Chapter 4 FIN417

CFA Institute Ethical and Professional Standards of Corporate Governance Management

- Do they have a code of ethics? - Are there lots of perquisites? - How is their compensation structured?

Financial development can contribute to economic growth in three ways:

-It enhances the efficiency of investment allocation. -It channels savings toward real investments in productive capacities. -It enhances savings.

Overseas Stock Listing

Companies domiciled in countries with weak investor protection can bond themselves credibly to better investor protection by listing their stocks in countries with strong investor protection

Volker Rule:

Deposit-taking banks will be banned from proprietary trading and from owning more than a small fraction of hedge funds and private equity firms.

Discuss different ways that dominant investors use to establish and maintain the control of the company with relatively small investments.

Dominant investors may use: (i) shares with superior voting rights, (ii) pyramidal ownership structure, and (iii) inter-firm cross-holdings.

Consequences of Law

Protection of investors' rights has major economic consequences. consequences include: -The pattern of corporate ownership and valuation. -Development of capital markets. -Economic growth.

Many companies grant stocks or stock options to the managers. Discuss the benefits and possible costs of using this kind of incentive compensation scheme.

Stock options can be useful for aligning the interest of managers with that of shareholders and reduce the wedge between managerial control rights and cash flow rights. But at the same time, stock options may induce managers to distort investment decisions and manipulate financial statements so that they can maximize their benefits in the short run.

Systematic Risk Regulation

Systematically important firms will be identified and their financial condition will be monitored

Differences in Legal Protection of Investors

There is a marked difference in the legal protection of investors between the two most influential legal systems: English common law and French civil law.

Law and Corporate Governance

•Commercial legal systems of most countries derive from a relatively few legal origins. -English common law -French civil law -German civil law -Scandinavian civil law It should also be noted that the quality of law enforcement varies a great deal across countries

CFA Institute Ethical and Professional Standards of Corporate Governance The Board

- Is it largely independent? - Are the directors qualified? - Do they have access to outside resources? - How are they elected? - Do any directors have cross-company relationships?

Corporate Boards: Japan

-In Japan, most corporate boards are insider-dominated and primarily concerned with the welfare of the keiretsu to which the company belongs.

Derivatives

: OTC derivatives trading will move to electronic exchanges, with contracts settled through a clearinghouse

Consumer Protection

A new, independent Consumer Financial Protection Bureau will be set up to monitor mortgages and other loan products.

Epic bribe scandal at Petrobras, a major oil company controlled by the Brazilian government, that broke out in 2015 shocked the economic and political system of Brazil. Put simply, the company insiders, outside suppliers and contractors, and politicians colluded and stole billions of dollars from the company via kickbacks, bid riggings, overcharging for construction projects, etc. The Petrobras scandal led to a sharp drop of the company share price, laying off thousands of workers, and tilting the national economy toward recession. The scandal also seriously tarnished the image of Brazil as one of the promising emerging markets. Document in detail what happened at Petrobras and then investigate how the company's governance and the country's political culture may have contributed to the scandal.

According to the 2015 Corruption Perceptions Index compiled by Transparency International, a global civil organization, Brazil ranks 76th in the world below countries like Romania and Senegal. There has been wide-spread discontent in Brazil about the rampant corruption in the highest echelons of business and politics. Since March 2014, Brazil has been shaken by the news exposing the largest scandal involving the state-controlled Petrobras, the largest company in Brazil. Even Brazil's former President Luiz Inacio Lula da Silva was detained and interrogated for possible wrongdoings. The Petrobras corruption scheme involves multiple companies colluding to win over-priced contracts from Petrobras and paying a part of those contracts back to high-level employees of Petrobras as bribes. In return for the bribes, Petrobras executives condone the cartel scheme of the contracting companies. High-level government officials and politicians responsible for overseeing Petrobras also take bribes for condoning the corruption schemes. In Brazil, it is difficult to prosecute those suspects with high government positions due to the privileged status they enjoy. But prosecutors managed to successfully prosecute corrupt businessmen, bankers, and politicians.

Concentrated Ownership

Another way to alleviate the agency problem is to concentrate shareholdings •In the United States and the United Kingdom, concentrated ownership is relatively rare. •Elsewhere in the world, however, concentrated ownership is the norm

It has been shown that foreign companies listed in the U.S. stock exchanges are valued more than those from the same countries that are not listed in the U.S. Explain the reasons why U.S.-listed foreign firms are valued more than those which are not. Also explain why not every foreign firm wants to list stocks in the United States.

Foreign companies domiciled in countries with weak investor protection can bond themselves credibly to better investor protection by listing their stocks in U.S. exchanges that are known to provide a strong investor protection. Managers of some companies may not wish to list shares in U.S. exchanges, subjecting themselves to stringent disclosure and monitoring, for fear of losing their control rights and private benefits.

