1. Definition of Corporate Governance
A basic definition of Corporate Governance is the following: “The system by which organizations are directed and controlled” or “An internal system encompassing policies, processes and people, which serves the needs of shareholders and other stakeholders, by directing and controlling management activities with good business savvy, objectivity, accountability and integrity. Sound corporate governance is reliant on external marketplace commitment and legislation, plus a healthy board culture which safeguards policies and processes”.
Traditionally defined as the ways in which a firm safeguards the interests of its financiers, Corporate Governance is a term that refers to the rules, processes and laws by which businesses are operated, regulated, and controlled. It is concerned with systems, processes, controls, accountabilities and decision-making at the highest level of an organization.
Corporate governance is about the way in which top managers execute their responsibilities and authority and how they account for that authority in relation to those that have entrusted them with assets and resources. In particular it is concerned with the potential abuse of the power and the need for openness, integrity and accountability in the decision-making processes of the organization.
The term can refer to internal factors defined by the officers, stockholders or constitution of a corporation, as well as to external forces such as consumer groups, clients, and government regulations.
2. Theoretical principles of Corporate Governance
2.1 Ownership and control separation
The separation of ownership and management of business contains a control problem caused by the special peculiarities in the relationship between the financial risk-bearer (principal) and the charged decision-maker (agent).
The investing public is a major source of funds for new or expanding operations. As companies have grown, their need for funds has grown, with the consequence that legal ownership of companies has become widely dispersed. Although large blocks of shares may be held by wealthy individuals or institutions, the total amount of stock in these companies is so large that even a very wealthy person is not likely to own more than a small fraction of it. The chief effect of this stock dispersion has been to give effective control of the companies to their salaried managers. Although each company holds an annual meeting open to all stockholders, who may vote on company policy, these gatherings, in fact, tend to ratify ongoing policy. Even if sharp questions are asked, the presiding officers almost invariably hold enough proxies to override outside proposals. The only real recourse for dissatisfied shareholders is to sell their stock and invest in firms whose policies are more to their liking. It is in the managers’ interest to keep the stockholders happy, for, if the company’s shares are regarded as a good buy, then it is easy to raise capital through a new stock issue. Thus, if a company is performing well in terms of sales and earnings, its executives will have a relatively free hand. If a company gets into trouble, its usual course is to agree to be merged into another incorporated company or to borrow money. In the latter case, the lending institution may insist on a new chief executive of its own choosing. If a company undergoes bankruptcy and receivership, the court may appoint someone to head the operation.
The specific feature if an agency relationship is that one party (agent) independently takes decisions by order of the other party (principal). An interpretation of the agency as delegation or transfers of property rights illustrate the close entanglement of Agency Theory in Property Rights Theory. Because off different payoff functions of principal and agent, an incentive exists for the agent to increase his own profit at the principal’s expense. The possibility of behaving opportunistically is opened to him by an asymmetrical distribution of information between both parties after contract, causing moral hazard.
There are two potential reasons for an ex-post information advantage of the agent:
• In a hidden-action type principal-agent relation the principal can neither observe all actions undertaken by the agent. Nor, can him effort of the agent. The principal only observes the outcomes of the agent’s actions.
• The agent may also have hidden knowledge; the principal does not know the exact information level of the agent. For that reason he cannot verify whether or not the agent has used his information correctly in the principal’s sense. The problem exists independently of the observability of the agent’s actions.
2.2 Information asymmetry
Condition in which at least some relevant information is known to some but not all parties involved, the information asymmetry is a condition in which information is not entirely shared among individuals belonging to the economic process, so some of the agents has more information than the rest of the participants and can benefit from this configuration. Information asymmetry is closely linked to the ownership and separation control, because of access to information for shareholders. Information asymmetry is a very important concept because securities markets are subject to information asymmetry problems. This is because of the presence of inside information and insider trading. Insiders know more than outsiders about the true quality of the firm. They may take advantage of their privileged position of information to earn excess profits. They may take actions that are beneficial to them but are detrimental to the interests of investors.
