Faculty of Business

International
Finance
IBF301 – FPT UNIVERSITY
CHAPTER 4
Corporate Governance Around the
World
Content
1. The Agency Problem

2. Remedies for the Agency Problem

3. Law and Corporate Governance

4. Consequences of Law

5. Corporate Governance Reform

Chapter Objective:
This chapter discusses corporate governance structures, which varies a
great deal across countries, reflecting divergent cultural, economic,
political, and legal environments.
Corporate Governance
Corporate governance can be defined as the economic, legal, and institutional framework in
which corporate control and cash flow rights are distributed among shareholders, managers, and
other stakeholders of the company.

Other stakeholders may include workers, creditors, banks, customers, and even the government.

It is vitally important to strengthen corporate governance to protect shareholder rights, curb

managerial excesses, and restore confidence in capital markets.
 Corporate Governance
The central problem in corporate governance remains the same everywhere:
i. How to best protect outside investors from expropriation by the controlling insiders so that the investors can receive
fair returns on their investments.

ii. How to deal with this problem has enormous practical implications for shareholder welfare, corporate allocation of
resources, corporate financing and valuation, development of capital markets, and economic growth.

In the rest of this chapter, we will discuss the following issues in detail:
1. Agency problem

2. Remedies for the agency problem

3. Law and corporate governance

4. Consequences of law

5. Corporate governance reform

1. The Agency Problem
IBF301 – CHAPTER 4
The Agency Problem
Shareholders allocate decision-making
authority to the managers
◦ Residual control rights refer to the right to make
discretionary decisions under those contingencies
that are not specifically covered by a contract

Managers can exercise substantial discretion

over the disposition and allocation of
investors’ capital
◦ Investors are no longer assured of receiving fair
returns on their funds

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The Agency Problem (Continued)
With the control rights, managers may allow themselves to consumer exorbitant
perquisites
◦ E.g., private jets worth tens of millions of dollars

Managers may also steal investors’ funds

◦ E.g., transfer pricing scheme

Self-interested managers may also waste funds by undertaking unprofitable

projects that benefit themselves but not investors
Managers may also adopt antitakeover measures to ensure personal job security

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RESERVED. 4-9
2. Remedies for the
Agency Problem
IBF301 – CHAPTER 4
Governance mechanisms
Several governance mechanisms exist to alleviate or remedy the agency problem:

1. Independent board of directors

2. Incentive contracts

3. Concentrated ownership

4. Accounting transparency

5. Debt

6. Shareholder activism

7. Overseas stock listings

8. Market for corporate control

Remedies for the Agency Problem
Independent • In the U.S., shareholders have the right to elect the board of directors.
• If the board remains independent of management, it can serve as an effective mechanism for curbing the
board of directors agency problem.

• Many companies provide managers with incentive contracts, such as stocks and stock options, in order
Incentive to reduce this wedge and better align the interests of managers with those of investors.

contracts • With the grant of stocks or stock options, managers can be given an incentive to run the company in
such a way that enhances shareholder wealth as well as their own.

• An effective way to alleviate the agency problem is to concentrate shareholdings. If one or a few large
Concentrated investors own significant portions of the company, they will have a strong incentive to monitor
management.
ownership • With concentrated ownership and high stakes, the free-rider problem afflicting small, atomistic
shareholders dissipates.
• Strengthening accounting standards can be an effective way of alleviating the agency problem.
Accounting Basically, a greater accounting transparency will reduce the information asymmetry between corporate
insiders and the public and discourage managerial self-dealings.
transparency • To achieve a greater transparency, however, it is important for (i) countries to reform the accounting
rules and (ii) companies to have an active and qualified audit committee.
Remedies for the Agency Problem
• If managers fail to pay interest and principal to creditors, the company can be forced into bankruptcy
and managers may lose their jobs.
Debt • Borrowing can have a major disciplinary effect on managers, motivating them to curb private perquisites
and wasteful investments and trim bloated organizations.
• Excessive debt creates its own agency problems, however.

Shareholder • “Activist investors”, who invest in stocks of a company for the explicit purpose of influencing the
company’s management, started to play an import role in promoting shareholders’ interest.

activism • Pursue social and political agenda by promoting changes in companies’ environmental, social, and
governance practices

Overseas stock • Companies domiciled in countries with weak investor protection can bond themselves credibly to better
investor protection by listing their stocks in countries with strong investor protection (i.e., cross-listings)
listings • Studies confirm the effects of cross-border listings

Market for • The market for corporate control, if it exists, can have a disciplinary effect on managers and enhance

corporate control company efficiency.

