Corporate Governance completo

Introduction to corporate governance

Main definitions

Cadbury Committee: According to the Cadbury Committee, corporate governance refers to the system by which companies are directed and controlled. Boards of Directors (BoD’s) are responsible for the governance of their companies, where responsibility includes the setting of strategic aims, providing leadership to put them into effect, and the supervision of the management, reporting to shareholders on their stewardship (i.e., checking, controlling, questioning, challenging the BoD). This definition belongs to the so-called narrow view: it refers to corporate governance focusing on the structure and functioning of BoD’s and focusing on the rights of shareholders in boardroom decision making.

Margaret Blair: According to Margaret Blair, corporate governance is not all about the BoD. Corporate governance may also include corporate laws and boardroom practices, aspects of corporate finance, bankruptcy law, law for the behavior of financial institutions, contract law and practices, internal information, and control systems. This definition belongs to the so-called broad view: it refers to corporate governance as the whole set of legal, cultural, institutional arrangements that determine what publicly traded corporations can do, who controls them, how control is exercised, and how risks/returns are allocated. Corporate governance is a set of mechanisms aimed at both promoting a company’s long-term performance and assuming a balanced distribution of value to all stakeholders.

OECD: According to the OECD, corporate governance comprises the procedures and processes according to which an organization is directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among the participants in the organization (BoD, management, shareholders, stakeholders, …) and gives rules and procedures for decision-making.

Shareholder approach

The shareholder view is based on different theories and assumptions. In the 1980s, one of them was the theory by which the firm should be viewed as a nexus of contracts. This theory represents the key point of the shareholder view. It highlights the nature of relationships underlying the firm (managers, employees, suppliers …) and states that all of these relationships are governed by contracts that specify what each party has to do and what it should get in return. Here arises the main assumption: shareholders are different than other stakeholders since they are considered as residual claimants. Shareholders are not entitled to a fixed amount but get what is left over after all participants receive what they’re contractually entitled to receive. In this way, maximizing shareholders’ value will maximize company value.

Another assumption is related to the efficient capital markets hypothesis, by which share price is considered a good measure of company value. This theory can be easily debated since it is proven that such a context cannot be possible. Despite this, there is evidence that market prices in US stock markets respond very quickly to good/bad news. On the other hand, there is also evidence that financial markets go through periods of boom and bust in which share prices deviate from their underlying fundamental value.

Another basis of the shareholder approach refers to the importance of the high-powered incentives assumption, by which directors and managers can be disciplined by adopting a system of incentives based on performance to align their own interests to company ones. The main issue is that stock option plans create skewed incentives since their holders win when share price goes up and have no loss when it goes down. In such a context, it is obvious that directors become more attracted to risky decisions [subprime crisis].

The market for corporate control is an important assumption that disciplines managers since financial markets give the possibility for hostile takeovers and leveraged buyouts (LBO’s) by which a company can acquire and better manage an underperforming company.

Then, an ultimate assumption is that US law supports shareholders’ supremacy. This is not always true, as can be stated by looking at the evidence. The Exxon Valdez case showed that shareholders may not be protected by law, since the environmental disaster in Alaska (due to an oil spill caused by the impact of a ship hitting a rock) was a clear example of the possibility for a CEO to take risky decisions that may damage the value of the firm and so the shareholders’ value.

Basically, all assumptions behind the shareholder approach can be contradicted.

Stakeholder approach

The stakeholder approach refers to the company as an entity that must simultaneously satisfy the interests of all participants who have a stake in the organization. It is governed by the BoD, which is composed of people whose objective is to mediate different interests converging to the company. Shareholders are not considered as the only ones. In publicly traded companies, this role is certainly more difficult because of the pressure of financial markets. So, the company has responsibility to a wider group of stakeholders who are affected by the company’s activities and decisions (employees, customers, suppliers, social community, competitors, shareholders, …).

The stakeholder view can be described with the so-called team production model, by which the company is a team where groups of people work together and it is difficult to agree in advance on everyone’s contribution and reward. So, each member doing specific investments can be easily expropriated by other members. In such a context, the corporation is a separate entity and owns production assets. Directors have the legal responsibility to act for the company, and they are an institutional mechanism aimed at facilitating trust among all members by managing trade-offs between them.

Agency problem (principal-agent problem)

Agency problems typically occur in publicly traded companies where there is a separation between ownership and control (US, UK, and Anglo-Saxon countries). An agency relationship is one in which a principal (shareholders) delegates an agent (managers) to act in his/her interest. In such a context, it is obvious that agents may have different views and interests than principals. Agency problems occur because of human opportunism and behavior to satisfy one’s interests even if it damages other people. Agency costs are typically 1) monitoring costs - to control agents, and 2) bonding costs - to convince principals that everything is fine.