Information asymmetry models assume that at least one party to a transaction has relevant information whereas the other does not. Some asymmetric information models can also be used in situations where at least one party can enforce, or effectively retaliate for breaches of, certain parts of an agreement whereas the other cannot. This creates an imbalance of power in transactions which can sometimes cause the transactions to fail.
Asymmetry can lead to two main problems:
• Adverse selection- immoral behavior that takes advantage of asymmetric information before a transaction. For example, a person who is not being in optimal health may be more inclined to purchase life insurance than someone who feels fine.
• Moral Hazard- immoral behavior that takes advantage of asymmetric information after a transaction. For example, if someone has fire insurance they may be more likely to commit arson to reap the benefits of the insurance.
2.3 Agency problem and agency costs
The agency problem is an essential element of the so-called contractual view of the firm, a conflict of interest arising between creditors, shareholders and management because of differing goals. The essence of the agency problem is the separation of management and finance, or ownership and control. In this context, the agency problem refers to the difficulties financiers have in assuring that the investor’s funds are not expropriated or wasted on unattractive projects.
In the most general terms, the financer and the manager sign a contract that specifies what the manager does with the funds, and how the return are divided between him and the financers. The trouble is, most future contingencies are hard to describe and foresee, and as result, complete contracts are infeasible. This problem would not be avoided even if the manager is motivated to raise as much funds as he can, and so tries hard to accommodate the financier by developing a complete contract. Because of these problems in designing their contract, the manager and the financier have to allocate residual rights. For the simple reason that financiers are not qualified or informed enough to decide what to do, the manager ends up with substantial residual control rights and therefore discretion to allocate funds as he chooses. Agency cost is a type of internal cost that arises from, or must be paid to, an agent acting on behalf of a principal. Agency costs arise because of core problems such as conflicts of interest between shareholders and management. Shareholders wish for management to run the company in a way that increases shareholder value. But management may wish to grow the company in ways that maximize their personal power and wealth that may not be in the best interests of shareholders. These costs are defined as the sum of: monitoring costs of the shareholders and incentives fees paid to the managers. It can be expected that contracts will he devised that will provide the managers with appropriate incentives to maximize the shareholders’ wealth. Thus, the set of contracts theory suggests that the corporate firm will usually act in the best interests of shareholders. However, agency problems can never he perfectly solved, and managers may not always act in the best interests of shareholders. As a consequence shareholders may experience residual losses. Residual losses are the lost wealth of the shareholders due to divergent behavior of the managers.
2.4 Incomplete contractual relations
The incompleteness of contractual relationships designed to connect the developments in the theory of agency and implicit contracts with research on bounded rationality and the basis of computational models. These two related areas as implicit contracts are justified on the basis of bounded rationality, which is one of the justifications to calculating agent based models. The paper develops a general framework in which a population of individuals facing a long-term relationship. In this, two types of agents, sellers and buyers, a commodity exchange for a specified price on a set of characteristics specified in a private contract. We do not need to specify what is exchanged, but rather the institutional context in of the exchange, in order to be able to analyze the use of numerical simulations.
The agreement on an exchange constitutes acceptance of the terms of a contract. To that end, the officials must account for different facts, which are in short:
• The difficulty of including all possible contingencies in a contract.
• Asymmetries. Sellers have private information about intrinsic properties of the goods or service they sell.
• Expensive monitoring of the contract.
2.5 Incentive contracts
To help avoiding the problem of incomplete contracts, there are the so-called “incentive contracts”, that can induce the manager to act in investors’ interest without encouraging blackmail, although such contracts may be expensive if the personal benefits of control are high and there is a lower bound on the manager's compensation in the bad states of the world.
Incentive contracts can take a variety of forms, including share ownership, stock options or a threat of dismissal if income is low. The optimal incentive contract is determined by the manager’s risk aversion, the importance of his decisions and his ability to pay for the cash flow ownership up front.
