Overview of Corporate Governance Flashcards
Corporate governance
Mechanisms to ensure the actions of managers are consistent with the interests of shareholders
5 major responsibilities of the board of directors
Setting overall corporate strategy Appointing CEO and top management Monitoring top management Reviewing major resource allocation Looking after shareholder interests
Benefits of effective corporate governance
-Stronger corporate reputation
Greater trust and confidence of investors and customers
Ability to raise new capital
Lower cost of capital due to access to capital markets
-More effective strategic oversight
More efficient operations, minimised risks
More sustainable business
Agency theory
Shareholders’ and managers’ interests are not always aligned and therefore managers may not always act in shareholders’ best interests,
Managers may not always act in shareholders’ best interests, due to:
- Knowledge imbalances (the hired agents know more)
- Practical limits on monitoring of agents
- Misaligned incentives
Managers may:
Take riskier decisions than owners
Be excessively risk averse
Practise managerial opportunism
Espoused remedies
Knowledgeable principals
Effective monitoring
Well-designed incentives
What are vulnerable links in governance chain?
- Investment institutions
- Information intermediaries
- Investor knowledge limitations
Investment institutions
-Historically accused of being inactive shareholders who do not challenge the board and CEO
-Have recently tended to become more active
E.g. voting against excessive executive pay; supporting climate-responsible policy.
Information intermediaries
Social norms among analysts …
Potential for information available to small investors to lack true independence
Over-reliance on ratings agencies (2008 crisis)
Investor knowledge limitations
Feltex, NZ finance company cases, Dick Smith, …..
Vulnerabilities in Boards
- Independence of board and executive
- Effectiveness of Independent Directors is sometimes questioned: ability to combine
- Effectiveness and independence
Independence of board and executive
Often the same person is Board Chair and CEO (especially in USA)
Effectiveness of Independent Directors is sometimes questioned: ability to combine
Independence
Knowledge
Leadership
Effectiveness and independence of
Nominating Committee
Audit Committee
Remuneration Committee
The collapse of Enron: Alleged causes included
- Hiding debts in ‘partners’ (misleading accounts)
- Failure of auditing process
- Board ineffective as a check on the executive
Potential agency problems
- Empire building
- Buying businesses that increase the size of the company without increasing shareholder wealth
- Risk taking (Lehman, Enron)
- Rewards based on share price generate distorted incentives
- Creative accounting (profit boosters, balance sheet distortions)
- Board ‘interlocks’ with related parties
- Insider trading (usually unlawful)
Moral hazard
-When managers do not bear the full consequences of their decisions, they have an incentive to make reckless decisions
Example: government guarantees a bank’s deposits, but the government does not oversee its lending practices
Stewardship theory
- Agency theory takes a narrow ‘rational-economic’ view of managers and ignores other motivations
- Senior executives invest their career in the firm and hence identify with its fortunes
- Shareholders can easily buy and sell, and might not know what is good for them
Shareholder view of governance:
Responsibility is to shareholders above all other stakeholders
+Undiluted focus on financial returns; support for innovation
-Risk of short-termism, and reliance on active institutional investors in the governance chain
Stakeholder view of governance:
A broader view of which parties contribute to and benefit from the firm’s prosperity
+Longer time horizons and less reckless risk-taking
-Less decisive or innovative
What are the three types of board:
Inactive boards in owner-managed firms
Active boards with representation from venture capital investors
Advisory boards to provide advice and perspective to owner-managed firms
Why did Dick Smith collapsed in 2016
The firm collapsed in early 2016 because it had to taken too much debt in order to build up its stock of goods