3. Law and Corporate
Governance
IBF301 – CHAPTER 4
Law and Corporate Governance
Commercial legal systems of most countries derive from a relatively few legal
origins.
◦ English common law
◦ French civil law
◦ German civil law
◦ Scandinavian civil law

Thus the content of law protecting investors’ rights varies a great deal across
countries.
It should also be noted that the quality of law enforcement varies a great deal
across countries.

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4. Consequences of Law
IBF301 – CHAPTER 4
Consequences of Law
Protection of investors’ rights has major economic consequences.
These consequences include
◦ The pattern of corporate ownership and valuation.
◦ Development of capital markets.
◦ Economic growth.

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Ownership and Control Pattern
Companies domiciled in countries with weak investor protection may need to have concentrated
ownership as a substitute for legal protection. With concentrated ownership, large shareholders
can control and monitor managers effectively and solve the agency problem.

Dominant investors may acquire control through various schemes, such as:
1. Shares with superior voting rights

2. Pyramidal ownership structure

3. Interfirm cross-holdings
Ownership and Control Pattern
(Continued)
Large shareholders, who are often founders and their families, can use a
pyramidal ownership structure in which they control a holding company that
owns a controlling block of another company, which in turn owns controlling
interests in yet another company, and so on
Equity cross-holdings among a group of companies, such as keiretsu and
chaebols, can be used to concentrate and leverage voting rights to acquire
control

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RESERVED. 4-19
Private Benefits of Control
Once large shareholders acquire control rights exceeding cash flow
rights, they may extract private benefits of control that are not
shared by other shareholders on a pro-rata basis
◦ Studies demonstrate large shareholders tend to extract significant private
benefits of control in those countries where the rights of minority
shareholders are not well protected

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RESERVED. 4-20
Capital Markets and Valuation
Investor protection promotes the development of external capital markets.
When investors are assured of receiving fair returns on their funds, they will be
willing to pay more for securities.
Thus strong investor protection will be conducive to large capital markets.
Weak investor protection can be a factor in sharp market declines during a
financial crisis.

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Capital Markets and Valuation
(Continued)
Existence of well-developed financial markets, promoted by strong investor
protection, may stimulate economic growth by making funds readily
available for investment at low cost
Per Beck et al. (2000), financial development can contribute to economic
growth in three ways:
1. Enhances savings
2. Channels savings toward real investments in productive capacities, thereby
fostering capital accumulation
3. Enhances efficiency of investment allocation through monitoring and signaling
functions of capital markets
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RESERVED. 4-22
5. Corporate
Governance Reform
IBF301 – CHAPTER 4
Corporate Governance Reform
Scandal-weary investors around the world are demanding corporate
governance reform
◦ More than these companies’ internal governance mechanisms failed; auditors,
regulators, banks, and institutional investors also failed in their roles

Failure to reform corporate governance will damage investor

confidence, stunt the development of capital markets, raise the cost of
capital, distort capital allocation, and even shake confidence in
capitalism itself

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RESERVED. 4-24
Objectives of Reform
Strengthen the protection of outside investors from expropriation by managers
and controlling insiders.
Among other things, reform requires:
i. strengthening the independence of boards of directors with more outsiders,

ii. enhancing the transparency and disclosure standard of financial statements, and

iii. energizing the regulatory and monitoring functions of the SEC (in the United States) and
stock exchanges.
Political Dynamics
Reform is easier said than done
◦ It is not easy to change historical legacies, which produced the existing
governance systems
◦ Many parties have vested interests in the current system, and they will resist
any attempt to change the status quo

Reformers should understand the political dynamics surrounding

governance issues and seek help from the media, public opinion,
and nongovernmental organizations (NGOs)

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RESERVED. 4-26
The Sarbanes-Oxley Act
The U.S. Congress passed the Sarbanes-Oxley Act in July 2002. The key objective of the Act is
to protect investors by improving the accuracy and reliability of corporate disclosure, thereby
restoring the public’s confidence in the integrity of corporate financial reporting.

The major components of the Sarbanes-Oxley Act are:

• The creation of a public accounting oversight board charged with overseeing the auditing of
Accounting regulation public companies, and restricting the consulting services that auditors can provide to clients.

Audit committee • The company should appoint independent “financial experts” to its audit committee.

• Public companies and their auditors should assess the effectiveness of internal control of
Internal control assessment financial record keeping and fraud prevention.