The existence of the incentive contracts demonstrates the positive relationship between pay and performance. The most important problem is that contracts with important incentives create enormous opportunities for self-dealing for the managers. This means that managers might negotiate for themselves such contracts when they have for example the security that profits or stock price are likely to rise, or for example, this type of contracts could lead managers to manipulate accounting numbers and investment policy to increase their pay. To avoid this, there are numerous regulations, which have been very important to keep down the sensitivity of executive pay to performance.
3. Two systems of corporate governance
The governance system defines the relationship of the owners to their firm and the mechanisms through which the owners affect the institution's behavior. The governance issue is to ensure that management's interests are aligned with those of the shareholders. The focus on shareholder wealth is justified by recognizing that other suppliers of capital have mechanisms through which they can protect their interests after having committed their capital. Shareholders are unique in that they provide large amounts of capital but they could receive potential abuses through opportunistic behavior undertaken by managers.
Currently, there are two different systems of corporate governance: Insider control system, based on banks and developed in Germany; and Outsider control system, based on market and developed in USA and UK.
3.1 Insider control system
Insider control system is based on theory, which the main goal of the company is, beside maximization of the shareholders benefits, also respecting interest of all participating parties on the company activities, stakeholders. That is the reason why is called Stakeholders Theory.
In this system, the owners can be also members of management and the employees and unions can participate in the company control through its representatives in the supervisory board. Dominant owners are strategic investors, mainly banks and investment funds; private pension funds and institutional investors almost do not exist. The owners have an interest to eliminating foreign investors, so access of an outside investor into a company is uneasy. The greater importance in the Insider system is placed on the regulation and company control by supervisory board, it does not rely on capital market effect. The ownership is concentrated and companies own control block of shares among themselves, cross-ownership; the banks have, through that, high voting rights. The concentrated ownership enables the investors to monitor and influence management by active participation in the managing board and supervisory board. Managing board is the company executive body and consisting of managers is responsible to the supervisory board. The ownership control from the side of the owners is performed directly, by voting in the supervisory board that also appoints the managing board.
3.2 Outsider control system
Outsider control system is focused on theory, which the main goal of the company is to maximize the benefit of owners, Shareholders Value Theory. The management should respect and follow the interests of owners, which is primarily rate of return of owned share through the growth of dividends or share price. The interest of management can be in conflict with the interest of owners, because the hired managers want to maximize their own benefit and arises a problem in economical theory, agency problem. The manager are interested in reinvesting the generated profit again in the company and by that securing its growth and stable existence, but the interest of the shareholders is to invest the generated profit more effective elsewhere or spend on consumption.
The ownership control is performed by the stock market for company outsider control; owners show their dissatisfaction by selling their shares. The ownership is divided among institutional investors and minority shareholders, who have an insignificant decision power; but also the large institutional portfolio shareholders execute their power rarely directly. That is why they often use indirect voting by selling and buying shares instead of direct participation in the board of directors. The boards of directors are controlled by managers and non-executive directors, appointed also by managers, play rather small role in the ownership control.
The stock market is characterized by a large number of companies that trade on it and by a high liquidity; significant role on these markets is played by pension funds, insurance companies and other institutional investors.
3.3 Comparison of both systems
The main different between an insider control system and an outsider control system is that the first one is distinguished by strategic investors, like banks and investment funds and the second one is distinguished by a small number of controlling shareholders and little intercorporate equity holdings.
Characteristic Outsider Control System Insider Control System
Method of securing company control Threat of hostile takeover Direct monitoring by owners
Appraisal of a company Market by share price Non-market by owners
Access to information about a company Wide and easy Public difficult, privileged access by banks
Insider dealing Necessity of expensive regulation Rarely
Speculative capital existence Often Rarely
Number of companies traded on stock market High Low
Number of individual investors Relatively high Low
The role of institutional investors Portfolio Strategic
Flexibility to market changes High Low
Capital allocation Effective Potentially ineffective
Dominating agency conflict Shareholders versus management Majority shareholders vs minority shareholders
The role of hostile takeovers Important Very limited
A basic definition of Corporate Governance is the following: “The system by which organizations are directed and controlled” or “An internal system encompassing policies, processes and people, which serves the needs of shareholders and other stakeholders, by directing and controlling management activities with good business savvy, objectivity, accountability and integrity. Sound corporate governance is reliant on external marketplace commitment and legislation, plus a healthy board culture which safeguards policies and processes”.
