CORPORATE GOVERNANCE

Definition
• The term ‘CorporateGovernance’ has no single
formal definition, and is often therefore used
in a variety of differing ways.
• Generally speaking, however, the term is used
to describe a range of issues relating to the
ways in which companies may be directed and
controlled (CIMA, 2009).
 Definition
• Shleifer and Vishny (1997) define corporate governance by
stating that it “deals with the ways in which suppliers of
finance to corporations assure themselves of getting a
return on their investment”.
• John and Senbet (1998) propose the more comprehensive
definition that “corporate governance deals with
mechanisms by which stakeholders of a corporation
exercise control over corporate insiders and management
such that their interests are protected”.
• Zingales (1998) defines “corporate governance” as “the
complex set of constraints that shape the ex-post
bargaining over the quasi-rents generated by a firm”.
 The growing interest in corporate
governance?
• Countries that suffered dramatic reversals of
fortune during the Asian financial crisis have
identified weaknesses in corporate governance as
one of the major sources of vulnerabilities that
led to their economic meltdown in 1997 (ADB).
• Recent financial scandals associated to
accounting and other frauds allegedly blamed to
top company managers (e.g. Enron, Worldcom)
• Better corporate governance lead to better firm
performance
 Why corporate
governance is needed?
• A firm is viewed as a nexus of contracting
relationships.
• Every parties may pursue their self-interest.
• There is an agency problem, or conflict of
interest, involving members of the organisation
(contracting parties) – these might be owners,
managers, workers or consumers.
• Due to bounded rationality, conflict of interest
cannot be satisfactorily resolved by complete
contracting (i.e. incomplete contract).
 Agency Problem Type 1
• Capitalism is a good economic system because it
can provide rewards for those who work hard
through the accumulation of personal wealth (i.e.
property right)
• When the firm were becoming so large, the
ownership and control was separated. That is, the
stockholder own the firm while executive control
the firm. This situation comes because hundreds
of thousands of investors who own public firm
could not make the daily decision of the firm and
therefore hire managers for that work.
 Agency Problem Type 1
• Separation of ownership and control lead to
conflict of interests between manager and
shareholder.
• Type: effort, horizon, differential risk
preference and asset use (see Byrd et al. 1998)
 Agency Problem Type 2
• Unlike in companies in the USA and UK, whose shares
are diffusely held, in a typical Asian corporation one or
several members of a family tightly hold shares.
• The company is often affiliated with a business group
also controlled by the same family, with the group
consisting of several to numerous public and private
companies.
• The family achieves effective control of the companies
in the group by means of stock pyramids and cross-
shareholdings, which can be quite complicated in
structure.
 Agency Problem Type 2
• Conflict of interest between majority and
minority shareholder
• Examples of the expropriation of minority
shareholder (tunnelling of Johnson et al, 2000):
expropriation of corporate opportunities from a
firm by its controlling shareholder, transfer
pricing favoring the controlling shareholder,
transfer of assets from a firm to its controlling
shareholder at non-market prices, loan
guarantees using the firm’s assets as collateral,
and so on.
 Agency Problem Type 3
• The issue of ownership and firm value is more
complicated when the state is the controlling
owner.
• The state is not the ultimate owner but the
agent of the ultimate owners - the citizens.
• Lead to “agent watch agent problem” or “who
monitors monitor”
 Agency Problem Type 4
• Family businesses are usually more complex in
terms of governance than their counterparts due
to the addition of a new variable: the family.
• The family—as the business owner—shows the
highest dedication in seeing its business grow,
prosper, and get passed on to the next
generations. As a result, many family members
identify with the company and are usually willing
to work harder and reinvest part of their profits
into the business to allow it to grow in the long
term.
 Agency Problem Type 4
• In his classic book The Wealth of Nations,
Adam Smith (1776) argues that:
• “ The directors of such [joint-stock] companies
however, being the managers of other
people’s money rather than of their own, it
cannot well be expected that they should
watch over it with the same anxious vigilance
with which partners in a private copartnery
frequently watch over their own “
 Agency Problem Type 4
• Many of family business fail to be sustainable in the
long term. Indeed about two-thirds to three-quarters
of family businesses either collapse or are sold by the
founder(s) during their own tenure. Only 5 to 15
percent continue into the third generation in the hands
of the descendents of the founder(s).
• Unlike in other types of businesses, family members
play different roles within their business, which can
sometimes lead to a non-alignment of incentives
among all family members (i.e. Family conclict).
Corporate Governance Mechanism
• External disciplining mechanisms
• Internal disciplining mechanisms
 External disciplining mechanisms
• The market for corporate control
• The managerial labour market and the role of
reputation
• Product-market competition
• The legal environment
• Auditor
• Security analyst
• Investment bank
• Creditors
• Government
• Media
 Internal disciplining mechanisms
• Large shareholders
• Management ownership
• Board of director (Board of commissioner)
• Executive compensation
• Debt policy
• Dividend policy