THE CHALLENGES OF CORPORATE GOVERNANCE

Nicolas Walenda

Introduction & Background

Background: 21st century increasingly characterized by financial crisis & high profile corporate scandals Recent rise in the nationalization of private companies has contributed to this dilemma (Washington Mutual, Northern Rock) World attention focused on corporate governance & shareholder rights Definition: the economic, legal & institutional framework in which corporate control & cash flow rights are distributed among shareholders, managers & other stakeholders of the company . (Cheol&Resnick, 2009)

Introduction & Background

Strength of corporate governance varies across nations US executives are criticized for awarding themselves millions of $ in corporate perks Corporate governance in developing countries often non-existent or at best very weak

Corporate Governance: The Model

Public corporations are jointly owned by many shareholders Model allows public corporations to raise large amounts of money to invest in projects Founded in principle of separation of ownership Shareholders elect Board of Directors of Company (Normaly) Board of Directors hire professional managers to run company on behalf of stakeholders Shareholders buy/sell shares on stock exchange as they see fit Shareholders protected with limited liability & have major economic advantages such as sharing risk Managers work for shareholders & executive board safeguards interests of stakeholders Corporate governance mechanisms include: ownership structure, board of directors, monetary incentives, market for corporate control, leverage, accounting standards and auditing, employee representation on board and product market completion.

The Challenges & Issues

In practice fusion rather than separation of control behind many large financial scandals e.g. Enron/2001 In Enron case managers were found to have transferred wealth from firm s shareholders to themselves in form of stock performance Managers were also major shareholders & their principle objective to drive up share value Enron example demonstrates risk when shareholders place extensive decision-making capability with management and fail to monitor the agent s behavior Other examples of failures due to inappropriate governance are WorldCom (2001) Lehman Brothers (2008)

Agency Theory
Agency theory refers to relationship by which one party called the principle delegates work to another the agent Relationship between the owners (shareholders) and the agency (managers) in public corporations is an example of agency theory in play Agency theory = key concept underlying the importance of corporate governance.

Conflict of Interest
Problems that typically characterize agency relationships in public corporations stem from conflict of interest between shareholders and managers Board of Directors frequently comprises managerfriendly insiders Often lacks independence required to monitor management Objectives of investors & managers are often not identical Managers often pursue own interest resulting in insufficient effort, extravagant investments/other actions not in best interests of the firm

Conflicting Interests of Shareholders & Managers

Shareholders:  Increasing earnings per share & current prices  Increasing investor rations (dividend per share, dividend cover, yield & price earning ration)  Improving corporate & social responsibility of the firm Managers:  Managing the firm to achieve objectives  Increasing firm s wealth size through expansion of activities  Increasing own personal wealth through high remuneration & benefits

Shareholder v Manager Interests & Conventional v Other Views

Contributing Factors to differing interests:  Risk attitude  Management decision on takeovers  Time in the office of the managers  Extent of reward management Agency Theory : Conventional v Others  Conventional view argues agency is similar to application of contract theory  Other views state reverse is case & a contract is a formalized but limited version of agency Theory but agency theory is not based on contract theory.

Ownership Variations
Problems increased where managerial ownership is reduced Ownership structure of public corporations varies across nations Anglo Saxon countries characterized by widely dispersed ownerships Continental Europe tend to have more concentrated ownership structure Following Table shows differences in ownership structures (Becht 2001)

Ownership Structure

Types of Agency Problems

Agency Problems: The Remedies

 Ensure shareholders have right to elect board of directors (as in USA)  Secure structure & legal charge of corporate boards  Incentive contracts  Concentration of Shareholdings  Better investor protection  The market for corporate control

Law & Corporate Governance

Law protecting investors rights varies depending on commercial law of country where firm domiciled Another factor that plays important role is extent to which nation enforces the law Countries with weak law enforcement may need to have concentrated ownership to substitute for legal investor protection: risk of abuse by large investors of smaller ones

The Key Issue for Corporate Governance

Shareholders in different countries face different corporate governance systems One key issue across all : How to ensure that the external investor remains in control & receives the correct returns on their investment How to protect against controlling insiders with too much control & situation where welfare of external investors is jeopardized

Conclusion
Corporate governance increasingly important for shareholders Also increasingly important for governments striving for economic stability Increasing demand for corporate governance reform on part of investors worldwide Results from recognition that not only internal governance of firms that has failed but also auditors, banks, institutional investors and other regulators Agency theory suggest imperfect labor & capital market with managers attempting to maximize own worth at cost of shareholder Due to asymmetry of information managers able to operate on own interests and not those of firm Agency costs can be significant as shareholders strive to encourage managers to maximize shareholder wealth & not self-interest If corporate governance is not reformed this will result in very damaging effect on investor confidence which already very low Consequence will be that capital market development severely hindered Confidence in capitalist system itself may even be disturbed

Thank you For Your Attention!!!