Introduction to Corporate Governance Sep 17 2011
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Introductory remarks on good corporate governance practices and implications on board performance and rights and responsibilities for Mongolian directors.
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Introduction to Corporate Governance Sep 17 2011
- 1. Corporate Governance: Role of the Board and Implications on Shareholder Wealth Creation Dr. Demir Yener USAID/Business Plus Initiative Sr. Finance and Corporate Governance Advisor CORPORATE GOVERNANCE DEVELOPMENT CENTER
- 2. Agenda Purpose: To explain the concept and processes of corporate governance Outline: 1. Introduction, definition for corporate governance, 2. OECD Principles of Corporate Governance 3. Forms of Business Ownership 4. Separation of Ownership and Control: The Principal-Agent Dilemma 5. Benefits of Good Corporate Governance 6. Mongolian CG Environment 7. Duties of the Board: Risk Management 8. Summary and Conclusions Governance Corporate 2
- 3. Learning Objectives Understand what is corporate governance and why it matters Understand the relationship between shareholders, management and the board Understand why corporate governance is necessary to incentivize good business practices Appreciate how to go about implementing corporate governance in the most effective way The relevance of good CG practices for Mongolian Companies Corporate Governance 3
- 4. INTRODUCTION, DEFINITION, AND OECD PRINCIPLES OF CG Corporate Governance 4
- 5. Working definition of Corporate Governance Corporate Governance involves a set of relationships and the networks between a company’s management, its board of directors, its shareholders and stakeholders. Good corporate governance practice ensures the shareholders a fair rate of return. Corporate Governance 5
- 6. Stakeholders in Corporate Governance Primary Other Stakeholders Stakeholders •Shareholders •Managers •Board •Employees •Executive Management Stakeholders •Customers of the Firm •Suppliers •Community at large •Government •Financial Markets Corporate Governance •Environmentalists 6
- 7. Corporate governance has many links Finance Culture Law Risk Ethics Mgmt Economi Strategy Governance Corporate 7 cs
- 8. Corporate Governance 8
- 9. FORMS OF BUSINESS OWNERSHIP Corporate Governance 9
- 10. Implications of the Legal Form of the Firm Corporate Form The nature of governance implies that when an entity adopts the legal form of a “corporation” it has shareholders, a board, and a separate management. Essential Attributes of a Corporation Centralized Ownership interests Separate Identity Limited Liability management are freely transferable Broad Application The term “corporate governance” is applicable to include all types and sizes of enterprises so long as they have owners, managers, and a business interest. Corporate Governance 10
- 11. Common forms of business ownership Sole Limited Proprietorship Joint Stock Cooperatives Liability or Company Company Partnership Ownership Multiple Single Owner or Shareholders Shareholders members (min 9) Partners Owner’s liability Limited Unlimited Limited Limited Easy access to No No No Yes capital market? Is management No No Yes Yes and ownership separate? Are business No No Yes Yes owners exposed to double Corporate Governance 11 taxation?
- 12. SEPARATION OF OWNERSHIP AND CONTROL: THE PRINCIPAL-AGENT DILEMMA Corporate Governance 12
- 13. Conflict of Interests: The heart of the matter in corporate governance The Principal – Agent Dilemma Shareholders’ Interests Managers’ Interests The Board is responsible for resolving the “conflict of interest” issue between shareholders and managers Corporate Governance 13
- 14. Principal-Agent Dilemma and Asymmetric Information Principal Agent Corporate Governance 14
- 15. Typical Agency Costs Divergence Monitoring Incentives • Management fails to • Developing and • Share Holders need to maximize SH wealth implementing monitoring remunerate management • Actual results deviate from and control structures with extra incentives that expected annual results reduce cash flow to SH reduce wealth The main role of corporate governance is to reduce total agency costs in order to maximize shareholder value.15 Corporate Governance
- 16. The Four Basic Values of Corporate Governance TRANSPARENCY ACCOUNTABILITY RESPONSIBILITY FAIR TREATMENT • Ensures timely, • CEO Accountable • Recognize the • Protect SH rights material & accurate to the BOD legal rights of all Treat all SHs and information is • BOD accountable SHs minorities available to the S/H • Encourage equitably • Info on Finance, Performance, cooperation • Provide for between company effective redress Ownership, and stakeholders Governance for violations • Prevents Information asymmetries Corporate Governance 16
- 17. Main governing bodies in the company Executive Shareholders Board Management Represents SH Helps formulate Provides capital and Execute Strategy Sets strategy Provides guidance to CEO Provides Elects or transparent dismisses BOD reporting and Monitors CEO disclosure Corporate Governance 17
- 18. The Board is the Representative of Shareholders The main role of the board is to monitor the management in order to reduce total agency costs, and ensure the Corporate Governance 18 maximization of SH’s wealth
- 19. Different Types of Boards ‘Yes-men’ ‘Good Old Boys’ ‘Rubber Stamp’ Board Board Board ‘The Real Thing’ ‘Phantom’ ‘Country Club’ Board Board ? ‘Trophy’ Board 19
