CORPORATE GOVERNANCE

CHAPTER 1
 1. INTRODUCTION
WHAT IS CORPORATE GOVERNANCE?
• Corporate governance is the system of principles, policies, procedures, and
clearly defined responsibilities and accountabilities used by stakeholders to
overcome the conflicts of interest inherent in the corporate form.
 Hence, the importance of understanding the different forms of business.
• Corporate governance affects the operational risk and, hence, sustainability of
a corporation.
 The quality of a corporation’s corporate of governance affects the risks and
value of the corporation.
 Effective, strong corporate governance is essential for the efficient
functioning of markets.

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 2. CORPORATE GOVERNANCE: OBJECTIVES
AND GUIDING PRINCIPLES
• There are inherent conflicts of interest in corporations in which the ownership
and management are separate.
• Objectives of corporate governance:
 To eliminate or mitigate conflicts of interest.
- Particularly those between corporate managers and shareholders; and
 To ensure that the assets of the company are used efficiently and
productively and in the best interests of its investors and other stakeholders.

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 CORE ATTRIBUTES OF AN EFFECTIVE
CORPORATE GOVERNANCE SYSTEM

Clearly defined manager Identifiable and

and director governance measureable
responsibilities accountabilities

Delineation of rights
of shareholders and
other stakeholders

Fairness and equitable Transparency and accuracy

treatment in dealings in disclosures

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 3. FORMS OF BUSINESS
AND CONFLICTS OF INTEREST
The form of business will dictate, in part, the relationship between the owners of
the business and management.
 The degree of separation may be minimal (e.g., sole proprietorship), or
significant (e.g., large corporation).
 When there is a separation between owners and managers, there is a
potential for agency problems, which may affect the value of the business.
 We will examine three business forms: the sole proprietorship, the
partnership, and the corporation.

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 SOLE PROPRIETORSHIP
• A sole proprietorship is owned and operated by a single person
• Sole proprietorships are the most numerous in terms of number of businesses.
• Who bears governance risk in a sole proprietorship?
 There are few risks with respect to governance from the perspective of the
owner.
 Creditors, including trade creditors, have the highest risk with respect to
governance.

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 PARTNERSHIP
• A partnership has two or more owner/managers.
• Who bears governance risk in a partnership?
 There are few risks with respect to governance from the perspective of the
owners, with ownership rights and responsibilities detailed in the partnership
agreement.
 Creditors, including trade creditors, have the higher risk with respect to
governance.

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 CORPORATION
• A corporation is a legal entity that has rights similar to an individual.
 For example, a corporation can enter into contracts.
• Corporations account for most business revenue around the world.
 Corporations around the world: Limited Company (U.K.), Gesellschaft
(German); Societé Anonyme (France), 公司 (China); şirket (Turkey); บริษท
ั
(Thailand)

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 ADVANTAGES OF THE CORPORATE FORM
1. A corporation can raise capital.
 Grant ownership stakes (that is, issue stock) or borrow (that is, issue bonds).
2. Owners need not know how to run the business.
 The corporation hires experts to manage the business.
3. Ownership interests are transferrable.

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 DISADVANTAGES OF THE CORPORATE FORM
1. Corporations are more highly regulated than are partnerships or sole
proprietorships.
 For example, in the U.S. there are State laws pertaining to corporations and
the Securities and Exchange Commission requires specific disclosures.
2. Separation of owners and managers.
 This is the agency relationship, in which someone (the agent) acts on
behalf of another person (the principal).
 The potential conflict between owners and managers is the agency problem
or principal-agent problem,
- Principals: shareholders
- Agents: Management and members of the board of directors
 There are costs to this agency relationship arising from conflicts of interest.

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 3. FORMS OF BUSINESS AND
CONFLICTS OF INTEREST
Characteristic Sole Proprietorship Partnership Corporation

Ownership Sole owner Multiple owners Unlimited ownership

Legal requirements and Few; entity easily Few; entity easily Numerous legal
regulation formed formed requirements
Legal distinction between None None Legal separation
owner and business between owners and
business
Liability Unlimited Unlimited but shared Limited
among partners
Ability to raise capital Very limited Limited Nearly unlimited

Transferability of ownership Non-transferable Non-transferable Easily transferable

(except by sale of
entire business)
Owner expertise in business Essential Essential Unnecessary

Exhibit 1-1, page 4

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 4. SPECIFIC SOURCES OF CONFLICT:
AGENCY RELATIONSHIPS

Management–Shareholder conflicts

Managers Board of directors Shareholders

Director–Shareholder conflicts

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 MANAGEMENT–SHAREHOLDER CONFLICTS
• Shareholders entrust management with funds from reinvested earnings or
newly issued stock, which management invests.
• The overarching objective is to maximize shareholders’ wealth.
• Issue: Managers are human
 Managers may be more interested in expanding the size of the business,
bonuses based on earnings, taking on excessive risks, or job security.
 Managers may consume excessive perquisites, or in effect, take advantage
of their position to spend excessively on things for themselves.
 Bottom line: there may be agency costs in terms of the explicit and implicit
costs when managers do not act in the best interest of shareholders.
• Effective corporate governance guards against agency costs.

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 DIRECTOR–SHAREHOLDER CONFLICTS
• The board of directors are an intermediary between the shareholders and
management, and represent shareholders’ interests by:
 Monitoring managers;
 Approving strategies and policies;
 Approving mergers and acquisitions;
 Approving audit contracts;
 Reviewing audit contracts and financial contracts;
 Establishing management compensation;
 Disciplining poorly performing managers.
• A conflict may arise if the board members align with management.

