Corporate governance notes
Lecture 9 - March 10th
Corporate governance:
Learning objectives of the course:
- Explain corporate governance theories, mechanisms and the cross-country differences;
- Evaluate scientific research on the functioning of corporate governance mechanisms
and their impact on firm value / performance.
Corporation and its typical features
A corporation is a legal entity that is separate and distinct from its owners, established
under the laws of state country.
Stakeholder: any individual or group on which the activities of the company have an impact.
Corporation typical features summary
- Separation of ownership and control
, o Ownership through shares: shareholders are the owners. Shares are transferable.
o Control: the power to make decisions about how the firm is run
▪ Managers/executives (e.g., CEO, CFO) have direct control over daily
decisions.
▪ Board of directors has formal oversight control.
▪ Shareholders have ultimate control through voting rights but often weak in
practice due to dispersion.
- Limited liability: shareholders of a corporation are only liable for the company’s debts
and obligations up to the amount they invested.
- Legal rights and responsibilities (legal person): it can be sue or be sued, enter into
contracts, and are held accountable for their actions under the law.
- Perpetual existence: It continues to exist independently of the lives, involvement, or
status of its owners (shareholders) and managers. A corporation only ends if it is legally
dissolved (e.g., bankruptcy, merger, liquidation).
Stakeholders are not a formal legal feature of a corporation, but they are an inherent part
of how corporations operate in society.
Corporate features create important benefits, such as efficiency and professional
management.
Agency theory
Separation of ownership and control -> managers are hired by shareholders
- Principal: anyone who hires someone else to do a certain job at their expense.
- Agent: a person hired to do a certain job in exchange for an agreed compensation.
- Principal and agent may have different interests ⇒ potential risk of agent acting in his
own interest on the principal’s expense ⇒agency problems arise
Agency theory in the corporate setting
Shareholders-manager problem
- Shareholders (principals) employ managers (agents) to run the firm in the best interest
of the shareholders.
- However, some managers act wrong and embezzle shareholder funds.
o Insufficient effort
, o Extravagant investments: pet projects and empire building
o Entrenchment strategies: take actions that hurt shareholders to keep or secure
their position
▪ invest in a declining industry or old-fashioned technology that they are
good at running
▪ manipulate performance measures
o Self-dealing: increase private benefits from running the firm
▪ outright expropriation of shareholder value
▪ excessive salaries and consumption of perquisites, e.g., private jet
What happens when managers own shares in the company they work for?
Managerial ownership and firm value
If you’re a CEO of a company and are a shareholder -> you reduce risk because it is all about
your personal wealth.
- Firm value initially increases with managerial ownership due to incentive alignment and
reduced agency costs, but beyond a certain point it declines as entrenchment and risk-
bearing inefficiencies dominate, producing an inverted-U relationship.
Conflicts between majority and minority shareholders
- When ownership is concentrated, controlling shareholders (families, founders, the state,
or business groups) may take actions that benefit themselves at the expense of minority
shareholders. This is known as the expopriation problem or tunneling.
o Related-party transactions
o Board control
o Dual-class structure
Conflicts between shareholders and debtholders
- Shareholders and debtholders are the firm’s primary investors.
o Debtholders: fixed claimants receiving a primised payment up to the value of their
loan
o Shareholders: residual claimannts receiving the remaining payoff after debt is
repaid
Why conflicts arise?
, - Different payoff structures create conflicting incentives
- Shareholders capture upside gains, while debtholders are exposed to downside risk
Typical agency probems include:
- Risk shifting (asset substitution)
- Underinvestment (debt overhang)
- Wealth transfer via dividends or buybacks
Information asymmetry theory
- There is also the problem of information asymmetry whereby different groups have
access to different levels of information.
- Typically the principal (shareholders) is at a disadvantage because the agent (managers)
will have more information.
- Information asymmetry theory studies situations in which one party to a transaction
possesses more or better information than the other, leading to market inefficiencies and
distorted incentives.
- Two types of information problems
o Adverse selection
o Moral hazard
Type 1: adverse selection
- Suppose in the second-hand car market, 50% cars are good type (“peach”) with value
$10,000 and 50% cars are bad type (“lemon”) with value $5,000.
- As a buyer, what will you offer if you cannot tell the quality of a car but the sellers can?
- If you are rational, you will offer the expected value of a car
50% × $10, 000 + 50% × $5, 000 = $7, 500
- But if you offer only $7,500, good quality car sellers will leave the market (Why?).
➔ all cars in the market are “lemon” (bad) cars!
Adverse selection
When one party in a transaction has more information than the other party, this can
lead to unfavorable outcomes for the less-informed party and market inefficiencies.
- used car market (“market for lemons”)
- Unhealthy people know they need insurance → they are more likely to buy it.
- Boards cannot perfectly observe the quality of managers → they may hire less
competent managers.
Type 2: Moral Hazard
- If your house is not insured, you may be careful and take actions to prevent damage.
- If your house is insured, incentives to exert precautionary effort decrease, e.g., smoking
in bed.