- 20. Degree of Board Involvement in Management Passive Certifying Engaged Intervening Operating Certifies to SH that CEO meets Provides insight Intensely At the & Support involved in Makes key expectations discretion of decision decision, and CEO Takes Understands its making on key management corrective monitoring role Limited Activity issues implements action Guides and & Participation Frequent and Fills gaps in Understands judges the CEO Limited intense management role of Has the right meetings—on experience. Accountability independent skills mix short notice directors Low High 20
- 21. The Chairman of the Board and Directors Corporate Governance 21
- 22. Role of Stakeholders Stakeholders cannot have claims on the firms except those specified by laws Firms have a social responsibility to fulfill so they must act in the broad interests of the society at large Corporate Governance 22
- 23. The Separation of Ownership and Control Corporate Governance 23
- 24. The Stakeholders of the Firm Employees Shareholders Community Government Environmental Management Customers Groups Suppliers Wage equity Financial returns Political Regulatory Pollution Financial Product safety corruption compliance returns (for people and the environment) Workplace Accurate and Local Pollution and Biodiversity Stock options Customer health and timely disclosure employment other satisfaction safety of operations environmental and performance issues Workforce Corporate Living Workplace Regulatory Executive Product diversity governance, environment/ health and compliance remuneration performance including safety executive compensation Job security Increase in share Environmental Employment Sustainability Increase share Responsible and prices standards value advertising regulatory practices compliance Salary Shareholder Regulatory Discrimination Human rights New technology Product increase proxies compliance environmental impact Dividends Risk Health and Social Socially Dividends/ Regulatory management safety benefits/taxes responsible financial compliance investments performance Growth, Protection of Standard of Environment Regulatory Growth, Safety standards Corporate Governance 24 prestige and rights/ living and safety compliance prestige and reputation dividends standards reputation
- 25. BENEFITS OF GOOD CG Corporate Governance 25
- 26. Good Corporate Governance Attracts Capital • Good corporate governance helps improve access to capital investment and finance with better terms and lowers cost of capital for good firms Corporate Governance 26
- 27. Benefits of Good Corporate Governance 5. Shareholder wealth creation assured 4. Improved operational efficiency increases competitiveness 3. Public recognition results in better access to finance 2. Improved CG structure lowers the cost of capital 1. Basic legal compliance improves company reputation 27
- 28. Good CG ensures better access to capital Good board Material Investor SH rights guidance and timely friendly protected & disclosure company oversight Access to finance facilitated Corporate Governance 28
- 29. Good CG Practices Stimulate Firm Performance • Streamlining business process • Improves operating performance Efficiency • Lowers costs and capital expenditures • Improving ROE • Increase profitability ROE • Improves the chances that SHs will receive sustainable dividends • Profitability improves share price performance • Firms gets better recognition as a good performing stock Higher • Attracts investor confidence, and new capital Share Price Corporate Governance 29
- 30. Lowering the cost of capital and raising the value of the firm 73% would consider a premium for better governed firms-depending on region Average premium of investors are ready to pay for well-governed companies, in % 13 Germany 14 USA 23 Poland 24 Brazil 25 China 39 Russia 0 10 20 30 40 50 Corporate Governance 30 Source: McKinsey, Global Investor Opinion Survey on Corporate Governance, 2002
- 31. Good Corporate Governance Increases Long Term Performance % 50 Average 30% Average premium investors would be willing to pay differs 40 41% Morocco by country and regions Egypt Average 22% Russia Average 22% Average 14% 30 China 25% Average 13% 27% Turkey 24% Argentina Philippines 23% Poland 20 South Africa Thailand 19% Mexico 22% Columbia Italy 19% Taiwan 14% USA 13% Germany Chile 18% 11% Canada 10 12% United Kingdom 0 E Europe/Africa Latin America Asia Western Europe Northern America Source: McKinsey Global Investor Opinion Survey on Corporate Governance, 2002 Corporate Governance 31
- 32. Building the Business Case for Good CG • Transparent • Investors are • Responsible protected • Accountable under the law • Fair • Prudential investment regulation environment Open Rule of Market Law Investor Lower Confiden Systemic ce Risk • Increasing • Transparency investor improves confidence market price attract discovery investments mechanism to the market Corporate Governance 32
- 33. The Analytical Framework for CG CG is a Public Policy Concern: Governments have now recognized the strong correlation between sound macro-economic policies and microeconomic foundations. Effective corporate governance practice is key to improving micro-economic efficiency through competitiveness and provides the foundation for access to finance for all firms. Corporate Governance 33
- 34. THE PROPER ENVIRONMENT FOR CORPORATE GOVERNANCE Corporate Governance 34
- 35. The Environment for Good Corporate Governance Good CG helps make the company Competitive Competitiveness requires: • Quality of the Business Environment • MACRO Economic Environment • The Quality of Business Strategy and Operations • Ensuring sustainable productivity growth Corporate Governance 35
