CORPORATE GOVERNACE Flashcards
Name three trade-offs in the financial system
(1) Trade-off 1 (Innovation vs. Volatility): Innovative development of new instruments and new markets for risk handling creates rapidly growing possibilities to efficiently reallocate ever more specific risks, but also new challenges regarding market volatility
(2) Trade-off 2 (Deregulation vs. Risk-taking): Dynamic development of globally integrated, highly competitive financial markets and deregulation are pivotal factors behind the very high growth rates, but it may create financial instability through excessive risk-taking by financial institutions
(3) Trade-off 3 (Reduced cost of intermediation vs. Lack of monitoring): The rise of index investing has reduced the costs of intermediation. However, cost considerations and agency problems of index fund managers have a negative impact on stewardship activities (monitoring of public companies).
Why financial systems are important?
Financial systems are crucial to the allocation of resources in a modern economy. They channel household savings to the corporate sector and allocate investment funds among firms; they allow intertemporal smoothing of consumption by households and expenditures by firms; and they enable households and firms to share risks.
What is Corporate Governance?
Corporate Governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on investment
What is the Corporate Governance Problem?
The directors of such companies, however, being the managers of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. /A.Smith/
What are Corporate Governance Tools?
Laws and Regulations Incentives/Motivation Monitoring/Reporting Reputation State Ownership
Describe Corporate Governance System
• Legal system – protection of property rights - Legal origin and tradition - Corporate law - Court system - Corporate charter - Fiduciary duty • Public regulation and supervision - Extra-legal rules and supervision - Listing and information requirements - Governance codes • Ex ante information systems and rules - Protection of minority interests • Ex post audit systems and regulation • Openness of society - Free press - Voice of claimholders - Level of corruption - International competition • Political system, quality and culture of civic society - Distribution of power, and political history
What is Fiduciary duty?
A legal term describing the relationship between two parties that obligates one to act solely in the interest of the other. The party designated as the fiduciary owes the legal duty to a principal, and strict care is taken to ensure no conflict of interest arises between the fiduciary and his principal.
Name three Types of Agency Problems
(1) Shareholders vs. Managers
- > Incomplete contracts
- > Private benefits of control
- > Boost own reputation rather than value of the firm
(2) Large shareholders vs. Minority Shareholders
- > Family interests, appointing family members to the board, etc.
(3) State as a Shareholder vs. Other Shareholders
- > Social welfare, protectionist motives, political agenda rather than value maximization
What Are Private Benefits of Control?
Private benefits of control (PBOC) (sometimes called perks)
- The extra value (utility) the controlling owners (management) get in addition to the financial return (dividends plus change in value) that all shareholders share proportionally.
PBOC uniquely enjoyed by controlling owners
- Dividend rights equally shared among all shareholders
- PBOC measured as the control premium paid in control block transactions
Examples of PBOC
(1) PBOC with positive effects on value on minority shareholders’ value - Entrepreneurial drive and creativity to build corporate values that last
- Wider responsibility than guided by strict individual pecuniary motives
- Ambition to build economic and social value around family name and firm
(2) PBOC with neutral effects on value on minority shareholders’ value
- Social status – awards visibility
- Exercising political power in the public arena
(3) PBOC with negative effects on value on minority shareholders’ value - Recruiting family members or friends to key positions
- Closed shop – generational problem: stupid heir problem
- Emotional ties loss making investments: hanging on to losers too long
- Private consumption at the firm’s expense
- Self-dealings: too high salaries, pensions and remunerations
- Siphoning off of corporate resources to private pocket
- Outright stealing
- Transfer of corporate resources to private firms at advantageous prices and internal transferring of goods and services
With what lower level of private benefits of control associated with?
- Better accounting standards
- Better legal protection of minority shareholders
- Better law enforcement
- More intense product market competition
- Freedom of the press
- A high rate of tax compliance
How to improve pay-for-performance sensitivity?
– Ownership of company stock
– Bigger rewards for superior performance and big penalties
for poor performance (but don’t forget relative
performance)
– Make threat of dismissal for poor performance real (avoid “golden handshakes”)
Describe Equity-based pay
Buyout and venture capital investors have made, and continue to make, substantial use of equity-based compensation in the firms they invest in
But…
• Equity-based compensation increased the incentives to manage
and manipulate accounting numbers
• Options are hard to value and not all of them show up as an expense on income statement
Why Reputation could reduce AC?
Reputation as a non-monetary benefit (cost):
- When there is asymmetry of information about somebody’s type, agents infer type from observed actions
- By collecting and selectively revealing information to different audiences, media shape people’s reputation
• What drives reporting:
– Some issues are intrinsically more newsworthy – News cycles (crowding out of news)
– Technology (Internet)
– Talent of the broadcaster (Michael Moore)
Name benefits and costs of large shareholders?
(1) Benefits of large shareholders:
- >Monitoring incentive
- >Avoids the free rider problem
(2) Costs of large shareholders
- >Not diversified
- >Potential minority shareholder abuse
- >One-share-one-vote principle (or the lack of it)
- >Control rights in excess of cash flow rights
