Appunti Corporate Governance

What is the purpose of a corporation?

Firm and its stakeholders

Stakeholders include shareholders, debt holders, public administration, customers, employees, and suppliers.

Production and distribution of value

Companies have an ambivalent nature (e.g. Barnard, 1938; March and Simon, 1958; Cyert and March, 1963):

• Produce value
• Distribute value to the stakeholders supplying the production factors

Each firm should create a dynamic equilibrium between:

• The value of the contribution supplied by stakeholders to the firm (e.g. equity, debt, labor, raw materials, services, etc.)
• The intrinsic and extrinsic rewards (e.g. money, status or power) given in exchange to stakeholders

Social responsibility of business

The maximization of shareholders’ value is the best way to reach the interest of society.

Shareholders value creation

The residual control rights allow shareholders to decide on very important matters, such as dividend policy, capital increase, corporate by-laws, election of board members, etc.

The shareholders’ view is based on some implicit assumptions:

• The maximization of shareholders value leads to the maximization of the corporate value
• Financial markets are efficient (they measure the value creation)
• The maximization of shareholders value disciplines top managers
• Stock incentive plans push managers to maximize the shareholders value
• The market for corporate control disciplines top managers
• The US law supports the shareholders’ supremacy

A corporate governance model based on shareholder supremacy has some practical advantages:

• By selecting for once and for all the class of stakeholders entitled to receive control rights, it avoids the problem of defining which interests to pursue in a specific decision, or which class of stakeholders should receive these rights in a specific company
• It allows the incorporation of both voting rights and cash-flow rights in a security instrument that can be traded on the financial market

The allocation of control rights to shareholders ignores that other classes of stakeholders implicitly receive a fraction of the residual income and bear part of the enterprise risk, not only in the event of a bankruptcy but also under normal conditions.

Shareholder value creation leaves unresolved the questions of:

• How to protect the interests of other stakeholders
• How to encourage them to contribute efficiently to the firm’s success

Critiques of the shareholder value perspective

The shareholder value perspective has been criticized by three viewpoints:

1. Business ethics: Managers should not maximize shareholder value, but should take decisions based on ethical standards
2. Corporate Social Responsibility (CSR): Managers have the responsibility to satisfy the needs of the stakeholders and the society at large
3. Stakeholder theory: Managers should manage stakeholders' expectations and satisfy their needs

Business ethics

Business ethics criticizes the “business is business” philosophy according to which managers should maximize the shareholder value even when this may imply negative externalities for the stakeholders. It encourages managers to take right and fair decisions based on sound moral principles: i.e., managers have moral obligations towards stakeholders. It challenges both an amoral view (there is no right and wrong in business decisions) and a moral subjectivism (morality belongs to individuals).

It underlines that managers should manage properly the ethical dilemmas, i.e. when two positive values (e.g., profit and ethic) support different decision outcomes. Examples of ethical dilemmas include:

• To offer side payments to win a large contract
• To increase pollution to minimize production costs

Some cognitive biases can lead organizations to deviate from ethical principles, such as companies’ incentives (e.g. billable hours), ignoring some behaviors (e.g. rating agencies), delegating some tasks to third parties (e.g. outsourcing), small vs large unethical acts (e.g. small frauds), and good outcomes (e.g. win tenders). Ethical dilemmas are very common in multinational companies. Companies should have ethical leaders, a code of ethics, training programs, monitor non-compliance, etc.

Many ethical issues are rooted in the fact that political systems, law, economic development, and culture vary significantly across countries. What is considered normal practice in one nation may be considered unethical in another.

Corporate social responsibility

CSR became popular in the first decades of the 20th century and highly relevant in the late ’60s and early ’70s when society called business to give greater attention to their responsibilities towards stakeholders and society. CSR comprises four areas of responsibility:

• Economic: To produce goods and services to satisfy consumers and generate a profit
• Legal: To comply with law and rules
• Ethics: To respect ethical standards
• Voluntary: To do discretionary good to the community and society at large

Firms embracing the CSR principles should measure the firm impact on society as a whole. The triple bottom line perspective – also known as the Three P’s (i.e., People, Planet, and Profit) – suggests that companies should report their performance on three dimensions, i.e. social, environmental, and economic. Despite several initiatives (e.g. Sustainability Reporting Framework, International Integrated Reporting Council), it is not easy to manage the trade-offs among these dimensions.

