Corpt Governance VII

8/7/2019 Corpt Governance VII

1/42

E & C G

Corporate GovernanceVII

1


2/42

Corporate governance issue- as old as

economics

The directors of companies, beingmanagers of other peoples money, cannot be

expected to watch over it with the same

vigilance with which they watch over their

own ( Adam Smith 1776 )

2


3/42

Agenda What is Corporate Governance?

Agency Problems

Governance mechanisms

Why do Governance Mechanisms Fail?

Some Governance Frame works Indian regulatory frame work

3


4/42

What is Corporate Governance?

Corporate governance is the system by which

companies are directed and controlled (Cadbury,

1992)

Corporate governance is about nurturing an

enterprise while ensuring accountability in the exercise ofpower and patronage by firms (world Bank, 1999)

4


5/42

Separation of Ownership and managerial Control

Basis of Modern Corporation

Shareholders purchase stock, becoming residual

claimants

Shareholders reduce risk by holding diversified

portfolios

Professional managers are contracted to providedecision making , operations

5


6/42

Modern public corporation form leads to efficientspecialization of tasks:

Risk bearing by shareholders

Strategy development and decision making by

managers

The vital link between shareholders and the managersTHE BOARD. The task-- strategy, directions ,control.

One major issue. Does the board represent only the

share holders or all stakeholders? Do they represent only the dominant share holder(s) or

all the share holders ?

6


7/42

An Agency Relationship

Managers (Agents)

DecisionMakers

Shareholders (Principals)Firm Owners

An Agency Relationship

Risk Bearing Specialist (Principal)

Paying Compensation toAManagerial decision-making

specialist agents

Hire

and create

7


8/42

Asymmetry of information

Managers have all the information

Selective release of information

Incomplete release of information

Share holders always at a disadvantage

8


9/42

Agency Relationship Problems

Principal and agent have divergent interests and

goals

Shareholders lack direct control of large, publicly

traded corporations

Agent makes decisions that result in the pursuit

of goals that conflict with those of the principal

It is difficult or expensive for the principal toverify that the agent has behaved appropriately

Agent falls prey to managerial opportunism

9


10/42

Managerial Opportunism

The seeking of self-interest with guile (cunning

or deceit)

Managerial opportunism is: An Attitude (inclination)

A set of behaviors (specific acts of self-interest)

Managerial opportunism prevents themaximization of shareholder wealth (the

primary goal of owner/principals)

10


11/42

Response to Managerial Opportunism

Principals do not know beforehand which

agents will or will not act opportunistically

Thus, principals establish governance andcontrol mechanisms to prevent managerial

opportunism

11


12/42

Examples of the Agency Problem

Possible Problems

- Product diversification

- Increased size and relationship of size to

managerial compensation- Reduction of managerial employment risk

Use of Free Cash Flows

- Managers prefer to invest these funds in

additional product diversification- Shareholders prefer the funds as dividends sothey control how the funds are invested

12


13/42

Agency Costs and Governance

Mechanisms

Principals may engage in monitoring behavior to

assess the activities and decisions of managers

- However, dispersed shareholding makes it

difficult and inefficient to monitor managements

behavior

Boards of Directors have a fiduciary duty to

shareholders to monitor management- However, Boards of Directors are often accused

of being lax in performing this function

13


14/42

Share holders dilemma

Cost of monitoring high and may be counter

productive

Lack of mechanism other than the Board toensure compliance

Too much control may curb risk taking which is

the very essence of managerial working

14


15/42

Governance Mechanisms

15


16/42

Internal Governance Mechanisms

Ownership Concentration Relative amounts of stock owned by individual

shareholders and institutional investors

Board of Directors Individuals responsible for representing the firms

owners by monitoring top-level managers strategic

decisions

The Firm16


17/42

Internal Governance Mechanisms

Executive Compensation

Use of salary, bonuses, and long-term incentives to alignmanagers interests with shareholders interests

The Firm

17


18/42

External Governance Mechanisms

Market for corporate Control

Purchase of a firm that is underperforming relative toindustry rivals in order to improve its strategic

competitiveness

The Firm

18


19/42

Governance Mechanisms

Ownership

Concentration (a)

Large Block shareholders have a

strong incentive to monitor

management closely:

- Their large stakes make it

worth their while to spend

time, effort and expense tomonitor closely

- They may also obtain Board

seats which enhances their

ability to monitor effectively

19


20/42

Governance Mechanisms (contd)

Ownership

Concentration (b)The increasing influence of

institutional owners (stock

mutual funds and pension

funds)

- Have the size and incentive(demand for returns to funds)

to discipline ineffective top-level

managers

20


21/42


Ownership

Concentration (c) Shareholder activism:

-Shareholders can convene to

discuss corporations direction

-If a consensus exists,

shareholders can vote as a block

to elect their candidates to the

board

21


22/42


Board of Directors

(a)

Board of directors

- Groups of elected individuals

that acts in the owners

interests to formally monitor

and control the firms top-levelexecutives

Board has the power to:

-Direct the affairs of the

organization

-Punish and reward managers

-Protect owners frommanagerial opportunism

Ownership

Concentration

22


23/42


Board of Directors

(b)

Composition of Boards :

- Insiders: the firms CEO and

other top-level managers

- Related Outsiders:

individuals Uninvolved with day-to-day operations, but who

have a relationship with the

firm

- Outsiders: individuals who are

independent of the firms day-

to-day operations and otherrelationships

Ownership

Concentration

23


24/42


Board of Directors

(c)

Criticisms of Boards of

Directors include:

-Too readily approve managers

self-serving initiatives

- Are exploited by managers

with personal ties to boardmembers

- Are not vigilant enough in

hiring and monitoring CEO

behavior

- Lack of agreement about the

number of and mostappropriate role of outside

directors

- Multiple directorships

Ownership

Concentration

24


25/42


Board of Directors

(d)

Enhancing the effectiveness of

boards and directors:

-More diversity in the

backgrounds of board members

- Stronger internalmanagement and accounting

control systems

- More formal processes to

evaluate the boards

performance

- Changes in compensation ofdirectors

Ownership

Concentration

25


26/42


Executive

Compensation (a)

* Forms of compensation:

- Salary, bonuses, long-term

performance incentives, stock

awards, stock options

Factors complicating executivecompensation:

- Strategic decisions by top-

level managers are complex,

non-routine and affect the firm

over an extended period

* Other variables affecting the

firms performance over time

Ownership

Concentration

Board of Directors

26


27/42


Executive

Compensation (b)

* Limits on the effectiveness of

executive compensation:

- Balance sheet not showing

executive wealth

- Options not expensed at the

time they are awarded

Ownership

Concentration

Board of Directors

27


28/42


Market for corporate

control (b)

* Managerial defense tactics

increase the costs of mounting a

takeover

Defense tactics my require:

-Asset restructuring-Changes in the financial

structure of the firm

- Shareholder approval

* Market for corporate control

lacks the precision of internal

governance mechanisms

Ownership

Concentration

Board of Directors

Executive

Compensation

28


29/42

Additional Governance Mechanisms

Debt holders

- Large debt holders can assume the role of active monitors

- When a firm defaults or violates debt covenants, the debtholders reserve a variety of control rights

- The need to make on going cash payments provides thefirm management with more incentives to operateefficiently to generate even more cash flow

Legal and Regulatory Mechanisms

Auditors

Banks and Analysts

Media and Public Activists

29


30/42

Why do governance mechanisms fail?

Shareholder concentration, identity and goals

- Principal-Principal goal incongruence

- Business Group structures (pyramidal, cross-

holdings)- Dual class equity shareholdings

Board Composition

- CEO and chairperson duality

- Inside/Outside director nomination andcomposition

Insider trading

30


31/42

International corporate governance

USA

Most ungovernable/ungoverned system

Philosophy demands no interventions External mechanism stock holder driven

worked

Repeated scandals SOX- emphasis on reporting

31


32/42

International Corporate Governance

Germany

- Owner and manager are often the same in

private firms- Public firms often have a dominant

shareholder, frequently a bank

- Frequently there is less emphasis on

shareholder value than in U.S. firms although

this may be changing

32


33/42


Germany: (Two-tiered Board)

Vorstand

Aufsichtsrat

Employees Union

members

Shareholders

Responsible for the functions of

direction and management

Responsible for appointing

members to the Vorstand

Responsible for appointing

members to the Aufsichtsrat

33


34/42

International Corporate Governance:

Japan

- Important governance factors:

* Obligation

* Family

* Consensus

- Banks (especially main bank) are highly

influential with firms managers- Keiretsus: strongly interrelated groups of firmstied together by cross-shareholdings

34


35/42


Japan (contd)

- Other governance characteristics:

* Powerful government intervention

* Close relationships between firms andgovernment sectors

* Passive and stable shareholders who exert

little control* Virtual absence of external market for

corporate control

35


36/42

Internal and External Governance Mechanisms:

A Global Perspective

External governance mechanisms

GermanyJapan

Canada

United States

United Kingdom

Internal

Governance

Mechanisms

weak

Weak

Strong

Strong

36


37/42

The Companies Act Disclosure of Interest,approval levels in organizations, corporateprocesses

Clause 41 of Listing Agreement with StockExchanges

Clause 49 of Listing Agreement with StockExchanges

Disclosure of price-sensitive information

SEBI Insider Trading Regulations

SEBI Takeover Regulations Regulations for Merchant Bankers,

Depositories, Debenture Trustees, Brokers,Mutual Funds, Venture Capital Funds

Sarbanes Oxley Act, 2002

Indian Regulatory Framework

37


38/42

Disclosure of Interest

Approval by shareholders

Approval by creditors

Approval by Company Law Board

Audit Committee

The Companies Act

A governance perspective

38


39/42

Furnish unaudited financial results on a quarterly basiswithin one month from the end of quarter to the stockexchanges

Make an announcement to the stock exchange where the

company is listed, immediately within 15 minutes of theclosure of the board meeting in which the unauditedfinancial results are placed

Number of investor complaints pending at the beginningof the quarter, received and disposed off during the quarter

and lying unresolved at the end of the quarter Announce the same within 48 hours of the conclusion of

the board meeting, in at least one English and one regionaldaily, where the registered office of the company is situated

Listing Agreement Clause 41

39


40/42

Board of Directors composition, compensation,Independent director, procedure, code ofconduct, term of office

Audit Committee qualified and independent,

meetings, powers & role, review of informationby Audit Committee, Audit Report & AuditQualification

Subsidiary companies

Disclosures related party transactions, boarddisclosures & risk management, proceedingsfrom IPOs, Remuneration of Directors,Management, Shareholders

CEO/CFO certification

Report on Corporate Governance

Listing Agreement Clause 49

40


41/42

Disclosure of price-sensitive information

SEBI Insider Trading Regulations

SEBI Takeover Regulations

Regulations for Merchant Bankers, Depositories,

Debenture Trustees, Brokers, Mutual Funds,

Venture Capital Funds

Sarbanes Oxley Act, 2002

Regulations - governance

41


42/42

Cases for the next class

Satyam from a corporate governance

perspective

Universal Engineering

Submit a one page (each ) report on the 2 cases.Work in groups

42

Documents

Corpt Governance VII