Explain "free cash flows." Why do managers like to retain free cash flows instead of distributing it to shareholders? Discuss what mechanisms may be used to solve this problem?

Free cash flow represents a firm's internally generated fund in excess of the amount needed to undertake all profitable investment projects. Managers may want to keep free cash flows to undertake unprofitable projects at the expense of shareholders to benefit themselves. Having some debt can impose disciplining effect on the managers and induce them to reduce waste of firm's resources.

The Market for Corporate Control

If a management team is really out-of-control, over time the share price will decline •At some point, a corporate raider will buy up enough shares to gain control of the board. •Then the raider either fires the incompetent managers and turns the firm around or he sells everything in sight for the break-up value. •Either way, the old managers are out of a job. •The threat of this unemployment may keep them in line.

Corporate Boards: England

In England, the majority of public companies voluntarily abide by the Code of Best Practice on corporate governance. It recommends that there should be at least three outside directors and that the board chairman and the CEO should be different individuals.

Studies show that the legal protection of shareholder rights varies a great deal across countries. Discuss the possible reasons why the English common law tradition provides the strongest and the French civil law tradition the weakest protection of investors.

In civil law countries, the state historically has played an active role in regulating economic activities and has been less protective of property rights. In England, control of the court passed from the crown to the parliament and property owners in seventeenth century. English common law thus became more protective of property owners, and this protection was extended to investors over time.

ENRON public corp

In the case of Enron and other dysfunctional corporations, the boards of directors grossly failed to safeguard shareholder interests

The Agency Problem

Shareholders allocate decision-making authority to the managers- Having short-term control of the firm's assets, managers might be tempted to act in the manager's short-term best interest instead of the shareholder's long-term best interest. A shareholder with a diversified portfolio would not have the time to devote to making the numerous decisions at each of his many companies anyway ex: Consumption of lavish benefits is one example. Outright stealing is another example. •Some Russian oil companies are known to sell oil to manager-owned trading companies at below-market prices. Even at that, they don't always bother to collect the bills

The Cadbury Code of the Best Practice adopted in the United Kingdom led to a successful reform of corporate governance in the country. Explain the key requirements of the Code and discuss how it may have contributed to the success of reform.

The Code requires that chairman of the board and CEO be held by two different individuals, and that there should be at least three outside board members. The recommended board structure helped to strengthen the monitoring function of the board and reduce the agency problem.

The Dodd-Frank Act

The Dodd-Frank Wall Street Reform and Consumer Protection Act passed in reaction to the financial crisis of 2007-2009. Volker Rule: Resolution Authority: Derivatives Systematic Risk Regulation: Consumer Protection:

The public corporation is owned by multitude of shareholders but managed by professional managers. Managers can take self-interested actions at the expense of shareholders. Discuss the conditions under which the so-called agency problem arises.

The agency problem arises when managers have control rights but insignificant cash flow rights. This wedge between control and cash flow rights motivates managers to engage in self-dealings at the expense of shareholders.

Resolution Authority:

The government can seize and dismantle a large bank if the bank faces impending failure.

Following corporate scandals and failures in the U.S. and abroad, there is a growing demand for corporate governance reform. What should be the key objectives of corporate governance reform? What kind of obstacles can there be thwarting reform efforts?

The key objectives of corporate governance reform should be to strengthen shareholder rights and protect shareholders from expropriation by corporate insiders, whether managers or dominant shareholders. Controlling shareholders or managers do not wish to lose their control rights and thus resist reform efforts.

The majority of major corporations are franchised as public corporations. Discuss the key strength and weakness of the 'public corporation'. When do you think the public corporation as an organizational form is unsuitable?

The key strength of the public corporation lies in that it allows for efficient risk sharing among investors. As a result, the public corporation may raise a large sum of capital at a relatively low cost. The main weakness of the public corporation stems from the conflicts of interest between managers and shareholders. If this problem, known as the agency problem, becomes severe with the entrenched management, resulting in misallocation of resources and destruction of shareholder wealth, the public corporation becomes unviable.

Key Issues of Governance and the Public Corporation

The public corporation, which is jointly owned by a multitude of shareholders protected with limited liability, is a major organizational innovation of vast economic consequences It is an efficient risk sharing mechanism that allows corporations to raise large amounts of capital A key weakness is the conflict of interest between managers and shareholders In principle, shareholders elect a board of directors, who in turn hire and fire the managers who actually run the company Furthermore, with diffused ownership, most shareholders have strong enough incentive to incur the costs of monitoring management themselves •In reality, management-friendly insiders often dominate the board of directors, with relatively few outside directors who can independently monitor the management.

Why is the English common law system more protective of investors than the French civil law system?

The state historically has played a more active role in regulating economic activities and has been less protective of property rights in civil law countries than in common law countries.

Corporate Boards Germany

The structure and legal charge of corporate boards vary greatly across counties. -In Germany the board is not legally charged with representing the interests of shareholders, but is instead charged with representing the interests of stakeholders (e.g. workers, creditors, etc.).