- 36. Impact Points on Micro and Macro Policies Policy* Company Impact Points** Category Instrument Finance Marketing Production Organization Monetary Interest Rates (A) X Credit (O) X Fiscal Tax Rates (L) X Investment Credit (L) X X Government Sales (O) X Government Purchases (O) X Incomes Price Controls (A) X Wage controls (A) X X Trade Tariffs (A) X X Import Quotas (A) X X Export Incentives (L) X X Exchange rates (A) X X Foreign Investment Ownership Requirements (L) X X Repatriation Limit (L) X Personnel Regulations (A) X Sectoral Technology Licensing (A) X X X Production Licensing (A) X X SOE Operations (O) X X X X Corporate Governance *Types of policy instruments: A = Administrative; L= Legal; O= Direct market operations 36 ** Management control aspects of each of the fours functional areas could also be affected Source: J.E. Austin Associates. Managing in Developing Countries, 1990
- 37. Macroeconomic Initiatives Monetary Policy Inflation Under Control (Stability & Interest Rates Predictability) Fiscal Policy Effective tax policy Budget Deficits Restrained Foreign Trade Greater Convertibility of Balance of Payments Tariffs Coming Down Currency 37
- 38. Microeconomic Initiatives Privatization Industrial Parks/EPZs/ Financial Sector Techno/Knowledge Parks Restructuring Labor Laws, Practices and Rule of Law, Commercial Mediation Mechanisms Law/Judicial Private Provision of Recourse/Arbitration Infrastructure Anti-Corruption Standards Bureaus Trade and Investment Telecom, IT and E-commerce Promotion Readiness Small Business Facilitation Intellectual Property Rights Civil Service Reform Efficient Provision of Key Education Reforms Services Workforce Development Sector-Specific Initiatives Corporate Governance 38
- 39. Relationship between Investment and Economics Quality of Investment Business Environment Capital Rule of law Economic Growth Corporate Governance 39
- 40. Corporate Governance is the Antidote to Corruption Corporate Anti- Governance corruption Corporate Governance 40
- 41. Seeking Balance between the Interests of Stakeholders Proper legal and regulatory frameworks will provide an equilibrium between the shareholders, other stakeholders and the firm that is sustainable over time. Corporate Governance 41
- 42. International Institutions Providing Guidance on Corporate Governance Organization for Economic Cooperation and Development (OECD) www.oecd.org The World Bank Group: IBRD/IMF/IFC www.worldbank.org Global Corporate Governance Forum (IFC/OECD) www.gcgf.org Basel Committee on Banking Supervision (BIS) www.bis.org Institute of International Finance (IIF) www.iif.com Financial Stability Forum (FSF) www.fsf.org International Organization for Securities Commissions (IOSCO) www.iosco.org Governments and financial sector regulators around the world Corporate Governance 42
- 43. OECD Principles of Corporate Governance www.oecd.org/daf/corporateaffairs/principles/text Corporate Governance 43
- 44. OECD Principles of Corporate Governance (2004) www.oecd.org 1. Ensuring the Basis for an Effective Corporate Governance Framework 2. The Rights of Shareholders and Key Ownership Functions 3. The Equitable Treatment of Shareholders 4. The Role of Stakeholders 5. Disclosure and transparency 6. The responsibilities of the board Corporate Governance 44
- 45. Source: Foreign Affairs, September-October 2002. Corporate Governance 45
- 46. CG ENVIRONMENT IN MONGOLIA Corporate Governance 46
- 47. Leading Mongolian Institutions Supporting Corporate Governance Governmental Financial Regulatory Commission (FRC) Central Bank of Mongolia (BOM) State Property Commission (SPC) Non-Governmental Mongolian National Chamber of Commerce and Industry (MNCCI) Mongolian Employers Federation (MONEF) Corporate Governance 47
- 48. Mongolian Corporate Governance Code Resolution no. 210 of the Financial Regulatory Commission, December 26, 2007 1- Principles of corporate governance 2- Meetings of shareholders 3- The role of the board of directors 4-The role of the executive management 5- Open and transparent information 6- The Stakeholders -- Participating entities 7- Supervision of operations 8- Dividend Policy 9- Settlement of disputes Corporate Governance 48
- 49. Mongolian Legal and Regulatory Frameworks supporting Corporate Governance Civil Code (2002) Competition Law (2000) Company Law (1999) Banking Law (1996, 1999, 2010) Securities Law (2002) Dispute Resolution (Mongolian NCCI) & Courts Law on NBFIs (2002) FRC Law (2005) Taxation Law (2006) Corporate Governance Code (2007) Bankruptcy and Insolvency Law (1997) 49 Corporate Governance
- 50. Legal and Regulatory Reforms in Mongolia Mongolia pursued legal reforms during the 1990s The judiciary is the backbone of a strong enforcement system. Deficiencies in enforcement is persistent Enhanced mandate and capacity of Financial Regulatory Commission/Bank of Mongolia is needed Corporate Governance 50
- 51. BOM CG Principles for Banks The Constituents Accountabilities and Authorities of the Board Functions of Senior Management Audit Committee and the Functions of Internal Audit Functions of External Audit Transparency Corporate Governance 51
- 52. THE ROLE OF THE BOARD IN RISK MANAGEMENT Corporate Governance 52
- 53. What is Risk? • The English word “Risk” derives from the Latin ―Periclum‖ that infers taking daring actions. • In this sense, “risk” represents a conscientious choices made by a firm, – as the consequence of the actions taken or strategies pursued, – rather than “fate” that befalls upon an entity by an act of nature that was unanticipated– even though that is also a possibility in life. Corporate Governance 53