Response to CSR

The responses to this call for action include:

• Increasing attention to CSR issues by the World Economic Forum and the World Business Council for Sustainable Development
• Launching governmental and international projects to promote CSR: UK appointed a Minister for CSR (from 2000 to 2010), and the EC published several reports
• Advancing proposals to extend directors’ fiduciary duties to also include stakeholders (e.g. section 172 of the UK companies act issued in 2006)
• Sending letters to CEOs (e.g., Larry Fink, founder and CEO of BlackRock) to invite them to address these issues
• Publishing new statements on the purpose of corporations, inviting CEOs to develop a commitment to all stakeholders (US Business Roundtable in 2019)

Stakeholder theory

The origins of stakeholder theory date back when General Electric (1930s), Johnson & Johnson (1947), Sears (1950) identified key stakeholders. Freeman (1984) publishes the first work on the stakeholder theory: firms have stakeholders who have legitimate rights and consequently companies must comply with their moral obligations towards their stakeholders.

Definition in a wide sense = Any group or individual who:

• Can affect the achievement of an organization's objectives
• Is affected by the achievement of an organization's objectives

Examples include protest groups, government agencies, trade associations, competitors, unions, as well as employees, customers, and shareholders.

Definition in a narrow sense = Any identifiable group or individual on which the organization is dependent for its continued survival. Examples include employees, customers, certain suppliers, key government agencies, shareowners, and certain financial institutions.

Debate about stakeholders

There is a debate about who are the stakeholders:

• Freeman, Reed (1983): Stakeholder in a wide sense (they may influence the firm) and in a narrow sense (they may influence the survival of the firm)
• Clarkson (1995): Primary stakeholder (who affect company survival) and secondary (who influence company or are influenced by the company)
• Clarkson (1998): Voluntary stakeholder (who decided to have a relationship with the firm) and involuntary (who did not decide to have a relationship or are not conscious to have a risk)
• Carroll, Nasi (1997): Internal stakeholder (shareholders, managers, employees) and external (consumers, suppliers, competitors, etc.)

Stakeholder theory argues that the board and the top management must consider the interests of all stakeholders “who affect or are affected by company’s business”. Top managers must manage the relationship between the company and its stakeholders at three different levels:

• The rational level: They should understand who the firm’s stakeholders are, and what expectations they have
• The process level: They should analyze the business processes used to interact, explicitly or implicitly, with the stakeholders and assess their consistency with stakeholders’ expectations
• The transactional level: They should analyze both the interactions with stakeholders, and their consistency with the results of the previous analysis

Stakeholders: nature of interest and power

ESG

• Environment: It addresses company operation’s environmental impact and environmental stewardship
• Social: It refers to how the company manages relationships with and creates value for society
• Governance: How the company is led and managed (company leadership, management philosophy)

Is it possible to combine shareholders and stakeholders value?

Managers think there is a trade-off between economic performance on the one hand, and social and environmental performance on the other hand. Some scholars have started to challenge this idea by proposing the concept of shared value. According to this view, companies’ competitiveness and the well-being of communities are strictly linked, and managers should expand the total value created for the shareholders and for society at the same time.

Companies can create shared value in three distinct ways:

• Re-imagining products and markets (e.g., by developing products for lower-income customers or underserved markets)
• Redefining productivity in the value chain (e.g., reducing energy and water consumption, reorganizing logistics and distribution, recycling resources, or improving employee health)
• Building supportive industry clusters (e.g., by improving infrastructures, educational programs, supply chain, and distribution)

Also, reputation, legal form that facilitates the contribution of stakeholders, assigning shares, stakeholders’ into the board, compensation schemes linking to ESG.

Define corporate governance

Financial economics perspective: “The ways in which suppliers of finance assure themselves of getting a return on their investment”. Main objective: Maximize shareholder value the shareholders are the residual risk bearers or the residual claimants to the firm’s assets. “A corporate governance system is the combination of mechanisms which ensure that the management runs the firm for the benefit of one or several stakeholders”.

Relationship perspective: Corporate governance specifies the distribution of rights and responsibilities among the different participants in the organization and lays down the procedures for decision-making.

Stakeholders perspective: Corporate governance deals with conflicts of interest between the providers of finance and the managers; the shareholders and the stakeholders; different types of shareholders (mainly the large shareholder and the minority shareholders) and the prevention or mitigation of these conflicts of interest.

Social perspective: Corporate governance is the whole set of legal, cultural, and institutional arrangements that determine what public corporations can do, who controls them, how the control is exercised, and how the risks and returns from activities they undertake are allocated. Relationship between individual, the firm, and society.

Behavioral perspective: Board of directors. Behaviors of members Command and Control. Codification and Compliance Collaboration and Conflict Group Decision-making and individual decision-making.