A good corporate governance structure is the one that tries to minimize agency costs (preferably when benefits from this operation exceed its costs). This can be done with two categories of tools: 1) incentives – made to align agent/principal interests, and 2) monitoring – such as supervising, internal and external control, analysis. Keep in mind that corporate governance issues arise in organizations whenever agency problems exist and transaction costs are such that agency problems cannot be dealt with through a contract.

It is obvious that without agency problems, all participants in the firm can be instructed to maximize profits or minimize costs. In this case, incentives to motivate people are not required.

The board of directors

In US/UK, shareholders are dispersed and therefore they delegate control to the BoD, which is influenced by the CEO (on top of the management board). It is different in the rest of the world since on top of the management board there is typically a major shareholder.

In theory, the Board of Directors positively influences firm performance as:

• Directors are very competent and expert persons;
• They have the responsibility to take the most important decisions.

In practice, BoD:

• Meet seldom;
• Receive a limited information flow;
• Are dominated by inside directors.

In fact, taking Adam Smith’s words from Wealth of Nations, 1776: when we delegate decision power to another person, we might have different views and interests. If I manage my own company, I will do my best; when I manage other companies, I don’t. For this reason, the delegation of power from shareholders (principal) to managers (agent) and BoD typically raises the so-called Agency Problem, caused by different interests and asymmetric information between parties. The solution to this problem brings two types of costs: monitoring cost and bonding cost (the cost of the agent to convince the principal that everything is fine). The principal-agent problem refers to the UK/US; in other countries, we can talk about the principal-principal problem. There exist two tools to minimize this problem: incentive strategies and monitoring. Those are the main ones, but we can also refer to: active market for corporate control, large blockholders (focus on management compensation), stock plans, directors’ fiduciary duties, internal and external auditors.

Periodic scandals emphasize inefficiency in boards’ functioning and lead to the development of good governance codes. The most famous is the Cadbury Code 1992 (the “code of best practice”). Corporate governance codes are defined as “soft-law” since companies are invited to comply with codes’ recommendations or to explain their choice (different from “hard law” – corporate law and commercial code – where you have the obligation to comply with it, otherwise legal issues arise). Typically, shareholders nominate the BoD, which then nominates the top management, with power flowing top-down.

Board tasks

1. Strategic: Directors define the mission and the vision of the company and contribute to the development of the business. Moreover, they approve strategic plans.
2. Control: Directors usually control the performance and top management behavior regarding both the operation and the strategic goals. Usually, the CEO presents the numbers (balance sheet, performance forecast…) and directors should ask questions looking at them in order to check if the CEO is doing managerial good. Further, directors must keep an eye on what is called myopia – the CEO’s tendency to maximize short-run profits even if damaging the long-run profits of the firm (BoD has to balance short and long-term).
3. Networking: Directors contribute to the development of corporate reputation and prestige and manage the relationship with shareholders and other stakeholders.

Board composition

In order to improve the chance that BoD does well, we have to analyze the following levels:

1. Board size: It is related to other variables like firm size, ownership structure, industry, etc. Moreover, we have to be careful about the risks related to it. Having a too big board can sometimes hide people, while in too small size boards there can be less opportunity to exchange different points of view. Typically, it is between 7 (in small companies) and 15 members (large firms).
2. Type of directors:
   • Chief Executive Officer
   • Inside or executive directors
   • Outside or non-executive directors: they are not the managers and are divided into:
     • Dependent: they could be biased
     • Independent: the BoD is required to identify who these are and specify the reason why they are meant to be independent.

In Italy on average, there are 3 executives (who take decisions and manage the firm) and 8 non-executive directors (new competences typically advisory). Within the non-executive, 3 are dependent, and 5 are independents. The latter are elected by the majority and then the minority of shareholders. The BoD is the one who decides whether a director is independent or not. Some studies in Italy underline that some directors named as independent fail to be such. Anyway, after 9 years a director is not considered independent anymore.

3. Diversity: It is a good characteristic for a good board. Differences can be according to age, nationality, gender, etc. The most important aspect is the presence of different professional, functional, and industrial backgrounds. Those are good when BoD has to deal with complicated and difficult tasks, and different points of view are essential when the decisions to be taken are complex. Diversity fits the different needs of the company. In Italy, we have diversity gender regulated under the law (about 30% of female in the board).