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 RESPONSIBILITIES OF THE
BOARD OF DIRECTORS
• Establish corporate values and governance structures for the company;
• Ensure that all legal and regulatory requirements are met and complied with
fully and in a timely fashion;
• Establish long-term strategic objectives for the company;
• Establish clear lines of responsibility and a strong system of accountability and
performance measurement;
• Hire the chief executive officer, determine the compensation package, and
periodically evaluate the officer’s performance;
• Ensure that management has supplied the board with sufficient information for
it to be fully informed and prepared to make the decisions that are its
responsibility, and to be able to adequately monitor and oversee the company’s
management;
• Meet regularly to perform its duties;
• Acquire adequate training.

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 5. CORPORATE GOVERNANCE EVALUATION:
BOARD OF DIRECTOR ATTRIBUTES
• The board should be comprised primarily of independent directors (that is, not
insiders)
• The Chairman of the Board should be independent;
• Directors should be qualified;
• There should be a regular election of members of the Board;
• There should be a regular self-assessment of the Board;
• The board should hold separate meetings of the independent directors;
• The board should require audit oversight by independent directors who have
sufficient expertise in finance, accounting, and the law.

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 5. CORPORATE GOVERNANCE EVALUATION:
BOARD OF DIRECTOR ATTRIBUTES (CONTINUED)
• The nominating committee should be comprised of independent directors;
• The compensation committee should be comprised of independent directors;
• The board should be able to hire outside counsel;
• The board should disclose governance policies;
• The board should ensure adequate disclosure and transparency;
• The board should require disclosure of any related-party transactions;

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 GUIDELINES AND REGULATIONS
ON CORPORATE GOVERNANCE
Principle 1: Every Institution should be headed by an effective Board.
Principle 2: There should be a strong and independent element on the Board
which is able to exercise objective judgment on corporate affairs
independently from management and substantial shareholders.
Principle 3: The Board should set and enforce clear lines of responsibility and
accountability throughout the Institution.
Principle 4: There should be a formal and transparent process for the
appointment of new directors to the Board.
Principle 5: There should be a formal assessment of the effectiveness of the
Board as a whole and the contribution by each director to the
effectiveness of the Board.
Principle 6: In order to fulfill their responsibilities, Board members should be
provided with complete, adequate and timely information prior to
board meetings and on an on-going basis by the management.

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 GUIDELINES AND REGULATIONS ON
CORPORATE GOVERNANCE (CONTINUED)
Principle 7: There should be a formal and transparent procedure for fixing the
remuneration packages of individual directors. No director should
be involved in deciding his own remuneration.
Principle 8: The level and composition of remuneration should be appropriate
to attract, retain and motivate the directors to perform their roles
and carry out their responsibilities.
Principle 9: The Board should establish an Audit Committee with a set of
written terms of reference that clearly sets out its authority and
duties.
Principle 10: The Board should ensure that there is an adequate risk
management system and sound internal controls.

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 GUIDELINES AND REGULATIONS ON
CORPORATE GOVERNANCE (CONTINUED)
Principle 11: The Board should ensure that an internal audit function that is
independent of the activities audited is established.
Principle 12: The Board should ensure that management formulates policies to
ensure dealings with the public, the Institution’s policyholders and
claimants, depositors and other customers are conducted fairly,
responsibly and professionally.
Principle 13: The Board should ensure that related party transactions with the
Institution are made on an arm’s length basis.

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 ORGANIZATION FOR ECONOMIC CO-OPERATION AND
DEVELOPMENT (OECD)
PRINCIPLES OF CORPORATE GOVERNANCE

• The rights of shareholders

I

• The equitable treatment of shareholders

II

• The role of stakeholders in corporate governance

III

• Disclosure and transparency

IV

• The responsibilities of the board

V

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 7. VALUATION IMPLICATIONS OF CORPORATE
GOVERNANCE

Benefits from a strong

corporate governance

Risks of weak
corporate governance

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 RISKS OF WEAK CORPORATE GOVERNANCE

Strategic
Accounting risk Asset risk Liability risk
policy risk
• The risk that a • The risk that the • The risk that • The risk that
company’s firm’s assets management managers may
financial may be will enter into enter into
statement misappropriated excessive transactions or
recognition and by managers or obligations that incur other
related directors. destroy the business risks
disclosures are value of that are self-
incomplete, shareholders’ serving and may
misleading, or equity. not be in the
materially best long-term
misstated. interest of
shareholders.

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 BENEFITS FROM STRONG GOVERNANCE
Evidence suggests that:
 companies with strong governance had greater investment performance.
 companies with strong shareholders’ rights outperformed those with weak
protections.

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 8. SUMMARY
 Corporate governance is the system of principles, policies, procedures, and
clearly defined responsibilities and accountabilities.
 The objectives of a corporate governance system are (1) to eliminate or
mitigate conflicts of interest among stakeholders, particularly between
managers and shareholders, and (2) to ensure that the assets of the
company are used efficiently and productively and in the best interests of the
investors and other stakeholders.
 The failure of a company to establish an effective system of corporate
governance represents a major operational risk to the company and its
investors.

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 SUMMARY (CONTINUED)
• The specific sources of conflict in corporate agency relationships are manager-
shareholder.
• The responsibilities of board members, both individually and as a group, are to
establish corporate values and effective governance structures for the
company.

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 SUMMARY (CONTINUED)
• Companies committed to corporate governance often provide a statement of
corporate governance policies. Analysts should assess:
 the code of ethics; statements of the oversight, monitoring, and review
responsibilities of directors;
 statements of management’s responsibilities with respect to information and
access of directors to internal company functions;
 reports of directors’ examinations, evaluations, and findings;
 board and committee self-assessments; management self-assessments; and
 training policies for directors.
• Weak corporate governance systems give rise to risks including accounting
risk, asset risk, liability risk, and strategic policy risk.

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