A Survey of Corporate Governance

By
Author(s): Andrei Shleifer and Robert W. Vishny

SUMMARY
Corporate Governance plays a key role in protection of the interest of all stakeholders especially
to those who provide funds to the corporations (supplier of funds) and expect returns on their
investments. The supplier of funds usually expect to get a reasonable return on their investments
therefore they expect that the managers will invest their funds in such projects that generates
positive cash flows. Such projects are risky but have the potential to generate positive cash flows
if undertaken. On the other hand the managers, having the element of risk in their minds are
hesitant to undertake such projects thus make deprive investors to get reasonable returns on their
investments. Since the managers are more concerned about their jobs security thus arising
agency conflict.
An agency, in general terms, is the relationship between two parties, where one is a principal and the other is an agent who
represents the principal in transactions with a third party. Agency relationships occur when the principals hire the agent to
perform a service on the principals' behalf. Principals commonly delegate decision-making authority to the agents. Agency
problems can arise because of inefficiencies and incomplete information. In finance, two important agency relationships are
those between stockholders and managers, and stockholders and creditors.

These differences and depriving the investors from getting their returns make investors feel that
their investment in the company is not safe and that their interest lies in the second tier, thus
making the investors reluctant to supply fund in the future. Many of the advanced market
economies have tried to overcome the problem of Corporte Governance to a great exent. Flowing
of funds to the corporations and getting appropriate returns on the investment is witness to that.
However, the problem of corporate Governanance is still there and needs to improved as there is
a room for improvement.
Advanced economies have a high level of gross domestic product per capita, as well as a very
significant degree of industrialization.

Easterbrook and Fischel (1991) and Romano (1993a) make a very positive evaluation of the US
corporate governance system. However, Jensen (1989a, 1993) argued that there are some serious

issues with the prvailing systmem of corporate governance in the US and needs to be improved.
But the U.S, Germany, Japan and the UK have excellent corporate governance practices. Barca
(1995) and Pagano, Panetta, and Zingales (1995), in their studies have argued that Italy has very
undeveloped system of corporate governance that has substatially reduce the flow of funds to the
corporations. In some of the underdeveloped countries there is hardly any Corporate Governance
to be practically witnessed. Due to weak Corporate Governance in Russia, the flow of funds to
the companies are negligible (Boycko, Shleifer, and Vishny (1995)).
Product market competition is the most effective mechanism that brings economic efficeincy in
the world but still there is no surity that it may serve the purpose of corporate governance alone.
Product market competition may reduce the returns in a way that managers can not be prevented
from exploitation the competititive returns after the capital is sunk.
This article focuses on one of the corporate governance agency perspective known as division of
ownership and control. How the suppliers of funds get the managers to return their funds?
The core of agency is the division of ownership and control. The management of a firm raises
funds because the firm may be in shortage of funds or want to put the money in some useful
projects. The investors on the other hand wants security that their funds are effectively being
utilized and want to have some reasonable returns on their investments. The agency problem in
these conditions are the hurdles that investors have in assuring that their money is safe and have
been invested in attractive projects.
Generally the investors and the manager sign a contract, specifying the allocation of funds and
the distribution of profits among them. It is not viable to have a complete contract. As future is
uncertain, managers take decisions beyond the contractual obligations because of the
uncertainity. Grossman and Hart (1986), Hart and Moore (1990) in their studies suggested that
due to these problems the management and the investors have to specify the powers of making
decisions under such conditions and that not been mentioned in the contract. The theory of
ownership expalin how these controlling rights can be allocated in an efficient manner.
Suppose a contract has been signed between manager and the investors, mentioning therein that
the investors will be having all the remainig control rights. if something happens unexpectedly
the investors will not be in a position to tackle with such contingencies. The reason is that
investors are not well qualified and exact informations are not being passed to them. Thats why

it is the manager who enjoys all these rights and used his discretion to use the funds whereever
he seems it appropriate. There may be limitations on these discretions mentioned in the contract.
The corporate governance deals with much of these limitations but the truth is that managers do
enjoy much of the residual controlling rights.
Pratically this situation is very complex. Firstly, the contract that is sign by the investors and the
managers donot need much explanation if enforeced by the courts. In US where the courts are
usually very active in such cases, having vast functions, even they do not interefere in the
business judgement rule. In other parts of the world courts get engage during enormous
conditions, like deleting the names of sharehloders from the register. Secondly, there are some
cases where financing needs to be collected from many investors. In scuh cases these investors
are very small even they are not being able to exercise their basic rights as they are not being
informed oftenly and/or weakly being informed. This leads them of no meaning to have/have not
any information about the company they have actually finance or to take part in the governance.
As a result of the above factors, the discretionary controlling rights remain with the management
and enjoy the rights to use the funds where they seems appropriate. These expropriation of funds
are serious than just taking the cash out. For instance; managers can form their own companies
with the funds and sells the outputs of the parent company to their own companies at less market
price. More drastic istances are to sell the assets of the parent company to the individual one.
Even the courts in the US can not prevent managers to use the free cash flows in such projects
that benefits them rather than the investors. Managers also exploit the investors in a sence that at
a specific point in time they are no longer helpful and capable to run the affairs of the company
but they still remains on the job (Shleifer and Vishny (1989)).
The corporate governance deal much with restrcitions that is to be imposed by the managers on
themselves or put by investors on them, not to misuse the funds after

the fact thereby

motivationg the investors to introduce more funds. The other way around if the management has
an option not to return the funds to investors then the management tend to undertake such
projects that benefits them at the cost of investors. Jensen and Meckling (1976) have discussed
that if there is no ownership of management in the firm then they will undertake such projects
that will add no value to investors thus the result will be a decrease in the supply of funds from
investors. The Coase (1960) theoram says that investors should give bribes to management in
order to avoid them from taking inefficient projects for their personal benefits only. But

