CHAPTER 4

AN OVERVIEW OF CORPORATE GOVERNANCE

INTRODUCTION TO CORPORATE GOVERNANCE

• Definition:

• Corporate governance is a set of devices (code of conduct)

that aim to protect investors against managerial
misbehavior. "Good" corporate governance is believed to
reduce the likelihood of bad or wrong management and,
as a result, to create shareholder value.
 EVOLUTION OF CORPORATE GOVERNANCE

• Before 17th Century:

 Corporations were established for limited purposes: most of corporations were
chartered for specific purposes, such as banking services.
 Corporations could only exist for a limited time, no perpetuity

 They were not allowed to make any political contributions.

 One corporation could not own stocks in other companies.

 Corporate control by shareholders was characterized by “voice” rather than by “exit”.

No possibility of free exit option.
 Investors were not attracted to purchase shares because of absence of exit option
EVOLUTION OF CORPORATE GOVERNANCE

• Industrialization Era (19th Century):

 Marked by the factory system replaced the old cottage system

 Technological advances and increasingly capital-intensive (mass)

production processes increased the optimal size of many firms.
 legislators began to take corporations more into consideration:
corporations were allowed to write broader and less restrictive
charters .
 EVOLUTION OF CORPORATE GOVERNANCE

Wave of privatization (Between 1895 and 1904)

• The corporation was transformed from state-controlled organizations to unlimited private

organizations with limited responsibility and limited accountability.

• Stock/Share market opened

• The free exit option introduced

• Separation of ownership and management took place - control of corporations shifted more
and more into the hands of the managers and therefore ownership and control separated.

• Control via voice shifted to the boards of directors, which in turn were dominated by managers.
EVOLUTION CONTINUED

• After 20th Century:

 Ownership and control were separated and therefore the agency
problem – deepened. The owner and the manager were no longer one
and the same person.
 The foundations of economic activity changed. A firm’s capital

requirements can be met in the form of debt or equity because

corporations are allowed to issue debentures and sale on debt
basis.
DEFINITION OF CORPORATE GOVERNANCE

The term “Corporate Governance” is susceptible of both narrow and broad

definitions, related to the two perspectives of shareholder and stakeholder
orientation.

• Narrow Definition:
• Focus on shareholder interests and profit maximization.

• Broad Definition:
• Includes societal expectations and legal obligations.
NEED FOR CORPORATE GOVERNANCE

1.Wide Spread of Shareholders

• Unorganized shareholders, need for practical implementation.

2.Changing Ownership Structure

• Rise of institutional investors.

3.Corporate Scams and Scandals

• Need to rebuild public confidence.

4. Greater Expectations of Society

• Demand for quality and ethical behavior.
 NEED FOR CORPORATE GOVERNANCE (CONTINUED)

5.Hostile Takeovers (Efficiency of management questioned).

Example of a Hostile Takeover

For example, Company A is looking to pursue a corporate-level strategy and expand into a new geographical market.

1. Company A approaches Company B with a bid offer to purchase Company B.

2. The board of directors of Company B concludes that this would not be in the best interest of shareholders in

Company B and rejects the bid offer.

3. Despite seeing the bid offer denied, Company A continues to push for an attempted acquisition of Company B.

• In this scenario, despite the rejection of its bid, Company A is still attempting an acquisition of Company B. This

situation would then be referred to as a hostile takeover attempt.

CORPORATE GOVERNANCE MECHANISMS

• Internal Mechanisms:
• Board of Directors
 The board of directors is elected by the shareholders at the general assembly
meeting and represents the shareholders’ interests.
 Consequently, its most important task is to monitor management on the
shareholders’ behalf.
• Shareholder Rights
 They have the right to vote on important corporate decisions, especially on who is
appointed to the board of directors.
• Executive Compensation
• Align management interests with shareholders.
CORPORATE GOVERNANCE MECHANISMS

• Audit Committees

• The company shall form an independent audit committee that:

• Oversee the company’s financial reporting process and the

disclosure of its financial information to ensure that the
financial statement is correct, sufficient and credible.
• Recommend the appointment and removal of external
auditor.
EXTERNAL CORPORATE GOVERNANCE MECHANISMS

• Market for Corporate Control

• Stock prices reflect management performance.

• Hostile Takeover Defenses

• Strategies to deter unwanted acquisitions.
 HOSTILE TAKEOVER STRATEGIES

• Tender Offer:
• A tender offer is an offer to purchase stock shares from Company B
shareholders at a premium to the market price. For example, if Company B’s
current market price of shares is $10, Company A could make a tender
offer to purchase shares of company B at $15 (50% premium).

• The goal of a tender offer is to acquire enough voting shares to have a

controlling equity interest in the target company.
HOSTILE TAKEOVER STRATEGIES

• Proxy Vote: Persuading shareholders to change management.

• Other Defenses: Poison pills, golden parachutes, etc.
 DETERMINANTS OF CORPORATE GOVERNANCE

• Legal Environment
• A firm’s legal environment is defined primarily by the written legislation and the law
enforcement by the state which includes contract law, company law, and securities law and
specifies the firm’s leeway in structuring corporate governance.

• Corporate Governance Environment

• Influence of shareholder actions and board defenses.

• Operational/Economic Environment
• Adaptation to specific industry needs.
 CHAPTER 5

Principles and Theories of

Corporate Governance
 INTRODUCTION TO CORPORATE GOVERNANCE
PRINCIPLES

• Importance of principles in guiding corporate governance practices.

• Overview of the four main pillars.
PILLAR 1: ACCOUNTABILITY

• Definition:
• Responsibility and answerability of management.

• Key Points:
• Importance for investor trust.
• Mechanisms for reporting and addressing misconduct.

• Importance:
• Promotes transparency and integrity.
• Builds trust among stakeholders.
PILLAR 2: TRANSPARENCY

• Definition:
• Openness in company operations and decisions.

• Key Points:
• Disclosure of financial performance and risks.
• Importance of regular reporting and communication.

• Importance:
• Builds stakeholder trust and allows for external review.
PILLAR 3: FAIRNESS

• Definition:
• Equitable treatment of all stakeholders.

• Key Points:
• Equal opportunity in decision-making.
• Fair compensation and performance evaluation.

• Importance:
• Enhances stakeholder confidence and participation.
PILLAR 4: RESPONSIBILITY

• Definition:
• Acting in a socially and environmentally responsible manner.

• Key Points:
• Ethical practices and community engagement.
• Importance of corporate social responsibility (CSR).

• Importance:
• Enhances brand loyalty and community support.
CORPORATE GOVERNANCE THEORIES OVERVIEW

• Theoretical frameworks that address governance challenges.

• Importance of understanding relationships between stakeholders.
 AGENCY THEORY

• Definition:
• Relationship between principals (shareholders) and agents (managers).

• Key Points:
• Potential for self-interest and opportunistic behavior.
• Emphasizes accountability and reward structures.
 STEWARDSHIP THEORY

• Definition:
• Executives as stewards of shareholder wealth.

• Key Points:
• Motivation through organizational success.
• Focus on autonomy and responsibility.
 STAKEHOLDER THEORY

• Definition:
• Accountability to a broad range of stakeholders.

• Key Points:
• Intrinsic value of all stakeholder interests.
• Focus on managerial decision-making.
 RESOURCE DEPENDENCY THEORY

• Definition:
• Role of board directors in securing resources.

• Key Points:
• Directors as links to external resources.
• Categories of directors: insiders, experts, specialists, influencers.
 POLITICAL THEORY

• Definition:
• Political influence on corporate governance.

• Key Points:
• Government participation and regulatory impact.
• Importance of understanding the political environment.