Board structure

1. CEO duality: There is a big discussion about the combination of the role of the CEO and the Chairman. The big debate rooted upon the trade-off of having high concentration power or a strong leadership.
   • The CEO has more responsibility about the business (the CEO should create value) and he is also at the top of the hierarchy. He can be an employee or not, in some other cases he is just a director.
   • The Chairman has the responsibility to lead the board: responsible for the meeting, information of the meeting, open the meeting, give the agenda, invite to make questions, finalize decisions.

US: CEO duality is in the hand of the same person in about 70% of the cases. The main reason for the combination of the two roles is the willingness to have a person who is very powerful, keeping him with strong incentives. They are in charge for 3/4 years on average, meaning it is a risky job since you can be fired easily. Today it is decreasing to 50%.

UK: They split the two roles. They want to split power to avoid negative excess power in the hand of one person: less possibility to manipulate numbers. The Chairman is typically older and previously an independent director. The CEO is younger, who makes numbers.

Italy: Executive Chairperson is really powerful; in family firms, it is the older guy.

2. Lead independent director: He should coordinate the independent director and represent the voice of the other directors of the board. Typically, he has high reputation, high experience, age (typically the older independent). Organize a meeting only with independents at least once a year.

3. Board committees: Executive committee
   • Until 1994, there was only the involvement with strategic decision making. The board delegates power to the CEO or to the strategic committee. In those cases, the BoD has the clear responsibility to be informed (continuous flow of info). The best case for the CEO is to give less info and share the responsibility of decision making.

The corporate governance code in the Cadbury Code (1994) introduced other committees, which should be made only by non-executive independents; this separates top managers from some decisions. They do not have real decision-making power; they don't take decisions but their task is just to make proposals. Those proposals are presented to the Chairman of the board, who takes the last decision.

• Audit: The most active, they meet every week (up to 40 per year). They are chaired by the Chairperson (in Italy, external auditors are invited). Internal auditors check compliance of the decisions and report the action and decisions taken to the CEO. It is a controlling body.
• Remuneration: Should make a proposal of compensation for top managers. Chairman, HR manager (bring company perspective in terms of indicator and performance), and a compensation consultant (bring information of peers - similar companies - and locate your company in quartile). The committee should evaluate the type of compensation and ex-post check result and calculate the bonus (typically on percentages). All this proposal has to be approved by the board.
• Nomination: Give indication on the board composition in the future: too large or too small board; lack some competencies; functioning properly; proposal for board election.
  • US (model 1 = dispersed ownership) assumed to make a proposal.
  • Italy (model 2 = concentrated ownership) controlling shareholders don't like that somebody else makes a proposal about board nominees, so this type of committee is debated.

Board functioning

1. Meetings:
   • The number of meetings depends on the decision that has to be made. (Ex: you are a very large company like P&G, the board should meet once a month). Usually, a month is the limit and the standard. If it is more, it is just because a big decision has to be taken. The number is important because the board takes decisions.

Strategic meetings:

• The length is about 3-4 hours. In case of necessity, you can also meet for two days long. Personal attendance is the best choice. With a teleconference, you are less engaged, and you might have interaction limits. According to fiduciary duties, directors of large companies should not have more than 4/5 board participations in other boards' meetings.

2. Information flow: Is just for board members, not to be shared outside the board. This might seem easy but is not in practice (ex: family members).
   • It is a matter of financial performance vs qualitative information.
   • Depth and independence from the management point of view: It is about trust. The answer is not, but it is always good to have a sort of independent information like press releases; even if they can be biased, it is always better to have them since they do not come from the manager or someone involved in the board. Asking and making questions is always key.
   • Availability on time: Like taking a decision on a big investment, you need to have access to the information about the investment before it occurs in order to have enough time to debate about it. You have to make good decisions; therefore, postpone the meeting if you are not well informed. If you have to make a decision, always better to trust 120%, and even in this case, you might face risk.

3. Board evaluation: The shareholder cannot have a big understanding about the decisions since for them are only available after the press release. For this reason, it is typically a:
   • Self-evaluation: It can be formal or real. A real independent consultant distributes a survey with 100-200 items and the result goes directly to the consultant. This survey is useful because you compare over years and among different people. Moreover, the consultant can also meet personally people and interview them. With these two tools, you prepare a report and give it to the Chairperson, and you also prepare a summary which typically provides recommendations.
   • Self-assessment: Means that directors evaluate other directors (CEO vs board vs directors’ evaluation). These are instruments to improve where to put your attention in order to improve board functions and coordination.