CORPORATE

GOVERNANCE

Kenneth Kim,
John Nofsinger &
Derek Mohr

3rd Edition
Pearson Prentice Hall

CHAPTER 1Corporations and Corporate Governance

 Chapter overview:
2

Forms of Business Ownership

Separation of Ownership and Control
Can Shareholders Influence Managers?
An Integrated System of Governance
International Monitoring
 Forms of Business Ownership
3

Four general types of business ownership:

Sole proprietorship
Partnership
Limited Liability Company (LLC)
Corporation
 Comparison of three forms
4

Sole Partnership LLC Corporation

proprietorship
Business owner Single owner Partners Members Shareholders

Owner’s liability Unlimited Unlimited Limited Limited

Easy access to No No No Yes
capital market?
Is management No No In Some Yes
and ownership Cases
separate?
Are business No No No Yes
owners exposed
to double
taxation?
 Pros and Cons of Corporations
5

Pros:
Easy access to capital markets (if public corp.)
Infinite life unless go bankrupt or merged by
others
Owners have limited liability
Liquid corporate ownership
Cons:
Shareholders are exposed to double taxation
Cost structure of running a corporation is higher
than simpler forms
Corporations suffer from potentially serious
governance problems.
 Separation of Ownership and Control
6

The thousands, or more, investors who own

public corporations could not collectively make
the daily decisions needed to operate a business.
Therefore:

The shareholders are owners of the firm

The shareholders elect directors to act as their
agents in supervising the firm
The directors appoint officers (or executives) to
actually run the firm on a day-to-day basis
 Principal-agent problem
7

 Principal-agent problem represents the conflict of

interest between the principal and the agent.
 Primary principal-agent problem in corporations:
Principal = ShareholdersAgent = Officers If
shareholders cannot effectively monitor the
officers’ behavior, then officers may be tempted
to use firm’s assets for their own personal use.
 Related principal-agent problems: Shareholders
controlling Directors Directors controlling Officers
 Solutions to Principal-agent problem
8

Incentives—aligning executive incentives with

shareholder desires.
e.g. stock, restricted stock, and stock options.
Monitoring—setting up mechanisms for
monitoring the behavior of managers.
 Can Shareholders Influence Managers?
9

 Shareholders do not directly hire/fire managers – so they

can’t vote to replace them
 Shareholders can influence managers indirectly through
the board of directors
 Changing board members can be difficult as management
controls the process and some inactive shareholders will
go along with whatever management wants.
 Some “active” shareholders are large enough to try and
influence management or change the board, but they are
often met with defeat.
 Monitors
10

 Monitors are called for because managers may

not act in the shareholder’s best interest.
 Figure 1.1 shows that monitors exist:

inside the corporate structure

Board of directors
outside the structure
Auditors, analysts, bankers, credit agencies, and attorneys
in government
SEC, and IRS
 Figure 1.1
11
 Inside monitors-Board of directors
12

 Oversee management and are supposed to represent

shareholders’ interests.
 Evaluates management and design compensation
contracts to tie management’s salaries to the firm’s
performance.
 Outside monitors
13

 Interact with the firm and monitor manager

activities
 Auditors
 Analysts
 Bankers
 Credit agencies
 Attorneys
 Government monitors
14

 The SEC regulates public firms for the protection

of public investors
 The SEC also makes policy and prosecutes
violators in civil courts.
 The IRS enforces the tax rules to ensure
corporations pay taxes.
 The Sarbanes-Oxley Act of 2002
 Other monitors
15

 Market forces
 Stakeholders
 Creditors
 Employees
 Society
 An Integrated System of Governance
16
 International Monitoring
17

 Important differences occur between the types of

monitoring and incentive used in other capitalist
countries and the U.S. due to:
 Different compensation contracts
 Different accounting standards
 Different institutional investing environment
 Bank-oriented or capital markets-oriented
 Different legal environment
 Summary
18

 The corporations, probably the most important business form,

generate approximately 90 percent of the country’s revenue.
 Separation of ownership and control causes the agency
problem.
 Possible solutions to Principal-agent problem are incentives
and monitoring.
 The corporate system has interrelated incentives.