Corporate Finance

Fifth Edition, Global Edition

Chapter 29
Corporate Governance

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Chapter Outline (1 of 2)
29.1 Corporate Governance and Agency Costs
29.2 Monitoring by the Board of Directors and Others
29.3 Compensation Policies
29.4 Managing Agency Conflict
29.5 Regulation

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Chapter Outline (2 of 2)
29.6 Corporate Governance Around the World
29.7 The Tradeoff of Corporate Governance

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Learning Objectives (1 of 4)
• Define corporate governance, and describe its role in the
successful reduction of agency problems.
• Describe the roles of the following in corporate
governance:
a. The board of directors
b. The market for corporate control
c. Regulation

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Learning Objectives (2 of 4)
• Define the term “captured board” and describe situations in
which a board is most likely to be captured.
• Discuss the costs and benefits of having managers as
shareholders, in terms of proper corporate governance.
• Discuss the costs and benefits of having managerial
compensation tied to firm performance, in terms of proper
corporate governance.

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Learning Objectives (3 of 4)
• Identify alternatives available to shareholders if the board
fails to act in their interests.
• Identify the methods that boards can use to entrench
themselves.
• Describe the provisions of the Exchange Acts of 1933 and
1934, the Sarbanes-Oxley Act of 2002, and the Dodd-
Frank Act of 2010, which attempt to improve shareholder
protections.

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Learning Objectives (4 of 4)
• Compare corporate governance practices across
countries. Specifically address the following:
a. Common-law v s. civil-law countries
ersu

b. Pyramidal ownership structures

c. Dual class shares
d. The role of employees in governance
e. Cross-holdings

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29.1 Corporate Governance and Agency
Costs
• Corporate Governance
– The system of controls, regulations, and incentives
designed to minimize agency costs between managers
and investors and prevent corporate fraud
 The role of the corporate governance system is to
mitigate the conflict of interest that results from the
separation of ownership and control without unduly
burdening managers with the risk of the firm.

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29.2 Monitoring by the Board of
Directors and Others
• In the United States, the board of directors has a clear
fiduciary duty to protect the interests of the shareholders.
– Most other countries give some weight to the interests
of other stakeholders in the firm, such as the
employees.

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Types of Directors (1 of 2)
• Inside Directors
– Members of a board of directors who are employees,
former employees, or family members of employees
• Gray Directors
– Members of a board of directors who are not as directly
connected to the firm as insiders are, but who have
existing or potential business relationships with the firm

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Types of Directors (2 of 2)
• Outside (Independent) Directors
– Any member of a board of directors other than an
inside or gray director

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Board Independence (1 of 2)
• On a board composed of insider, gray, and independent
directors, the role of the independent director is really that
of a watchdog.
– However, because independent directors’ personal
wealth is likely to be less sensitive to performance than
that of insider and gray directors, they have less
incentive to closely monitor the firm.

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Board Independence (2 of 2)
• Captured
– Describes a board of directors whose monitoring duties
have been compromised by connections or perceived
loyalties to management

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Board Size and Performance
• Researchers have found that smaller boards produce
surprisingly robust result that are associated with greater
firm value and performance.
– The likely explanation for this phenomenon comes from
the psychology and sociology research, which finds
that smaller groups make better decisions than larger
groups.

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Other Monitors
• Includes security analysts, lenders, the SE C, and
employees
– Securities analysts produce independent valuations of
the firms they cover so that they can make buy and sell
recommendations to clients.
– Lenders carefully monitor firms to which they are
exposed as creditors.
– Employees of the firm are most likely to detect outright
fraud because of their inside knowledge.
– The S E C protects the investing public against fraud
and stock price manipulation.

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29.3 Compensation Policies
• Stock and Options
– Managers’ pay can be linked to the performance of a
firm in many ways.
 Many companies have adopted compensation
policies that include grants of stock or stock options
to executives.
– These grants give managers a direct incentive to
increase the stock price, which ties managerial
wealth to the wealth of shareholders.

