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Corporate Governance
Corporate governance can be defined as the economic,…
Corporate Governance
Corporate governance can be defined as the economic, legal, and institutional framework in which corporate control and cash flow rights are distributed among shareholders, managers, and other stakeholders of the company
With the control rights, managers may allow themselves to consumer exorbitant perquisites
For example, Steve Jobs, the former CEO of Apple Inc., reportedly had a $90 million company jet at his disposal.
Managers may also steal investors’ funds.
For example, transfer pricing scheme.
Managers can exercise substantial discretion over the disposition and allocation of investors’ capital.
==> Investors are no longer assured of receiving fair returns on their funds
Self-interested managers may also waste funds by undertaking unprofitable projects that benefit themselves but not investors.
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There will be no complete contract due to have many possible future contingencies.
==> Shareholders allocate decision-making authority to the managers ( residual control rights)
- Corporate Governance Reform
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Failure to reform corporate governance will damage investor confidence, stunt the development of capital markets, raise the cost of capital, distort capital allocation, and even shake confidence in capitalism itself
Objectives of Reform
Strengthen the protection of outside investors from expropriation by managers and controlling insiders
Among other things, reform requires
- strengthening the independence of boards of directors with more outsiders
- enhancing the transparency and disclosure standard of financial statements
- energizing the regulatory and monitoring functions of the SEC (in the United States) and stock exchanges
Political Dynamics
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Many parties have vested interests in the current system,
and they will resist any attempt to change the status quo.
Reformers should understand the political dynamics surrounding governance issues and seek help from the media, public opinion, and nongovernmental organizations
The Sarbanes-Oxley Act
( protect investors by improving the accuracy and reliability of corporate disclosure, thereby restoring the public’s confidence in the integrity of corporate financial reporting)
Accounting regulation
The creation of a public accounting oversight board charged with overseeing the auditing of public companies, and restricting the consulting services that auditors can provide to clients.
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Internal control assessment
Public companies and their auditors should assess the effectiveness of internal control of financial record keeping and fraud prevention.
Executive responsibility
Chief executive and finance officers (CEO and CFO) must sign off on the company’s quarterly and annual financial statements. If fraud causes an overstatement of earnings, these officers must return any bonuses.
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Cadbury Code
The board should meet regularly, retain full and effective control over the company and monitor the executive management.
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- Remedies for the Agency Problem
Independent board of directors
- In the U.S., shareholders have the right to elect the board of directors.
- In Germany, there are two-tier boards consisting of supervisory and management boards.
- In the United Kingdom, there should be at least three outside directors and that the board chairman and the CEO should be different individuals.
- Japan Most corporate boards are insider-dominated
Incentive contracts
- Many companies provide managers with incentive contracts, such as stocks and stock options, in order to reduce this wedge and better align the interests of managers with those of investors.
- With the grant of stocks or stock options, managers can be given an incentive to run the company in such a way that enhances shareholder wealth as well as their own.
Concentrated ownership
- An effective way to alleviate the agency problem is to concentrate shareholdings. If one or a few large investors own significant portions of the company, they will have a strong incentive to monitor management.
- With concentrated ownership and high stakes, the free-rider problem afflicting small, atomistic shareholders dissipates.
Accounting transparency
- Strengthening accounting standards can be an effective way of alleviating the agency problem. Basically, a greater accounting transparency will reduce the information asymmetry between corporate insiders and the public and discourage managerial self-dealings.
- To achieve a greater transparency, however, it is important for (i) countries to reform the accounting rules and (ii) companies to have an active and qualified audit committee.
Debt
- If managers fail to pay interest and principal to creditors, the company can be forced into bankruptcy and managers may lose their jobs.
- Borrowing can have a major disciplinary effect on managers, motivating them to curb private perquisites and wasteful investments and trim bloated organizations.
- Excessive debt creates its own agency problems, however.
Shareholder activism
- “Activist investors”, who invest in stocks of a company for the explicit purpose of influencing the company’s management, started to play an import role in promoting shareholders’ interest.
- Pursue social and political agenda by promoting changes in companies’ environmental, social, and governance practices
Overseas stock listings
- Companies domiciled in countries with weak investor protection can bond themselves credibly to better investor protection by listing their stocks in countries with strong investor protection (i.e., cross-listings)
- Studies confirm the effects of cross-border listings
Market for corporate control
- The market for corporate control, if it exists, can have a disciplinary effect on managers and enhance company efficiency.
- Law and Corporate Governance
Legal scholars show that the commercial legal systems (e.g., company, security, bankruptcy, and contract laws) of most countries derive from relatively few legal origins
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The content of law protecting investors’ rights & the quality of law enforcement varies a great deal across countries.
Two most influential legal systems are English common law and French civil law, with the English system offering more protection to investors than the
French system
Protection of investors’ rights not only has interesting legal origins, but the concept is shown to have major economic consequences.
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Economic growth, and others
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