Traditionally defined as the ways in which a firm safeguards the interests of its financiers, Corporate Governance is a term that refers to the rules, processes and laws by which businesses are operated, regulated, and controlled. It is concerned with systems, processes, controls, accountabilities and decision-making at the highest level of an organization.
Corporate governance is about the way in which top managers execute their responsibilities and authority and how they account for that authority in relation to those that have entrusted them with assets and resources. In particular it is concerned with the potential abuse of the power and the need for openness, integrity and accountability in the decision-making processes of the organization.
The term can refer to internal factors defined by the officers, stockholders or constitution of a corporation, as well as to external forces such as consumer groups, clients, and government regulations.
2. Theoretical principles of Corporate Governance
2.1 Ownership and control separation
The separation of ownership and management of business contains a control problem caused by the special peculiarities in the relationship between the financial risk-bearer (principal) and the charged decision-maker (agent).
The investing public is a major source of funds for new or expanding operations. As companies have grown, their need for funds has grown, with the consequence that legal ownership of companies has become widely dispersed. Although large blocks of shares may be held by wealthy individuals or institutions, the total amount of stock in these companies is so large that even a very wealthy person is not likely to own more than a small fraction of it. The chief effect of this stock dispersion has been to give effective control of the companies to their salaried managers. Although each company holds an annual meeting open to all stockholders, who may vote on company policy, these gatherings, in fact, tend to ratify ongoing policy. Even if sharp questions are asked, the presiding officers almost invariably hold enough proxies to override outside proposals. The only real recourse for dissatisfied shareholders is to sell their stock and invest in firms whose policies are more to their liking. It is in the managers’ interest to keep the stockholders happy, for, if the company’s shares are regarded as a good buy, then it is easy to raise capital through a new stock issue. Thus, if a company is performing well in terms of sales and earnings, its executives will have a relatively free hand. If a company gets into trouble, its usual course is to agree to be merged into another incorporated company or to borrow money. In the latter case, the lending institution may insist on a new chief executive of its own choosing. If a company undergoes bankruptcy and receivership, the court may appoint someone to head the operation.
The specific feature if an agency relationship is that one party (agent) independently takes decisions by order of the other party (principal). An interpretation of the agency as delegation or transfers of property rights illustrate the close entanglement of Agency Theory in Property Rights Theory. Because off different payoff functions of principal and agent, an incentive exists for the agent to increase his own profit at the principal’s expense. The possibility of behaving opportunistically is opened to him by an asymmetrical distribution of information between both parties after contract, causing moral hazard.
There are two potential reasons for an ex-post information advantage of the agent:
• In a hidden-action type principal-agent relation the principal can neither observe all actions undertaken by the agent. Nor, can him effort of the agent. The principal only observes the outcomes of the agent’s actions.
• The agent may also have hidden knowledge; the principal does not know the exact information level of the agent. For that reason he cannot verify whether or not the agent has used his information correctly in the principal’s sense. The problem exists independently of the observability of the agent’s actions.
2.2 Information asymmetry
Condition in which at least some relevant information is known to some but not all parties involved, the information asymmetry is a condition in which information is not entirely shared among individuals belonging to the economic process, so some of the agents has more information than the rest of the participants and can benefit from this configuration. Information asymmetry is closely linked to the ownership and separation control, because of access to information for shareholders. Information asymmetry is a very important concept because securities markets are subject to information asymmetry problems. This is because of the presence of inside information and insider trading. Insiders know more than outsiders about the true quality of the firm. They may take advantage of their privileged position of information to earn excess profits. They may take actions that are beneficial to them but are detrimental to the interests of investors.