- 54. Risk Appetite: Living Dangerously, Speculation, or Calculated Risk? Corporate Governance 54
- 55. Effective Risk Management Strategies Help By: Being proactive in dealing with possible unanticipated losses; Protecting the firm’s credit rating; Ensuring growth and profitability of the firm; Contributing to creating positive public image and/or reputation; Increasing customer and stakeholder interest in firm; Making company attractive for recruiting good talent and better management compensation and contracts; Improving parameters in planning and budgeting; Corporate Governance 55
- 56. Types of Risk • EXTERNAL FACTOR • MARKET RISK RISKS • PROCESS RISKS • INTERNAL FACTOR • COMPLIANCE RISKS RISKS • PEOPLE RISKS • LEGAL & REGULATORY RISK STRATE-GIC OPERA- RISKS TIONS RISKS FINANCE INFORMA- RISKS TION RISKS • TREASURY RISKS • FINANCIAL RISKS • CREDIT RISKS • OPERATIONAL RISKS • TRADING RISKS • TECHNOLOGY RISKS • TAX RISK Corporate Governance 56
- 57. Risk Management is Board Responsibility Key board functions Source: OECD Principles of Corporate Governance, 2004. Review and guide corporate strategy, plans of action, risk policy, budget & business plans. Set performance objectives. Monitor implementation and corporate performance. Oversight and guidance on major capital expenditures, acquisitions and divestitures. BOD shall be a unit defining the strategic policy of corporate activities and imposing supervision on activities of the executive management. Source: Mongolian Code of Corporate Governance, December 2007 57 Corporate Governance
- 58. Risk Tolerance and Risk Appetite Risk Tolerance • ―The willingness of the board to take risk in order to achieve a predefined objective‖ Risk Appetite • ―The amount of risk an entity is willing to accept in pursuit of shareholder value creation‖ Corporate Governance 58
- 59. Determinants of Risk Appetite • Markets • Stakeholders • Shareholders Strategy • Market Risk • Credit Risk • Organizational • Operational Capital at Internal Structure • HR Risk Risk Constraints • Systems (IT) • ―What if‖ Scenarios Risk Appetite Corporate Governance 59
- 60. The Level of Board’s Risk Awareness The ―right‖ kind of risk The ―right‖ amount of risk ―Adequate‖ risk management Corporate Governance 60
- 61. What does it take to implement good governance? Board Commitment Disclosure & Board Transparency Leadership Shareholder Rights Protection 61
- 62. SUMMARY AND CONCLUSIONS Corporate Governance 62
- 63. Summary and Conclusion Private sector corporations are the most important business form, they generate most of the country’s GDP Separation of ownership and control causes the agency problem known as the ―principal-agent problem‖ are that can be resolved by adequate incentives and monitoring OECD Principles of CG provides the template for many codes globally. Corporate governance is the set of internal and external mechanisms which allows for the resolution of principal-agent problem In addition to the shareholders, stakeholders also play an important role in corporate governance Good CG ensures operational efficiencies, access to finance at a lower cost of capital, higher shareholder value and higher reputational benefits. CG is better understood if internal and external perspectives are considered but the different systems are increasingly converging as financial markets continue to globalize Corporate Governance 63
- 64. The Role of Disclosure ―If investors are not confident with the level of disclosure, capital will flow elsewhere..‖ Arthur Levitt, Former Chairman of US SEC Corporate Governance 64
- 65. Investor behavior is shaped by greed and fear Corporate Governance 65
- 66. Corporate Governance 66
Notas del editor
- There are two types of stakeholders of a firm:1- Primary Stakeholders which include: The Board, the Shareholders and the Executive Management.2- Other Stakeholders: The Management, Employees, Customers, Suppliers, Community, the Government, Financial Markets, and environments agencies and NGOs.The modern way of approaching the firms relationship with the stakeholders have gained more significance. The Stakeholders relationship is now considered to the best benefit of a firm, and is a matter of “enlightened self interest”/According to the OECD Principles of Corporate Governance (2004), the CG framework ought to recognize the rights of the stakeholders as established by law, but also by social norms. IV. The Role of Stakeholders in Corporate GovernanceThe corporate governance framework should recognise the rights of stakeholders established by law or through mutual agreements and encourage active co-operation between corporations and stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises.A. The rights of stakeholders that are established by law or through mutual agreementsare to be respected.B. Where stakeholder interests are protected by law, stakeholders should have theopportunity to obtain effective redress for violation of their rights.C. Performance-enhancing mechanisms for employee participation should be permittedto develop.D. Where stakeholders participate in the corporate governance process, they shouldhave access to relevant, sufficient and reliable information on a timely and regularbasis.E. Stakeholders, including individual employees and their representative bodies,should be able to freely communicate their concerns about illegal or unethicalpractices to the board and their rights should not be compromised for doing this.F. The corporate governance framework should be complemented by an effective,efficient insolvency framework and by effective enforcement of creditor rights.
