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Corporate Governance

Kenneth Kim

&

John Nofsinger

2th Edition

Pearson Prentice Hall

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Chapter 1

Corporations and Corporate Governance

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Chapter overview:

Forms of Business Ownership

Separation of Ownership and Control

Can Investors Influence Managers?

An Integrated System of Governance

International Monitoring

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Forms of Business Ownership

Three general types of business ownership:

Sole proprietorship

Partnership

Corporation

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Comparison of three forms

Sole proprietorship Partnership Corporation

Business owner Single owner Partners Shareholders

Owner’s liability Unlimited Unlimited Limited

Easy access to capital market?

No No Yes

Is management and ownership separate?

No No Yes

Are business owners exposed to double taxation?

No No Yes

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Pros and Cons of Corporations

Pros:Easy access to capital markets

Infinite life unless go bankrupt or merged by others

Owners have limited liability

Liquid corporate ownershipCons:Shareholders are exposed to double taxation

Costs of running a corporation is relatively high

Corporations suffer from potentially serious governance problems.

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Separation of Ownership and Control

The thousands, or more, investors who own public firms could not collectively make the daily decisions needed to operate a business. Therefore:

The shareholders are owners of the firm

The officers (or executives) control the firm

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Principal-agent problem

Principal—shareholders Agent—managers Principal-agent problem represents the

conflict of interest between management and owners. For example if shareholders cannot effectively monitor the managers’ behavior, then managers may be tempted to use the firm’s assets for their own ends, all at the expense of shareholders.

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Solutions to Principal-agent problem

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.

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Can Investors Influence Managers?

Some inactive shareholders will go along with whatever management wants.

Some active shareholders have tried to influence management, but they are often met with defeat.

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Monitors

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

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Figure 1.1

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Inside monitors-Board of directors

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.

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Outside monitors

Interact with the firm and monitor manager activities– Auditors– Analysts– Bankers– Credit agencies– Attorneys

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Government monitors

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

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Other monitors

Market forces Stakeholders Creditors Employees Society

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An Integrated System of Governance

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International Monitoring

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

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Summary

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.