Information asymmetry models assume that at least one party to a transaction has relevant information whereas the other does not. Some asymmetric information models can also be used in situations where at least one party can enforce, or effectively retaliate for breaches of, certain parts of an agreement whereas the other cannot. This creates an imbalance of power in transactions which can sometimes cause the transactions to fail.
Asymmetry can lead to two main problems:
• Adverse selection- immoral behavior that takes advantage of asymmetric information before a transaction. For example, a person who is not being in optimal health may be more inclined to purchase life insurance than someone who feels fine.
• Moral Hazard- immoral behavior that takes advantage of asymmetric information after a transaction. For example, if someone has fire insurance they may be more likely to commit arson to reap the benefits of the insurance.
2.3 Agency problem and agency costs
The agency problem is an essential element of the so-called contractual view of the firm, a conflict of interest arising between creditors, shareholders and management because of differing goals. The essence of the agency problem is the separation of management and finance, or ownership and control. In this context, the agency problem refers to the difficulties financiers have in assuring that the investor’s funds are not expropriated or wasted on unattractive projects.
In the most general terms, the financer and the manager sign a contract that specifies what the manager does with the funds, and how the return are divided between him and the financers. The trouble is, most future contingencies are hard to describe and foresee, and as result, complete contracts are infeasible. This problem would not be avoided even if the manager is motivated to raise as much funds as he can, and so tries hard to accommodate the financier by developing a complete contract. Because of these problems in designing their contract, the manager and the financier have to allocate residual rights. For the simple reason that financiers are not qualified or informed enough to decide what to do, the manager ends up with substantial residual control rights and therefore discretion to allocate funds as he chooses. Agency cost is a type of internal cost that arises from, or must be paid to, an agent acting on behalf of a principal. Agency costs arise because of core problems such as conflicts of interest between shareholders and management. Shareholders wish for management to run the company in a way that increases shareholder value. But management may wish to grow the company in ways that maximize their personal power and wealth that may not be in the best interests of shareholders. These costs are defined as the sum of: monitoring costs of the shareholders and incentives fees paid to the managers. It can be expected that contracts will he devised that will provide the managers with appropriate incentives to maximize the shareholders’ wealth. Thus, the set of contracts theory suggests that the corporate firm will usually act in the best interests of shareholders. However, agency problems can never he perfectly solved, and managers may not always act in the best interests of shareholders. As a consequence shareholders may experience residual losses. Residual losses are the lost wealth of the shareholders due to divergent behavior of the managers.
2.4 Incomplete contractual relations
The incompleteness of contractual relationships designed to connect the developments in the theory of agency and implicit contracts with research on bounded rationality and the basis of computational models. These two related areas as implicit contracts are justified on the basis of bounded rationality, which is one of the justifications to calculating agent based models. The paper develops a general framework in which a population of individuals facing a long-term relationship. In this, two types of agents, sellers and buyers, a commodity exchange for a specified price on a set of characteristics specified in a private contract. We do not need to specify what is exchanged, but rather the institutional context in of the exchange, in order to be able to analyze the use of numerical simulations.
The agreement on an exchange constitutes acceptance of the terms of a contract. To that end, the officials must account for different facts, which are in short:
• The difficulty of including all possible contingencies in a contract.
• Asymmetries. Sellers have private information about intrinsic properties of the goods or service they sell.
• Expensive monitoring of the contract.
2.5 Incentive contracts
To help avoiding the problem of incomplete contracts, there are the so-called “incentive contracts”, that can induce the manager to act in investors’ interest without encouraging blackmail, although such contracts may be expensive if the personal benefits of control are high and there is a lower bound on the manager's compensation in the bad states of the world.
Incentive contracts can take a variety of forms, including share ownership, stock options or a threat of dismissal if income is low. The optimal incentive contract is determined by the manager’s risk aversion, the importance of his decisions and his ability to pay for the cash flow ownership up front.