- Further complicating matters is the fact that corporate governance is made up of many distinct fields, such asFinance, accounting and audit on the one hand, that provides the set of financial management processes and procedures for the assets and the liabilities of a firm, while accounting provides a record of all economic actions of the firm including the internal control systems and disclosure of the firm’s operating results to the outside world, and; on the other, Economics, can be defined as the larger system in which all economic entities, households, the government and other stakeholders create the demand for and the supply of goods and services that involve the firm and its operations.Corporate law: That regulates the legal environment in which the firm must operate and provides rules of engagement regarding the right and responsibilities of all involved parties. Corporate culture and organizational theory: Corporate culture is a set of values that the firm defines in its vision and mission statement which is explains the behavioral aspects of the firm’s shareholders, its management and its stakeholders.Internal controls and risk management: Involves the type of financial instruments that the firm uses to finance the firms assets, how these financial instruments are valued; the limits in place the system as well as the major risks resulting from using the financial instruments.Strategic management: Ways in which the firm formulates its strategic initiatives towards the achievement of its stated goals and objectives and the strategies by which these strategies are implemented.Ethics: can be defined as the critical, structured examination of how people & institutions should behave in the world of commerce. In particular, it involves examining appropriate constraints on the pursuit of self-interest, or (for firms) profits, when the actions of individuals or firms affects others. Each of these are intricately linked with one another. For example, establishing a remuneration policy for a company’s directors involves legal questions (e.g. how do you structure the contract, liability issues), accounting issues (e.g. how do you expense stock options), economics (how do you align shareholder and management interests), etc.
- The “Principal-Agent Dilemma” or the “Agency” issue results from the separation between ownership and control.In academic terms the “Separation of Ownership and Control” phenomenon is known as the Principal-Agent problem or the Agency Problem. Principal-agent problem represents the conflict of interest between management and owners. For example, if shareholders cannot effectively monitor the managers’ behavior, then managers may be tempted to use the firm’s assets for their own ends, all at the expense of shareholders.Principals = Shareholder; and Agents = ManagersThe owners arethe principals (also shareholders) and the managers are the agents who are supposed to work for the owners. If shareholders cannot monitor the managers behavior effectively, then managers may be tempted to use the firm’s assets for their own ends, all at the expense of shareholders.Here, the examples could be given of employees taking supplies for personal use, executives using perks at the expense of shareholders. Reason, each expensive perk that is used by the managers is an amount of money that is not utilized for profitable investments, or dividends that are not distributed.Another Example: Could investors influence management? Hewlett Packard CEO CarlyFiorina’s takeover of Compaq Computers; Steve Jobs was ousted as CEO of Apple in 1983, only to be re-invited in 1990s as CEO. The potential agency problem arises whenever the manager of a company owns less than 100 percent of the stock of the firm.If the firm is a proprietorship managed by its owner, then the owner- manager will presumably operate so as to maximize his own welfare, with welfare measured in the form of increased personal wealth, more leisure, or perquisites.If the owner- manager incorporates his company and then sells some of the stock to outsiders, a potential conflict of interest will immediately arise.The case represents the conflict of interest that lies at the heart of the Agency problem. In this case, the shareholders will need to monitor the actions of the managers so as to align the interests of the managers with their own interests in the firm. Also let us consider:Finite Resources vs. Infinite Demand: Distribution IssueCorporate Social Responsibility vs. Shareholder Value: Role of Firm in Society
- In political science and economics, the principal–agent problem or agency dilemma treats the difficulties that arise under conditions of incomplete and asymmetric information when a principal hires an agent, such as the problem that the two may not have the same interests, while the principal is, presumably, hiring the agent to pursue the interests of the former.Various mechanisms may be used to try to align the interests of the agent in solidarity with those of the principal, such as piece rates/commissions, profit sharing, efficiency wages, performance measurement (including financial statements), the agent posting a bond, or fear of firing.The principal–agent problem is found in most employer/employee relationships, for example, when stakeholders hire top executives of corporations. Numerous studies in political science have noted the problems inherent in the delegation of legislative authority to bureaucratic agencies.As another example, the implementation of legislation (such as laws and executive directives) is open to bureaucratic interpretation, which creates opportunities and incentives for the bureaucrat-as-agent to deviate from the intentions or preferences of the legislators. Variance in the intensity of legislative oversight also serves to increase principal–agent problems in implementing legislative preferences.