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Pay and Performance Sensitivity (1 of 4)
• The use of stock and option grants in the 1990s has lead
to a substantial increase in management compensation.
– However, this has had some negative consequences.

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Pay and Performance Sensitivity (2 of 4)
• For example, often options are granted “at the money,”
meaning that the exercise price is equal to the current
stock price.
– Managers therefore have an incentive to manipulate
the release of financial forecasts so that bad news
comes out before options are granted (to drive the
exercise price down) and good news comes out after
options are granted.

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Figure 29.1 CE O Compensation

Source: Execucomp
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Pay and Performance Sensitivity (3 of 4)
• Recent research has found evidence suggesting that many
executives have engaged in backdating their option grants.

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Pay and Performance Sensitivity (4 of 4)
• Backdating
– The practice of choosing the grant date of a stock
option retroactively, so that the date of the grant would
coincide with a date when the stock price was lower
than its price at the time the grant was actually
awarded.
 By backdating the option in this way, the executive
receives a stock option that is already in-the-money.

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29.4 Managing Agency Conflict
• Academic studies have supported the notion that greater
managerial ownership is associated with fewer value-
reducing actions by managers.
– But while increasing managerial ownership may reduce
perquisite consumption, it also makes managers
harder to fire.

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Direct Action by Shareholders (1 of 3)
• Shareholder Voice
– Any shareholder can submit a resolution that is put to a
vote at the annual meeting.
 Recently, unhappy shareholders have started to
refuse to vote to approve the slate of nominees for
the board.

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Direct Action by Shareholders (2 of 3)
• Shareholder Approval
– Shareholders must approve many major actions taken
by the board.
 For example, target shareholders must approve
merger agreements.

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Direct Action by Shareholders (3 of 3)
• Proxy Contests
– Disgruntled shareholders can hold a proxy contest and
introduce a rival slate of directors for election to the
board.
 This gives shareholders an actual choice between
the nominees put forth by management and the
current board and a completely different slate of
nominees put forth by dissident shareholders.

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Figure 29.2 Proxy Contest Outcomes

Source: FactSet SharkWatch

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Management Entrenchment
• Large investors have become increasingly interested in
measuring the balance of power between shareholders
and managers in a firm.
– The Investor Responsibility Research Center (I RR C)
has collected information on 24 different characteristics
that can entrench managers.

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The Threat of Takeover
• Many of the provisions listed in the I RR C index concern
protection from takeovers.
– One motivation for a takeover can be to replace poorly
performing management.
 An active takeover market is part of the system
through which the threat of dismissal is maintained.

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29.5 Regulation
• The Sarbanes-Oxley Act (SO X)
– The overall intent of SO X was to improve the accuracy
of information given to both boards and to
shareholders.
 S O X attempted to achieve this goal in three ways:
1. By overhauling incentives and independence in
the auditing process.
2. By stiffening penalties for providing false
information.
3. By forcing companies to validate their internal
financial control processes.

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The Cadbury Commission
• Following the collapse of some large public companies, the
U.K. government commissioned Sir Adrian Cadbury to
form a committee to develop a code of best practices in
corporate governance.

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Dodd-Frank Act
• Dodd-Frank added a number of new regulations designed
to strengthen corporate governance, including
– Independent Compensation Committees
– Nominating Directors
– Vote on Executive Pay and Golden Parachutes
– Claw back Provisions
– Pay Disclosure

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Insider Trading
• Insider Trading
– Occurs when a person makes a trade based on
privileged information
 Some examples of insider information include
knowledge of an upcoming merger announcement,
earnings release, or change in payout policy.
– The penalties for violating insider trading laws
include jail time, fines, and civil penalties.

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29.6 Corporate Governance Around the
World
• Protection of Shareholder Rights
– The degree to which investors are protected against
expropriation of company funds by managers and even
the degree to which their rights are enforced vary
widely across countries and legal regimes.