normally, the management is not being paid as such for their one time events that is why the
Jensen & Meckling findings are found empirically correct and the Coase Theoram is incorrect.
The other reason of the failure of this theoram is that the investors at large should be in
consenses to bribe the management. One reason of not witnissing the threats from the
management to shareholders is the duty of loyalty that prevents the management of threatning
the shareholders to bribe them as not to take the inefficient projects.
In order to overcome the agency problem and to line up the interests of both management and
investors, there should have been large subjective, strategic incentive contracts before the fact.
If the management has been offered large incentives then they would not be in a position to
threat the shareholders, as these incentives are much higher than what would have been gained
from that of undertaking inefficient projects for their personal benefit.
The evidences from various studies have shown that the law and political interference in the US
and other parts of the world have decreased the importance of executive compensation to
performance. However this does not mean that the management have no concern with
performance rather it is justifiable to say that incentive contracts can not eliminate the agency
problem wholelly and solely.
when investors invest their funds they hope to have returns after successful operations. On the
other hand, the management ensure to repay the loans in order to create goodwill in the market
and to get future financing. Also the investors are innocent and can easily be dodged. These
approaches from various studies indicate that investors donot secure any controlling right in
return of providing their funds. Diamond (1989, 91) showed how companies create their
goodwill as credit worthiness. Gomes (1996) showed how payout enable companies to raise new
equity. The investors usually invest by looking into the share appreciation of the company that
encourage them to invest without looking into the long run perspective of gettting back their
money. Through Ponzi scheme whereby the management raise new funds in oder to settle
down the previous one, false impressions of creditworthiness are created. Also there are models
that shows shareholders optimism thus creating outside fundings.
Investment provides certain rights to the investors in the form of contract owning the assets of
the company. If the management negate the contractual obligations, the financiers have the right
to go to the court of law. The key legal right of shareholders is the voting power in key issues
like mergers and liquidation, and appointments of BoD. However, the management can use the

proxies during the annual general meeting thus make such decision that just serves their purpose.
Even if the BoD is elected by the shareholders even then they do not serve their interests. The
key factor of duty of laoyalty is the legal protection on management, like clear/absolute theft,
high remunerations, and issuing of secondary offerings. Sometimes these are prohibited by the
law and sometimes courts implement the company Act.
If the legal protections do not serve the purpose by giving reasonable controlling rights to large
financiers, then they can do so by providing them with ownership rights. Such rights can be
shaped in different ways like providing the financiers with large bunch of shares so that when
their interest and rights are increased in a given firm then managers can not afford to misinform
them. Another way according to the author could be avoiding humungus takeovers to be the
executives of the firms because in large takeovers the net earnings of the firm which is needed to
be distributed equally among the financier is wasted in unnecessary acquiring of a new firm, due
to takeovers agency issues araise and thats why takeovers should be tackled. Funds arranged
through large financing organizations is observed to have a positive impact on corporate
governance and tackling the agency problems in developed nations like in Germany the presence
of large banks as funds providers showed positive outcomes in minimizing the agency problems.
In comparison to the advantages linked with large investors the disadvantages of them are also
very prominent such as by providing large chunks of money these financiers might demand
higher returns as compared to market. Another disadvantage argued in this paper is that due to
big financial investment these financing organizations would prefer their own interests rather
than considering the well being of the firm in which they have invested. They can also bribe the
executive of that firm so to have such decisions which would favour their well being thereby
rising to agency problem.
In addition to above phenomenas discussed along with their positives and negatives there is also
some alternate methods available, like opting for debt and equity or governament role as an
owner in a given organization. Current trends in the researches elaborates that debt can have vital
role in fund raising as well avoiding agency issues. For debt option to be availed by a firm, that
firm must follow some agreements promised with debt providers otherwise the debt providers on
account of unfulfilling the payments agreement can become the owners of that firm. Various
studies indicate that benefits of debt contract. Debt will lead to redcution in agency problems as
in contracts made with such funds providers are shield by law and thus managers can not afford

to mingle with them but along with it would prevent the management from investment in a
healthy project. Equity is a best alternate tool available when debts are hard to come by. But the
costs of raising funds though shares is very high in comparison to debt, i.e, debts creats value to
the firm (MM 1963). The rights of share owners are less protected as compared to debtors.
Research indicates that when firm conducts LBOs profit generation is increased and increase
efficiency of the organization which in some sort reduces agency issues. But the negative aspect
of LBO is the centralization of ownership which indeed leads to agency issues again but this
argument is negated by researchers that debt also leads to centralization of ownership. In case of
state ownership there would be rise in corruption as compare to private organizations. Research
evidence has also proven that there is very little economies of scale when an organization is held
by a state also the objectives of those who are runing a government are very diverse than that of
society.
There are cases which prove that protecting financiers by law would help in tackling the agency
issues. Whereas on the contrary there are cases which stresses on the phenomena of large
financiers rather than law and legume. For instance in case of Europe and Japan priority is given
to huge investor than any law and legume. Whereas in case of America the protection through
law is welcomed rather than large bunch of financiers. Thus this reveals that a share of both the
systems i.e. Law and Large financiers, should be in action for tackling the agency issues. There
is no one ideal country to be followed in order to tackle Corporate Governance but economies
like America, Germany and Japan could be followed as better models in regard to agency issues.
The primary question to consider is that what assurity to financiers can be given that they invest
and get their return and this assurity could only be given via corporate governance. Research
showed that a good corporate governance enviroment like that in America, Germany and Japan is
a combiantion of both safeguarding through law and legume and having large chunk of a
financier. Whereas in the rest of the world there is very minimum protection by law for fund
providers.