- The “Principal-Agent Dilemma” or the “Agency” issue results from the separation between ownership and control.In academic terms the “Separation of Ownership and Control” phenomenon is known as the Principal-Agent problem or the Agency Problem. Principal-agent problem represents the conflict of interest between management and owners. For example, if shareholders cannot effectively monitor the managers’ behavior, then managers may be tempted to use the firm’s assets for their own ends, all at the expense of shareholders.Principals = Shareholder; and Agents = ManagersThe owners arethe principals (also shareholders) and the managers are the agents who are supposed to work for the owners. If shareholders cannot monitor the managers behavior effectively, then managers may be tempted to use the firm’s assets for their own ends, all at the expense of shareholders.Here, the examples could be given of employees taking supplies for personal use, executives using perks at the expense of shareholders. Reason, each expensive perk that is used by the managers is an amount of money that is not utilized for profitable investments, or dividends that are not distributed.Another Example: Could investors influence management? Hewlett Packard CEO CarlyFiorina’s takeover of Compaq Computers; Steve Jobs was ousted as CEO of Apple in 1983, only to be re-invited in 1990s as CEO. The potential agency problem arises whenever the manager of a company owns less than 100 percent of the stock of the firm.If the firm is a proprietorship managed by its owner, then the owner- manager will presumably operate so as to maximize his own welfare, with welfare measured in the form of increased personal wealth, more leisure, or perquisites.If the owner- manager incorporates his company and then sells some of the stock to outsiders, a potential conflict of interest will immediately arise.The case represents the conflict of interest that lies at the heart of the Agency problem. In this case, the shareholders will need to monitor the actions of the managers so as to align the interests of the managers with their own interests in the firm. Also let us consider:Finite Resources vs. Infinite Demand: Distribution IssueCorporate Social Responsibility vs. Shareholder Value: Role of Firm in Society
- Corporate governance concerns the relationships among a company’s:Shareholders through the General Meeting of Shareholders (GMS);Management, i.e. General Director and/or Executive Board; andThe Board of Directors (also referred to as the Supervisory Board).A series of relationships, structures, and processes exists between each of these bodies. For example, shareholders provide capital to managers who in turn report transparently to shareholders. Similar relationships exist between the other governing bodies.But relationships also exist within the governing bodies, for example, between the board of directors and its committees, or between the managers and internal control function. The purpose of management of a firm is to make decisions and take actions to maximize the value of a firm’s stock. Management’s basic overriding goal is thus to create value for stockholders. This goal is consistent with the wealth maximization objective sought by shareholders when investing an a firm.Shareholders own the stocks of the firm. Ownership legally belongs to them. As a result stockholders get to elect the directors, who then hire the managing executives.The directors, as representatives of the stockholders, determine manager’s compensation, rewarding them if performance is superior or replacing them if performance is poor. The directors have little choice but to operate like this, because stockholders will remove them if they fail in their fiduciary duty.Therefore, institutional investors increasingly use “proxy fights” and takeovers and takeovers to force changes in poorly performing companies.Managers are empowered by the principal owners (shareholders) of the firm to make decisions. However, managers have personal goals that may compete with shareholder wealth maximization, and such potential conflicts of interest are addressed by “Agency Theory”.An Agency Relationship arises whenever one or more individuals, called “principals” hires another individual or organization, called an “agent” to perform some service; Then delegates the decision making authority to that manager who is the agent.
- The Passive Board - Functions at the discretion of the CEO, limits its activities and participation, limits its accountability, ratifies mgmt. preferences.The Certifying Board - Certifies to shareholders that the CEO is doing what the board expects and that management will take corrective action when needed, emphasizes the need for independent directors and meets without CEO, stays informed about current performance and designates external board members to evaluate the CEO, establishes an orderly succession process, Is willing to change mgmt. Is credible to shareholders.The Engaged Board - Provides insight, advice, and support to the CEO and executive management, recognizes its ultimate responsibility to oversee the CEO and company performance; guides and judges the CEO, conducts useful, two-way discussions about key decision facing the company, seeks out sufficient industry and financial expertise to add value to decisions, takes time to define the roles and behaviors required by the board and boundaries of CEO and board responsibilities.The Intervening Board - Becomes intensely involved in decision making around key issues. Convenes frequent, intense meetings, often on short notice.The Operating Board - Makes key decisions that management then implements, Fills gaps in mgmt. experience.In the past most boards may have probably fitted the image of a “certifying board”. More recently, awareness in good corporate governance has increasingly caused the boards to become an “engaged board”.
- As discussed before, agency theory focuses on the separation of ownership and control. Shareholders (owners) are the central point of concern.From this perspective, corporate governance is mainly about the incentive systems and monitors designed to protect the shareholders’ interests.The primary goal of the firm is to create wealth for these shareholders. However, this is not the only perspective from which to consider corporate governance. Many believe that companies should have a greater responsibility to society. Proponents argue that companies have unique opportunities to improve the society.The stakeholder view of the firm describes the firm as having different groups with legitimate interests in the firms’ activities. Strategic management concepts argue that this is based on creating positive relationships with all stakeholders. Through creating these positive relationships, firms can create sustainable economic wealth.Many international codes, including the OECD Principles, discuss the role of stakeholders in the governance process. The role of stakeholders in governance has been controversial in the past, with some arguing that stakeholders have no claim on the enterprise other than those specifically set forth in law or contract. Others have argued that companies fulfill an important social function, have a societal impact and must, accordingly, act with the broad interests of society in mind. This broader view may mean that companies, at times, act at the expense of shareholders. More recently, the argument has been settled, on a pragmatic level if not on a conceptual one, by agreeing that modern companies cannot effectively conduct their businesses while ignoring the concerns of stakeholder groups. However, there is also increasing acceptance of the notion that companies which consistently place other stakeholder interests before those of shareholders cannot remain competitive over the long run. Corporations should recognize that the contributions of stakeholders constitute a valuable resource for building competitive and profitable companies. It is, therefore, in the long-term interest of corporations to foster wealth-creating co-operation among stakeholders. The governance framework should recognize that the interests of the corporation are served by recognizing the interests of stakeholders and their contribution to the long-term success of the corporation. Companies must find the balance between the two opposing views
