
• Selection and removal of directors
voting rules
• Decision rights, i.e. the right to initiate and ratify management decisions

Standards:
Standards regulating self-dealing transactions, insider trading, requirement for
“acting in good faith” (ex-post verification of compliance necessary)
Entry-Exit regulation:
Disclosure requirements, i.e. prospectus requirements, rights of share transfers,
appraisal rights
• Sharing rule (i.e. equal treatment of shareholders holding the same share
class)
• Facilitation of the establishment of reward systems
• Facilitation of “trustee” relations, i.e. the role of independent director,
auditor (which count no the reputation effects)

Enforcement: Public enforcement (e.g. courts, SEC, organs of the state; ex-ante Regulatory strategies are prescriptive, i.e. they dictate
and ex-post); private enforcement (e.g. shareholders’ derivative suit, class actions, substantive terms that govern the content of the principal-
private parties enforcement through reputational sanctions; mostly ex-post);
agent relationship, while governance strategies aim to facilitate
Gatekeeper control (e.g. accountants)
the principals’ control over the agents
Disclosure
Takeovers allow for a change of control…and management
• The firm is subject to takeover threat when underperforming: the share price can be increased if the new owners
replace the management

• In the takeover, the raider firm makes an offer to buy all or a fraction of the outstanding shares at tender price

• Hostile takeovers lead to the replacement of underperforming management (change of control)

• However, takeovers are a rather costly mechanisms

֍ Most of the rents might accrue to the target shareholders in order for them to sell (e.g. Grossman and Hart, 1980)

֍ Managers of the target firms can resist takeovers by implementing takeover defenses, such as poison pills and staggered
boards (entrenchment or current shareholders’ bargaining?)

• Note: When stock market prices deviate from the fundamental values, they cannot be taken as a reliable guide for the
efficient allocation of control
Agenda: Introduction to Corporate Governance

1. Defining corporate governance (CG)

• Traditional view of Corporate Governance
• Corporate governance and sustainability

2. Reconciling interests through CG: Key mechanisms

3. How should good corporate governance look like?

4. Current issues and Conclusion

Countries provide recommendations on how the CG mechanisms should be devised
GOOD PRACTICE recommendation for the mechanism (focus is on the maximization of shareholder returns):
• Recommendations on how to provide the shareholders with sufficient rights to participate and vote at the
assembly
• Recommendations for the firms to implement one-share-one–vote structure, disclosure requirements, etc.
• Transparency of the large blockholders’ actions, disclosure of owners’ identity and intentions
• Use of stock-option and other performance-based compensation to incentivize managers
• Independent directors for the objectivity of board of directors, no CEO-chair duality, diversity

• For more examples of good practice, see CORPORATE GOVERNANCE CODES at the European Corporate
Governance Institute web-site
 Is there a one size-fits-all corporate governance system?

• It is unlikely that a single set of practices exist for all firms across the various countries, although some
basic standards largely apply to all

• Differences in what is considered ‘optimal’ governance exists also across the companies within the
same country, depending on the industry, strategic life cycle, role of human capital, etc.

• In one of the lectures we will indeed look at how the design of corporate governance will change as a
company grows from a start-up to the IPO, mature publicly listed company etc.

• The design of the corporate governance mechanisms might also differ depending on the size and
identity of the largest owners, firms’ strategic objectives and demands (e.g., restructuring)
Is there a one size-fits-all corporate governance system?
• In order to function properly, CG mechanisms need to be understood, accepted and enforced

• The organizational culture and the broader social/institutional contexts play an important role in this regard

• The same mechanisms of corporate governance (e.g., high incentives for the CEO) might not work equally well
across the different social contexts and might even backfire

• Focusing on the analysis of a single mechanism of CG without considering the broader context may lead to
wrong conclusions on the efficiency of this mechanism

• It is important what kind of issues each of the corporate governance mechanisms aims to address, to
understand the extent to which these issues apply to the specific firm and to also consider how a specific CG
mechanism relates to other CG mechanisms in the firm (country) and the eventual negative side-effect it
might create
Agenda: Introduction to Corporate Governance

1. Defining corporate governance (CG)

• Traditional view of Corporate Governance
• Corporate governance and sustainability

2. Reconciling interests through CG: Key mechanisms

3. How should good corporate governance look like?

4. Current issues and Conclusion

Open challenges of CG
• Sustainable governance

• Complexity of human behavior and social influences (behavioral corporate governance)

• Comparative corporate governance: CG across countries, multinational business group governance

• Fintech, crowdfunding and governance of startups

• Platform governance

• Owner heterogeneity, common ownership

• Inclusion and diversity

Concluding points
• Corporate Governance is a complex and dynamic system that involves the interaction of a diverse set of
constituents, all of whom play a role in monitoring and shaping the behavior of firm managers and other key
constituencies with influence in the firm

• The approaches and theoretical lenses differ in relation to the relevance they attribute to the various
constituencies, with an increasing focus on governing the social and environmental effects of corporations

• Focusing on the analysis of a single mechanism of CG without considering the other mechanisms in the firm
and the broader context may lead to wrong conclusions on the efficiency of this mechanism

• Agents and principals are humans: they make errors in judgement and might not always behave as the classical
economic theory predicts
 Homework

• Check the site of EUROPEAN CORPORATE GOVERNANCE INSTITUTE (https://ecgi.global/)

• Check the Danish Corporate Governance Code Danish CG recommendations

• Have a look at the Remuneration policy and elements of CEO pay at Danske Bank

Remuneration Policy Danske Bank

Example of executive leadership compensation (Danske Bank)
Example of executive leadership compensation (Danske Bank)