Session 2: Corporate Governance Flashcards
What is corporate governance, and why is it important?
- Corporate governance refers to the processes, policies, laws, and institutions that guide corporate decision-making and control.
- It focuses on stakeholder relationships and aligning corporate goals.
- Importance: Ensures ethical management, prevents misbehavior, and balances costs and benefits.
- Examples of failures: Silicon Valley Bank, Volkswagen
What are agency problems in corporate governance?
Agency Relationship:
- Principals (owners/shareholders) hire agents (managers) to run the company.
- Conflict of interest: Managers may act in their own interest rather than maximizing shareholder value.
Agency Costs:
- Indirect Costs: Lost opportunities (e.g., managers avoiding shareholder-preferred investments).
- Direct Costs: Excessive spending by management that benefits them but harms shareholders.
- Monitoring costs are incurred to oversee managers.
How does the Unitary System (UK & US) function?
- Board reports directly to Shareholders, who elect them at the AGM.
- Composed of Directors (e.g., CEO, CFO, etc.) and Independent Members for supervision.
- Both report back and forth → More information flow, less complexity, and faster decision-making.
How does the Two-Tier System (Germany) function?
- Board (daily business) reports to a Supervisory Board, which elects them.
- Supervisory Board includes representatives from banks, government, trade unions, and stakeholders.
- More complex, less information flow, and clear separation of powers.
What is the role of Non-Executive Members / Supervisory Board?
- Advice & monitoring
- Define & approve major business decisions
- CEO selection
- Executive compensation
- Risk management
- Audits
What is a common criticism of Boards of Directors?
- Risk of being a “rubber-stamp assembly”.
- Executives have superior information and can influence board member selection.
- Non-executive directors often have small financial stakes in the company.
What is the Collective Action Problem in Ownership Structure?
- Small shareholders lack incentives to monitor managers.
- Leads to inefficiency in corporate governance.
What is Concentrated Ownership?
- Preferred in many countries to overcome the collective action problem.
- Large blockholders have more incentives to monitor management.
What are the benefits of Concentrated Ownership?
Large blockholders gather more information and actively monitor management.
What are the costs of Concentrated Ownership?
- Collusion between large shareholders and management (tunneling risk).
- Reduced liquidity in secondary markets.
- Overmonitoring by boards can stifle management initiative.
What are the two types of firms based on ownership structure?
Widely-Held Firms (e.g., BSF)
- Ownership & control are separate.
- Agency issues exist between managers & shareholders.
- Exit investment strategies are common.
Closely-Held Firms (e.g., BMW – Family owns 51%)
- Manager & shareholder incentives are more aligned.
- Agency issues arise between controlling & non-controlling shareholders.
- Investors have a stronger voice in decision-making & investment strategies.
What is the Free-Rider Problem in Corporate Governance?
- Occurs when individuals benefit from resources without contributing to cost or effort.
- Common in widely-held firms → Small shareholders rely on large blockholders for monitoring.
- Leads to free-riding, where small shareholders benefit without responsibility.
- Worsens the collective action problem, leading to inefficiency.
- Less common in closely-held firms → Large shareholders have a stronger incentive to monitor.
What are the components of Managerial Compensation?
- Base salary
- Performance-based bonuses (linked to short-run accounting metrics)
- Stock participation plans
- Stock options
What is the economic function of Executive Compensation?
- Aligns management interests with stockholders’ interests.
- Encourages managers to work toward increasing shareholder value.
What are implicit incentives in Executive Compensation?
- Manager’s reputation
- Future career prospects
- Can motivate better performance beyond financial incentives.
What is a Hostile Takeover?
- Extreme & costly mechanism for replacing or disciplining management.
- Occurs when target company’s management rejects the deal.
- If successful, brings in new managers with fresh ideas, leading to a change of control.
How does the threat of a takeover affect managers?
- Encourages short-term performance focus (at the expense of long-term value).
- Can lead to short-term (myopic) decision-making.
What are common Takeover Defenses?
- Poison pills – Makes the company less attractive to acquirers.
- Staggered boards – Board members are elected in phases to prevent quick changes.
- Supermajority rules – Requires a larger percentage of votes to approve a takeover.
How are investors protected?
- Through laws, regulations, court rulings, and legal enforcement.
- Differences exist between Civil Law and Common Law countries.
What is Common Law and how does it affect Investor Protection?
- Developed through court rulings.
- Flexible & quick to adjust to events.
- Provides stronger investor protection.
What is Civil Law and how does it affect Investor Protection?
- Developed through regulation & code of laws.
- Based on principles that change less frequently.
- Provides weaker investor protection.
What is the impact of stronger Investor Protection on countries economic landscapes?
Countries with stronger legal protection tend to have:
- Bigger stock markets.
- More IPOs (Initial Public Offerings).
- More external capital (equity).
- Less concentrated ownership.
What role does Corporate Debt play?
Acts as another layer of oversight since companies must allocate earnings for debt repayment instead of using them freely.
How does Debt act as a Disciplinary Device?
- Forces management to use cash flow for business rather than personal perks or bad investments.
- Incentivizes managers to make better financial decisions, as they must repay debt in the future.
How do Creditor Rights compare to Shareholder Rights?
- Creditor rights are clearer than shareholder rights → Better protection for debt investors.
- With debt, there’s a risk of bankruptcy or illiquidity, limiting excessive borrowing.
- If the company faces financial trouble, creditors can take control to protect their investment.
What role do Investment Banks play in Corporate Governance?
- Monitor firms and identify issues early.
- Often have better information than most investors.
What is a potential Conflict of Interest for Investment Banks?
- Analysts may avoid criticizing firms to protect client relationships.
- Rating agencies face conflicts as they charge firms for ratings & consulting, leading to potential bias.
What are Proxy Voting Advisors?
- Firms like ISS & Glass Lewis help investors decide how to vote at annual shareholder meetings.
- Useful when investors do not form their own opinions.
What is the influence of Proxy Voting Advisors?
- Hold significant power in shaping shareholder votes.
- Often provide consulting services beyond voting advice.
What is the main distinction between Bank-Based and Market-Based Corporate Governance?
- Bank-Based Systems → Rely on banks for monitoring & control.
- Market-Based Systems → Rely on securities markets (stock exchanges) for governance.
What are characteristics of Bank-Based Systems? (e.g., Germany, Japan)
- Banks actively monitor firms to protect investors’ interests.
- Banks transfer funds between capital suppliers and demanders.
- Closer relationships between banks & companies → More internal control & long-term stability.
- Lower shareholder activism, as banks play a key role in governance.
What are characteristics of Market-Based Systems? (e.g., US, UK)
- Securities markets (e.g., stock exchanges) play a major role in governance.
- Companies are disciplined by market forces like stock prices, shareholder voting, & investor reactions.
- Higher investor activism, as external investors use voting rights & capital markets to influence decisions.
How do Bank-Based and Market-Based Systems differ in governance style?
- Bank-Based → Internal, hands-on monitoring by financial institutions.
- Market-Based → Broader market forces & investor behavior drive governance.