• Chief executive and finance officers (CEO and CFO) must sign off on the company’s
Executive responsibility quarterly and annual financial statements. If fraud causes an overstatement of earnings, these
officers must return any bonuses.
The Cadbury Code of Best
Practice
British government appointed the Cadbury Committee in 1991 with the broad
mandate of addressing corporate governance problems in the U.K.
Committee issued its report in December 1992, including the Code of Best
Practice (i.e., Cadbury Code) in corporate governance, recommending:
1. BODs of public companies include at least three outside (nonexecutive) directors
2. Positions of CEO and COB be held by two different individuals

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RESERVED. 4-28
Cadbury Code
“The board should meet regularly, retain full and effective control over the
company and monitor the executive management. There should be a clearly
accepted division of responsibilities at the head of a company, which will ensure
a balance of power and authority, such that no one individual has unfettered
power of decisions. Where the chairman is also the chief executive, it is
essential that there should be a strong and independent element on the board,
with a recognized senior member. The board should include non-executive
directors of significant calibre and number for their views to carry significant
weight in the board’s decisions.”
The Dodd-Frank Act
U.S. Congress passed the Dodd-Frank Wall Street Reform and Consumer
Protection Act in July 2010, and key features include the following:
◦ Volker rule: Deposit-taking banks will be banned from proprietary trading and from owning
more than a small fraction of hedge funds and private equity firms
◦ Resolution authority: Government can seize and dismantle a large bank in an orderly manner
if the bank faces impending failure and poses a systemic risk to the broader financial system

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RESERVED. 4-30
The Dodd-Frank Act (Continued)
◦ Derivative securities: OTC derivatives trading will move to electronic
exchanges, with contracts settled through central clearing houses
◦ Systematic risk regulation: Systemically important financial firms will be
identified and monitored
◦ Consumer protection: A new, independent Consumer Financial Protection
Bureau will monitor predatory mortgage loans and other loan products

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RESERVED. 4-31
The Dodd-Frank Act (Concluded)
In May 2018, U.S. Congress passed a new law, the Economic Growth,
Regulatory Relief, and Consumer Protection Act, that significantly weakened
the Dodd-Frank Act
◦ Raises asset threshold for application of Dodd-Frank’s enhanced prudential standards from
$50 billion to $250 billion, exempting most small and mid-size banks and bank holding
companies from stress testing and heightened risk management requirements
◦ Banks and bank holding companies with assets of $10 billion or less are exempted from the
Volker Rule

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RESERVED. 4-32
Summary
IBF301 – CHAPTER 4
Summary
1. The public corporation, which is jointly owned by many shareholders with limited liability, is a major
organizational innovation with significant economic consequences. The efficient risk-sharing
mechanism allows the public corporation to raise large amounts of capital at low cost and profitably
undertake many investment projects, boosting economic growth.

2. The public corporation has a major weakness: the agency problem associated with the conflicts of
interest between shareholders and managers. Self-interested managers can take actions to promote their
own interests at the expense of shareholders. The agency problem tends to be more serious for firms
with excessive free cash flows but without growth opportunities.

3. To protect shareholder rights, curb managerial excesses, and restore confidence in capital markets, it
is important to strengthen corporate governance, defined as the economic, legal, and institutional
framework in which corporate control and cash flow rights are distributed among shareholders,
managers, and other stakeholders of the company.
Summary
4. The central issue in corporate governance is: how to best protect outside investors from expropriation by managers and
controlling insiders so that investors can receive fair returns on their funds.

5. The agency problem can be alleviated by various methods, including (a) strengthening the independence of boards of
directors; (b) providing managers with incentive contracts, such as stocks and stock options, to better align the interests of
managers with those of shareholders; (c) concentrated ownership so that large shareholders can control managers; (d)
using debt to induce managers to disgorge free cash flows to investors; (e) listing stocks on the London or New York
stock exchange where shareholders are better protected; and (f ) inviting hostile takeover bids if the managers waste funds
and expropriate shareholders.

6. Legal protection of investor rights systematically varies across countries, depending on the historical origin of the
national legal system. English common law countries tend to provide the strongest protection, French civil law countries
the weakest. The civil law tradition is based on the comprehensive codification of legal rules, whereas the common law
tradition is based on discrete rulings by independent judges on specific disputes and on judicial precedent. The English
common law tradition, based on independent judges and local juries, evolved to be more protective of property rights,
which were extended to the rights of investors.
Summary
7. Protecting the rights of investors has major economic consequences in terms of corporate ownership
patterns, the development of capital markets, economic growth, and more. Poor investor protection
results in concentrated ownership, excessive private benefits of control, underdeveloped capital
markets, and slower economic growth.

8. Outside the United States and the United Kingdom, large shareholders, often founding families, tend
to control managers and expropriate small outside shareholders. In other words, large, dominant
shareholders tend to extract substantial private benefits of control.

9. Corporate governance reform efforts should be focused on how to better protect outside investors
from expropriation by controlling insiders. Often, controlling insiders resist reform efforts, as they do
not like to lose their private benefits of control. Reformers should understand political dynamics and
mobilize public opinion to their cause.
Thank you for your attention!

END OF CHAPTER