- There are four basic advantages that good corporate governance can bring to the company. Better access to outside capital;At lower cost of capital (because of transparency that leads to resolution of firm related risks for the investors);Improved operational efficiency and performance; andBetter company reputation.Improving corporate governance of Mongolian companies matters because the country needs capital investment for its economic growth. Companies seeking to lower their cost of capital are concerned about their rankings by global investors.Studies also show evidence that good corporate governance significantly enhances market value of the firmMcKinsey (top global management consulting company) surveyed the largest global investors in 2001 and found that ‘governance’ premium varied from 17% to 27 % on top of ROE depending on the country. However, the extent by which a company is able to draw upon these benefits will depend on how corporate governance is implemented. For example, little benefit can be expected if corporate governance is viewed as a minimum legal requirement, in particular in an emerging country such as in Mongolia. Only those companies that truly and holistically implement corporate governance, and are publicly recognized as such, can expect to reap the potential benefits that corporate governance offer. A closer look at each of these four benefits follows. Good corporate governance provides more immediate benefits such as: effective management improved technical and operational performance, increased productiongrowth in the financial viability of companies
- Better access to outside capital:Second, let us focus on accessing outside capital. Corporate governance practices can indeed determine the ease with which companies are able to access capital markets. Well governed firms are perceived as investor-friendly, providing greater confidence in their ability to generate returns without violating shareholder rights.Good corporate governance is based on the principles of transparency, accessibility, efficiency, timeliness, completeness, and accuracy of information at all levels. With the enhancement of transparency in a company, investors benefit by being provided with an opportunity to gain insight into the company’s business operations and financial data. Even if the information disclosed by the company is negative, shareholders will benefit from the decreased risk of uncertainty. Of particular note is the observable: Recently, there is a trend among investors to include corporate governance practices as a key decision-making criterion in investment decisions. The better the corporate governance structure and practices, the more likely that assets are being used in the interest of share-holders and not being tunneled (this expression relates to the abuses committed by mutual fund managers in the Czech Republic who unscrupulously sold highly liquid and valued stocks within the mutual fund portfolios and left the shareholders of these funds with only bankrupt company shares or illiquid stocks), or otherwise misused (wasted) by managers. Such actions cause panics in the capital markets and not very conducive to attracting investors.Governance practices can take on particular importance in emerging markets where shareholders do not always benefit from the same protections as are available in more developed markets.
- Improved Operational Efficiency:The academic debate about the value of corporate governance focuses on the question of whether there is any proof that adding independent directors to a board of directors or adopting various other good governance practices actually improves a company's bottom-line performance for investors. The answer to this question has been all over the map, but a few new studies seem to suggest that there is a long-term link between governance and performance in several areas.Critics of such studies will argue, with merit, that there cannot possibly be a perfect correlation between the board and corporate governance practices and performance, because so many factors affect a company's performance beyond simply the quality of the supervisory board. However, a perfect correlation may not be necessary: These reports all show a tendency, on average, for companies to have somewhat better shareholder returns and profits if they embrace better practices and try to have largely independent boards to oversee management. If these conclusions are upheld by further study, this is as much evidence as shareholders need to see to demonstrate the concrete value of good governance practices.
- Conclusion of the last three slides:Good corporate governance helps improve transparency and disclosure, thereby reducing the perceived riskiness of the firm by the investors.This allows more information to flow to the investing public and reduces “information asymmetry” which the market factors into the price of the stock. Transparency improves price discovery mechanism in the markets by helping the stock price reach its maximum potential value.This resolution of risk, helps reduce systemic risk in the markets and helps the financial system provide flexibility to outside shocks.Better corporate transparency helps reduce corruption. Good corporate governance is the antidote to corruption. By so doing, corporate governance helps improve the cost of doing business (no bribes, no corruption) by improving the business environment.Increased transparency, fairness, accountability and responsibility will increase the investor interest in making investments and thereby channels savings into the financial sector.Good Corporate governance not only improves business environment, but it also helps improve public sector governance.Improved transparency and disclosure helps innovation and the general outlook for the economy of a country.However, free markets do not by themselves provide the improvements in corporate governance, and thus investor rights ought to be protected by prudential regulation.
- Despite effective macro economic policies of the government,private investment response is not automatic…Some further policies must be formulated.
- The most solid relationship in economies and economics: the positive link between investment and economic growthBut it is not only quantity but quality of investment that matters. Thus, growth will depend on how investment is: (1) Mobilized, (2) Allocated, and finally (3) Monitored.Economic Rationale: In addition to the above-mentioned benefits it brings to companies and its shareholders, corporate governance also significantly contributes to economic growth.As we learned before, corporate governance helps companies attract financing, improve operational performance and strategic oversight, etc. Such companies in turn are likely to contribute to a dynamic and vibrant corporate sector, and deepen financial markets. LaPorta et al (1997) for example find that a correlation between shareholder rights protection and the size of local stock markets exists.Corporate governance is a tool for reducing systemic risk in emerging markets. Enforceable legal investor protection mechanisms reduce the risk of expropriation for investors and hence can create confidence and reduce volatility in the markets (Johnson et al 2000). Market confidence will help resume capital inflows and may help financial crisis. Good corporate governance finally ensures that investment is put to the best possible use. How so? Simply because investment as such is inadequate. Only quality investments in sustainable businesses that generate returns will ultimately benefit the economy. For this to occur, capital first needs to be mobilized, allocated and finally monitored. More specifically: - Capital will only be mobilized when a country offers rule of law, secure methods of ownership registration, effective property protection, credible enforceable effective legal redress mechanisms, as well as clear and credible information.- The market can only make the best possible choices concerning the allocation of capital among alternative uses if transparency and disclosure is accurate, material, reliable, timely, and comparable. Only such information allows investors to allocate their capital to the best performing assets. - Corporate governance arrangements finally have a crucial impact on the effective monitoring of capital that is handed over to companies. This concerns the procedures for corporate decision-making, distribution of authority among company organs and the design of incentive schemes.