The existence of the incentive contracts demonstrates the positive relationship between pay and performance. The most important problem is that contracts with important incentives create enormous opportunities for self-dealing for the managers. This means that managers might negotiate for themselves such contracts when they have for example the security that profits or stock price are likely to rise, or for example, this type of contracts could lead managers to manipulate accounting numbers and investment policy to increase their pay. To avoid this, there are numerous regulations, which have been very important to keep down the sensitivity of executive pay to performance.
3. Two systems of corporate governance
The governance system defines the relationship of the owners to their firm and the mechanisms through which the owners affect the institution's behavior. The governance issue is to ensure that management's interests are aligned with those of the shareholders. The focus on shareholder wealth is justified by recognizing that other suppliers of capital have mechanisms through which they can protect their interests after having committed their capital. Shareholders are unique in that they provide large amounts of capital but they could receive potential abuses through opportunistic behavior undertaken by managers.
Currently, there are two different systems of corporate governance: Insider control system, based on banks and developed in Germany; and Outsider control system, based on market and developed in USA and UK.
3.1 Insider control system
Insider control system is based on theory, which the main goal of the company is, beside maximization of the shareholders benefits, also respecting interest of all participating parties on the company activities, stakeholders. That is the reason why is called Stakeholders Theory.
In this system, the owners can be also members of management and the employees and unions can participate in the company control through its representatives in the supervisory board. Dominant owners are strategic investors, mainly banks and investment funds; private pension funds and institutional investors almost do not exist. The owners have an interest to eliminating foreign investors, so access of an outside investor into a company is uneasy. The greater importance in the Insider system is placed on the regulation and company control by supervisory board, it does not rely on capital market effect. The ownership is concentrated and companies own control block of shares among themselves, cross-ownership; the banks have, through that, high voting rights. The concentrated ownership enables the investors to monitor and influence management by active participation in the managing board and supervisory board. Managing board is the company executive body and consisting of managers is responsible to the supervisory board. The ownership control from the side of the owners is performed directly, by voting in the supervisory board that also appoints the managing board.
3.2 Outsider control system
Outsider control system is focused on theory, which the main goal of the company is to maximize the benefit of owners, Shareholders Value Theory. The management should respect and follow the interests of owners, which is primarily rate of return of owned share through the growth of dividends or share price. The interest of management can be in conflict with the interest of owners, because the hired managers want to maximize their own benefit and arises a problem in economical theory, agency problem. The manager are interested in reinvesting the generated profit again in the company and by that securing its growth and stable existence, but the interest of the shareholders is to invest the generated profit more effective elsewhere or spend on consumption.
The ownership control is performed by the stock market for company outsider control; owners show their dissatisfaction by selling their shares. The ownership is divided among institutional investors and minority shareholders, who have an insignificant decision power; but also the large institutional portfolio shareholders execute their power rarely directly. That is why they often use indirect voting by selling and buying shares instead of direct participation in the board of directors. The boards of directors are controlled by managers and non-executive directors, appointed also by managers, play rather small role in the ownership control.
The stock market is characterized by a large number of companies that trade on it and by a high liquidity; significant role on these markets is played by pension funds, insurance companies and other institutional investors.
3.3 Comparison of both systems
The main different between an insider control system and an outsider control system is that the first one is distinguished by strategic investors, like banks and investment funds and the second one is distinguished by a small number of controlling shareholders and little intercorporate equity holdings.
Characteristic Outsider Control System Insider Control System
Method of securing company control Threat of hostile takeover Direct monitoring by owners
Appraisal of a company Market by share price Non-market by owners
Access to information about a company Wide and easy Public difficult, privileged access by banks
Insider dealing Necessity of expensive regulation Rarely
Speculative capital existence Often Rarely
Number of companies traded on stock market High Low
Number of individual investors Relatively high Low
The role of institutional investors Portfolio Strategic
Flexibility to market changes High Low
Capital allocation Effective Potentially ineffective
Dominating agency conflict Shareholders versus management Majority shareholders vs minority shareholders
The role of hostile takeovers Important Very limited