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Controlling Owners and Pyramids (1 of 8)
• Much of the focus in the United States is on the agency
conflict between shareholders and managers.
• In many other countries, the central conflict is between
what are called “controlling shareholders” and “minority
shareholders”.

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Controlling Owners and Pyramids (2 of 8)
• In these firms, there is usually little conflict between the
controlling family and the management (it is often made up
of family members).
• Instead, the conflict arises between the minority
shareholders (those without the controlling block) and the
controlling shareholders.

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Controlling Owners and Pyramids (3 of 8)
• Dual Class Shares and the Value of Control
– Dual Class Shares
 When one class of a firm’s shares has superior voting
rights over the other class
– One way for families to gain control over firms even
when they do not own more than half the shares is to
issue dual class shares.
• For example, a class B share might have 10
votes for every one vote of a class A share.
• Controlling shareholders will hold all or most of
the shares with superior voting rights and issue
the inferior voting class to the public.

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Controlling Owners and Pyramids (4 of 8)
• Pyramid Structures
– Pyramid Structure
 A way for an investor to control a corporation without
owning 50% of the equity whereby the investor first
creates a company in which he has a controlling
interest.
– This company then owns a controlling interest in
another company.
– The investor controls both companies but may
own as little as 25% of the second company.

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Controlling Owners and Pyramids (5 of 8)
• Pyramid Structures
– The following slide details an actual pyramid controlled
by the Pesenti family in Italy as of 1995.
 The Pesenti family effectively controls five
companies even though it does not have more than
50% ownership of any one of them.

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Figure 29.3 Pesenti Family Pyramid,
1995

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Controlling Owners and Pyramids (6 of 8)
• Pyramid Structures
– Tunneling
 A conflict of interest that arises when a shareholder
who has a controlling interest in multiple firms
moves profits (and hence dividends) away from
companies in which he has relatively less cash flow
toward firms in which he has relatively more cash
flow rights (“up the pyramid”).

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Controlling Owners and Pyramids (7 of 8)
• The Stakeholder Model
– Stakeholder Model
 The explicit consideration most countries (other than
the United States) give to other stakeholders
besides equity holders, in particular, rank-and-file
employees.

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Table 29.1 Employee Participation in Corporate
Governance in OEC D Countries
Mandated Works Employee Constitutional No Explicit
Councils Appointed Board Employee Requirements
Members Protections
Austria Austria France Australia
Belgium Czech Republic Iceland Canada
Denmark Denmark Italy Chile
Finland Estonia Norway Ireland
France France blank Israel
Germany Germany blank Japan
Greece Hungary blank Mexico
Hungary Luxembourg blank New Zealand
Korea Netherlands blank Poland
Netherlands Norway blank Switzerland
Portugal Slovak Republic blank Turkey
Slovenia Slovenia blank United Kingdom
Spain Sweden blank United States
Source: Based on Organization for Economic Cooperation and Development, Survey of Corporate
Governance Developments in OEC D Countries (2004) and OEC D Corporate Governance Factbook
2017.
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Controlling Owners and Pyramids (8 of 8)
• Cross-Holdings
– While in the United States it is rare for one company’s
largest shareholder to be another company, it is the
norm in many countries.
 In Japan, groups of firms connected through cross-
holdings and a common relation to a bank are
known as keiretsu.
 In Korea, huge conglomerate groups comprise
companies in widely diversified lines of business
and are known as chaebol.

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29.7 The Tradeoff of Corporate
Governance
• Corporate governance is a system of checks and balances
that trades off costs and benefits.
– This trade-off is very complicated. No one structure
works for all firms.
– Good governance is value enhancing and is something
investors in the firm should strive for.

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Chapter Quiz
1. What is corporate governance?
2. What does it mean for a board to be captured?
3. What is the negative effect of increasing the sensitivity of
managerial pay to firm performance?
4. What is the role of takeovers in corporate governance?
5. Describe the main requirements of the Sarbanes-Oxley
Act of 2002.
6. How does shareholder protection vary across countries?

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