Explain 'the wedge' between the control and cash flow rights and discuss its implications for corporate governance.

When there is a separation of ownership and control, managers have control rights with insignificant cash flow rights, whereas shareholders have cash flow rights but no control rights. This wedge gives rise to the conflicts of interest between managers and shareholders. The wedge is the source of the agency problem

Ownership and Control

•Companies domiciled in countries with weak investor protection many need to have concentrated ownership as a substitute for legal protection. •This is not without costs. In companies with concentrated ownership, large shareholders can abuse smaller shareholders.

The Agency Problem at Enron

•Enron had about 3,500 subsidiaries and affiliates. Many of these were run and partly owned by Enron executives. •In retrospect, conflict of interest should have been an obvious concern. -The partnerships performed hundreds of millions of dollars of transactions with Enron itself, in some cases buying assets from the company or selling assets to it. •The problem is this: Where did the executives' loyalties lie? Are they trying to negotiate the best deal for the company that employs them and the shareholders who own the company, or the best deal for the partnership where they had an ownership stake? •To protect itself in dealings with these partnerships, the company supposedly set up safeguards that required top company officers and the board to review and approve deals between Enron and the partnerships.

Debt

•If managers fail to pay interest and principal to creditors, the company can be forced into bankruptcy and managers may lose their jobs. •Borrowing can have a major disciplinary effect on managers, motivating them to curb private benefits and wasteful investments and trim bloated organizations. •However, excessive debt creates its own agency problems.

Consequences of Law: Italy vs. the United Kingdom (concluded)

•In addition, as of 1999 only 247 companies are listed on the stock exchange in Italy, whereas 2,292 companies are listed in the United Kingdom. •In the same year, the stock market capitalization as a proportion of the annual GDP was 71 percent in Italy but 248 percent in the United Kingdom. •The stark contrast between the two countries suggests that protection of investors has significant economic consequences.

Remedies for the Agency Problem

•In the U.S., shareholders have the right to elect the board of directors. If the board remains independent of management, it can serve as an effective mechanism for curbing the agency problem

Capital Markets and Valuation

•Investor protection promotes the development of external capital markets. •When investors are assured of receiving fair returns on their funds, they will be willing to pay more for securities. •Thus, strong investor protection will be conducive to large capital markets. Weak investor protection can be a factor in sharp market declines during a financial crisis

Incentive Contracts

•It is difficult to design a compensation scheme that gives executives an incentive to work hard at increasing shareholder wealth. •Accounting-based schemes are subject to manipulation. •Executive stock options are an increasingly popular form of incentive compatible compensation

Consequences of Law: Italy vs. the United Kingdom

•Italy has a French civil law tradition with weak shareholder protection, whereas the United Kingdom, with its English common law tradition, provides strong investor protection. •In Italy the three largest shareholders own 58 percent of the company, on average. In the U.K. the three largest shareholders own 19 percent of the company, on average. -Company ownership is thus highly concentrated in Italy and more diffuse in the United Kingdom. •The stark contrast between the two countries suggests that protection of investors has significant economic consequences.

The Sarbanes-Oxley Act

•Major components of the Sarbanes-Oxley Act include: -Accounting regulation. -Audit committee. -Internal control assessment. -Executive responsibility. •Many companies find compliance burdensome, costing millions of dollars. Some foreign firms have chosen to list their shares on the London Stock Exchange instead of U.S. exchanges to avoid costly compliance

Corporate Governance Reform

•Scandal-weary investors around the world are demanding corporate governance reform. •It's not just the companies' internal governance mechanisms that failed; auditors, regulators, banks, and institutional investors also failed in their respective roles. Failure to reform corporate governance will damage investor confidence, stunt the development of capital markets, raise the cost of capital, distort capital allocation, and even shake confidence in the capitalist system itself

The Cadbury Code of Best Practice

•The Cadbury Code of Best Practice is an ethical standard, without the force of law. However, the London Stock Exchange requires listed firms to either comply or explain why they cannot. -About 90 percent of LSE-listed firms comply with the code. •Requires the board of directors of firms to: -Meet regularly. -Retain full and effective control over the company. -Monitor executive management. •The code says that there should be a clearly accepted division of responsibilities at the head of a company, such that no one person has unfettered power. •The board should include non-executive directors in sufficient number for their views to carry weight.

Pyramidal Ownership Structure

•The pyramidal ownership structure illustrated in Exhibit 4.6 makes it possible for large investors to acquire significant control rights with relatively small investments. -For example, Robert Bosch GmbH controls 25 percent of Stella Automobil, which in turn owns 25 percent of Mercedes-Automobil Holding, which controls 25 percent of Daimler-Benz. -AG. Robert Bosch can possibly control up to 25 percent of the voting rights of Daimler-Benz AG with only 1.56 percent cash flow rights in the company.