Interest to satisfy

Satisfying shareholders’ interests, and those of capital providers (e.g., including also debtholders). Balancing all interests converging within the firm:

• “A system of structuring, operating, and controlling a company such as to achieve the following:
• Fulfill the long-term strategic goal of the owners, which after survival may consist of building shareholder value or establishing a dominant market share
• Consider and care for the interests of employees, past, present, and future
• Take account of the needs of the environment and the local community, both in terms of physical effects and interaction with the local population
• Work to maintain excellent relations with both customers and suppliers
• Maintain proper compliance with all the applicable legal and regulatory requirements under which the company is carrying out its activities.” (Sheridan, Kendall, 1992: 1).

Politically connected directors

Reasons why business should be involved in political issues:

• A pluralistic system invites many participants
• Economic stakes are high for firms
• Business counterbalances other social interests
• Business is a vital stakeholder of government

Reasons why business should NOT be involved in political issues:

• Managers are not qualified to engage in political debate
• Business is too big, too powerful
• Business is too selfish to care about the common good
• Business risks its credibility by engaging in partisan politics

Theories of corporate governance

Agency problem

It occurs in private companies, public companies, state-owned companies, joint-ventures, not-for-profit organizations, and governmental bodies. The agency dilemma arises whenever there is a separation between ownership and control (Berle and Means, 1932). In its simplest form: Principal (owner), Agent who makes the action and decides his effort, Asymmetry of information.

A firm can be viewed as a nexus or network of contracts implicit and explicit, among various parties or stakeholders (Jensen & Meckling, 1976). The pay-off of different classes of stakeholders is different. The degree of alignment of interests with those of the agents in the firm who control the major decisions in the firm are also different. This gives rise to potential conflicts among the stakeholders, called “agency (principal-agent) problems”.

Today agency relationships in public companies can be complex. We can classify agency problems on the basis of conflicts among particular parties to the firm (John and Senbet, 1998):

1. Managerial agency or managerialism: conflicts between shareholders (principals) and management (agent), between shareholders and directors, between large shareholders and minority shareholders
2. Debt agency: conflict between shareholders (agents) and debtholders
3. Social agency: conflict between the private sector (agent) and the public sector
4. Political agency: conflict between the agents of the public sector (e.g., regulators) and the rest of society or taxpayers

Shareholders vs managers

Managers, seeking to maximize their own personal benefit, take actions that are advantageous to themselves but detrimental to the shareholders. The management - stockholder conflict leads to managerial propensity for:

• Expanding a span of control in the form of “empire building'' at the expense of the capital contributors or owners
• For unduly conservative investments in the form of seeking safe (but inferior) projects to maintain the safety of wage compensation and their own tenure

Shareholder vs CEO

Agency theory involves a contract under which one or more persons (shareholders) engage another person (CEO) to perform some service on their behalf. If both parties to the relationship are utility maximizers, there is a good reason to believe the agent will not always act on the best interests of the principal.

Agency problem in corporate governance

A potential way to mitigate the agent-principal problem is complete contracts. Such contracts are unlikely to be complete as (Williamson 1984): Impossible to predict all future contingencies, Too complex contracts to write, Impossible to monitor. Directors know far more about corporate situations than shareholders. Shareholders have to rely on the managers to decide what information they should have over the minimum required by regulation and corporate law.

Large vs minority shareholders

In most listed corporations over the world, control lies with one or few shareholders and NOT with the management as in UK and in US! In these corporations, there are two types of shareholders: Controlling (or large) shareholders and Minority shareholders (lack power to intervene).

Shareholders and debtholders

When a firm has very little equity left (i.e. financial distress), there may be a temptation to invest debtholders’ money into high-risk projects (John and John, 1993). In the case of SUCCESS most of the payoff will go to shareholders (residual claimants), in the case of FAILURE major costs will be incurred by the debtholders.

Criticisms of agency theory

• Board behavior is influenced by interpersonal behavior, group dynamics, and political intrigue
• Agency theory is too simplistic
• Agents cannot be trusted: the legal concept of the corporation says the opposite!
• Short-term (US and UK) vs long-term (Japan and Germany)

Stewardship theory

The dominant motive, which directs managers to accomplish their job, is their desire to perform excellently. Managers are conceived as being motivated by a need:

• To achieve satisfaction through successfully performing
• To exercise responsibility and authority
• To gain recognition from peers and bosses

Therefore, there are non-financial motivators for managers. It reflects the idea that directors’ legal duties. No man puts himself in a position in which his interest and his duty will be in conflict.

Resource dependence theory

It sees the governing body of a corporate entity as a linchpin between the company and resources it needs to achieve. The directors are viewed as a node of a network able to connect the business to strategic resources.