Lecture 9 - March 10th
Corporate governance:
Learning objectives of the course:
- Explain corporate governance theories, mechanisms and the cross-country differences;
- Evaluate scientific research on the functioning of corporate governance mechanisms
and their impact on firm value / performance.
Corporation and its typical features
A corporation is a legal entity that is separate and distinct from its owners, established
under the laws of state country.
Stakeholder: any individual or group on which the activities of the company have an impact.
Corporation typical features summary
- Separation of ownership and control
, o Ownership through shares: shareholders are the owners. Shares are transferable.
o Control: the power to make decisions about how the firm is run
▪ Managers/executives (e.g., CEO, CFO) have direct control over daily
decisions.
▪ Board of directors has formal oversight control.
▪ Shareholders have ultimate control through voting rights but often weak in
practice due to dispersion.
- Limited liability: shareholders of a corporation are only liable for the company’s debts
and obligations up to the amount they invested.
- Legal rights and responsibilities (legal person): it can be sue or be sued, enter into
contracts, and are held accountable for their actions under the law.
- Perpetual existence: It continues to exist independently of the lives, involvement, or
status of its owners (shareholders) and managers. A corporation only ends if it is legally
dissolved (e.g., bankruptcy, merger, liquidation).
Stakeholders are not a formal legal feature of a corporation, but they are an inherent part
of how corporations operate in society.
Corporate features create important benefits, such as efficiency and professional
management.
Agency theory
Separation of ownership and control -> managers are hired by shareholders
- Principal: anyone who hires someone else to do a certain job at their expense.
- Agent: a person hired to do a certain job in exchange for an agreed compensation.
- Principal and agent may have different interests ⇒ potential risk of agent acting in his
own interest on the principal’s expense ⇒agency problems arise
Agency theory in the corporate setting
Shareholders-manager problem
- Shareholders (principals) employ managers (agents) to run the firm in the best interest
of the shareholders.
- However, some managers act wrong and embezzle shareholder funds.
o Insufficient effort
, o Extravagant investments: pet projects and empire building
o Entrenchment strategies: take actions that hurt shareholders to keep or secure
their position
▪ invest in a declining industry or old-fashioned technology that they are
good at running
▪ manipulate performance measures
o Self-dealing: increase private benefits from running the firm
▪ outright expropriation of shareholder value
▪ excessive salaries and consumption of perquisites, e.g., private jet
What happens when managers own shares in the company they work for?
Managerial ownership and firm value
If you’re a CEO of a company and are a shareholder -> you reduce risk because it is all about
your personal wealth.
- Firm value initially increases with managerial ownership due to incentive alignment and
reduced agency costs, but beyond a certain point it declines as entrenchment and risk-
bearing inefficiencies dominate, producing an inverted-U relationship.
Conflicts between majority and minority shareholders
- When ownership is concentrated, controlling shareholders (families, founders, the state,
or business groups) may take actions that benefit themselves at the expense of minority
shareholders. This is known as the expopriation problem or tunneling.
o Related-party transactions
o Board control
o Dual-class structure
Conflicts between shareholders and debtholders
- Shareholders and debtholders are the firm’s primary investors.
o Debtholders: fixed claimants receiving a primised payment up to the value of their
loan
o Shareholders: residual claimannts receiving the remaining payoff after debt is
repaid
Why conflicts arise?
, - Different payoff structures create conflicting incentives
- Shareholders capture upside gains, while debtholders are exposed to downside risk
Typical agency probems include:
- Risk shifting (asset substitution)
- Underinvestment (debt overhang)
- Wealth transfer via dividends or buybacks
Information asymmetry theory
- There is also the problem of information asymmetry whereby different groups have
access to different levels of information.
- Typically the principal (shareholders) is at a disadvantage because the agent (managers)
will have more information.
- Information asymmetry theory studies situations in which one party to a transaction
possesses more or better information than the other, leading to market inefficiencies and
distorted incentives.
- Two types of information problems
o Adverse selection
o Moral hazard
Type 1: adverse selection
- Suppose in the second-hand car market, 50% cars are good type (“peach”) with value
$10,000 and 50% cars are bad type (“lemon”) with value $5,000.
- As a buyer, what will you offer if you cannot tell the quality of a car but the sellers can?
- If you are rational, you will offer the expected value of a car
50% × $10, 000 + 50% × $5, 000 = $7, 500
- But if you offer only $7,500, good quality car sellers will leave the market (Why?).
➔ all cars in the market are “lemon” (bad) cars!
Adverse selection
When one party in a transaction has more information than the other party, this can
lead to unfavorable outcomes for the less-informed party and market inefficiencies.
- used car market (“market for lemons”)
- Unhealthy people know they need insurance → they are more likely to buy it.
- Boards cannot perfectly observe the quality of managers → they may hire less
competent managers.
Type 2: Moral Hazard
- If your house is not insured, you may be careful and take actions to prevent damage.
- If your house is insured, incentives to exert precautionary effort decrease, e.g., smoking
in bed.