- The impact of good corporate governance is larger than the sum it provides. It is the best tool to fight corruption.Corporate governance may further:Reduce vulnerability to financial crises,Foster savings and welfare provision,Spill over into the realm of public governance, by:Tackling corruption, Avoiding that the rule of law is not undermined, andImproving the effectiveness of public institutionsFoster innovation.
- The total risk of a firm consists of a combination of risk factors:1- Operational risk: The likelihood that companies operations may break down, due to external or internal factors, natural disasters, power outages, machinery and equipment breakdown, malfunctioning.2- Input risk: The likelihood that suppliers may not be able to provide the firm the needed inputs on a timely basis, jeopardizing production function.3- Tax risk: Due to unexpected circumstance government imposes new taxes on a special product, pass a law that requires companies that use water need to pay higher taxes, road taxes imposed, etc.4- Regulatory risk: Likelihood that the firm will face strict new regulations, such as the Sarbanes Oxley Act, which many smaller firms find very expensive to comply with.5- Legal risk: Possibility of litigation by class action suits, or citizens litigation for polluting the environment, environmental cleanup costs, new emission standards cause increase in production costs, reducing international competitiveness, etc.6- Financial risk: Risks resulting from the degree of financial leverage used by the firm in financing its operations. Cost of capital may increase, bond rating may be reduced, new financing may become unavailable.7- Product market risk: Risk resulting from loss of competitiveness. Technological changes may make a certain product of the company obsolete. Kodak and Fujitsu film company transforming itself to the digital camera technology. Polaroid transformed into a digital imaging equipment maker.
- It is often easily expressed that the board needs to describe its risk appetite and risk tolerance.Risk tolerance and risk appetite are defined in this slide.Risk tolerance and risk appetite of a firm can not be decided without taking into consideration the interests of all stakeholders.Stakeholders have a significant influence on the firm’s development.
- In terms of a board’s role in risk management, three questions must be asked to identify where a company stands in the face of ERM:1- Is the company taking the right risks?2- Is the company taking the right amount of risks?3- Is the company managing the risks adequately?The crucial issue has to do with the strategic management of a company: When the firm is formed, it determines a vision, advances a mission statement, and a set of objectives and targets to achieve the mission objectives.Targeted activities must pay attention to the overall risks borne by the firm.The question of whether the firm is generating value for the given level of risks it has taken is a difficult question to respond to.We spoke about financial risk and other risks taken by the firm so that a well balanced combination of the total risks taken by the firm will result in the optimal level of risk for the firm, that will maximize its value, minimize its costs, and mitigate overall risk so that not only the shareholders, but the stakeholders also benefit.Academic studies have shown that risk management Can increase the market value of the firm, Can lower the cost of equity,Can lower the volatility of earnings, andIs viewed as a fiduciary responsibility of the firm.1- the right kind of risk: How are the risks we take related to our strategies and objectives?Do we know the significant risks we are taking?Do the risks we take give us a competitive advantage?How are the risks we take related to activities that create value?Do we recognize that business is about taking risks?Do we make conscious choices concerning these risks?2- the right amount of risk: Is the rate of return consistent with our overall level of risk?Does our organizational culture promote or discourage the right level of risk taking activities?Do we have a well defined organizational risk appetite?Has our risk appetite been quantified in aggregate and per occurrence?Is our actual risk level consistent with our risk appetite?3- Adequate management of the risk: Is our risk management process aligned with our strategic decision-making process and existing performance measures?Is our risk management process coordinated and consistent across the entire enterprise?Does everyone use the same definition of risk?Do we have gaps and/or overlaps in our risk coverage?Is our risk management process cost effective?
- Implementing good Corporate Governance requires:1- Commitment of the company to provide substance over form, full disclosure, recognition by all parties, and strong monitoring and control mechanisms in place to implement and the review of corporate governance practices by the officers and the board committees on various issues such as compensation, auditing, and strategy.2- Good Board practices involve as many independent directors on board, with adequate experience and competence on various technical areas, proper organizational structures and the presence of specialized committees depending on the size of the firm.3- Shareholders rights protected with a well organized general shareholders meetings, cumulative voting in meetings, a well developed dividend policy, and an independent registrar keeping records of all current shareholders.4- Disclosure and transparency: One of the important aspects of good corporate governance is the full disclosure of all relevant information about the firm and its activities including full disclosure of ownership structure, accounting and financial statement kept under International Financial Reporting Standards (IFRS), good internal controls in place, with an external independent auditor and a well defined risk management policy in place.