Corporate Governance: An Overview

Professor Alexander SettlesFaculty of Management, State University – Higher School of EconomicsEmail: asettles@hse.ru

Learning objectives

Corporate Governance and Competitiveness

Investor Protection Role of Public Sector in Setting Framework

for Good Corporate Governance Knowledge about theory of board

operation and Role of directors Theories of board organization Regulation concerning corporate boards Practice in corporate boards

Corporate Finance, Corporate Governance and Valuation

Corporate Governance is at the intersection of strategy, control and finance

Corporate Governance is a primary driver of firm specific and market risk in valuation approaches

Review of Valuation Models

Asset approach Market approach

Guideline Public Company method Transaction Method or Direct Market Data

Method Income approach

Discounted cash flows method Capital Asset Pricing Model (CAPM) Weighted Average Cost of Capital (WACC)

Review of Valuation Models

Understand concept of market efficiency and four techniques to determine value of common shares:

1) Dividend valuation model (DVM),2) Book value,3) Liquidation value, and4) Price/Earnings (P/E) multiple.

Discounts and premiums

Discount for lack of control Discount for lack of marketability Minority discount Control premium Lack of marketability Key person discount

Risk Premiums

Risk Premiums vary with specific issuers and issue characteristics including: Default risk, Maturity risk, Liquidity risk, Contractual provisions, and Tax risk.

Risk and Return Investors must be compensated for accepting

greater risk with higher expected returns.

Why Russian market down so much more than US/Western Markets?

BRIC effect – China off 60% Brazil off 21% India off 34% (Big gains in 2006 – 2007 – now investors cashing out to meet capital needs in western markets due to the credit crunch)

Return of Country Effect Stalled reform on corporate governance Threats of government control (Mechel &

Evraz) Geopolitical risk reevaluation Is your money safe in Russia?

Basic Valuation Model The value of any asset is the Present

Value of all future cash flows it is expected to provide over the relevant time period.

V0 = value of the asset at time zero

CFt = cash flow expected at the end of year tk = appropriate required rate of return

(discount rate)n = relevant time period

nn

k

CF

k

CF

k

CFV

)1(...

)1()1( 22

11

0

Cost of Capital Models

CAPM Where:

is the expected return on the capital asset is the risk-free rate of interest (the beta coefficient) is the sensitivity of the

asset returns to market returns, or also , is the expected return of the market is the market premium or risk premium (the

difference between the expected market rate of return and the risk-free rate of return)

Changes in Risk Although k is defined as the required

return, it is directly related to the nondiversifiable risk, which can be measured by beta.

Recalling the equation for the CAPM:ks = RF + [β (km - RF)]

Thus, actions that increase risk contribute toward a reduction in value, and actions that decrease risk contribute to an increase in value.

Historical Tradition in Corporate Governance

Formation of Open Joint Stock Companies in England and Holland 16th century

Use of OJSC in US as public companies in 19th and early 20th Century as engines of industrial growth – Corporate governance scandals of the 19th far exceed recent scandals

Securities Exchange Act of 1934 Securities Act of 1933

Sarbanes-Oxley Act of 2002

Recent Corporate Failures

Enron Corporation

Worldcom Parmalat GlobalCrossing Aledphia

Even more recent failure related to risk in the market

Fannie Mae & Freddie Mac BearSterns Meryl Lynch AIG Lehman Brothers

Corporate Governance Introduction

What is Corporate Governance? Definition of “Governance” vs.

“Administration,” “Management,” or “Control”

Corporate Governance structures Board of Directors Chair of the Board Corporate Secretary Shareholders – General Meeting of

Shareholders Why is it important to corporate finance?

Cost of Capital

What is a Corporation?

“The business corporation is an instrument through which capital is assembled for the activities of producing and distributing goods and services and making investments. Accordingly, a basic premise of corporation law is that a business corporation should have as its objective the conduct of such activities with a view to enhancing the corporation’s profit and the gains of the corporation’s owners, that is, the shareholders.” Melvin Aaron Eisenberg

What is a Corporation?

“When they [the individuals composing a corporation] are consolidated and united into a corporation, they and their successors are then considered as one person in law . . . For all the individual members that have existed from the foundation to the present time, or that shall ever hereafter exist, are but one person in law – a person that never dies: in like manner as the river Thames is still the same river, though the parts which composite are changing every instant.” Blackstone

“An ingenious device for obtaining individual profit without individual responsibility.” Ambrose Bierce, The Devil’s Dictionary

Corporate Form

1. limited liability for investors;2. free transferability of investor

interests;3. legal personality (entity-

attributable powers, life span, and purpose); and

4. centralized management.

Purpose of a Corporation

Human satisfaction Social structure Efficiency and efficacy Ubiquity and flexibility Identity Personality – morality ?

Measuring Performance

Long term versus short term Market value EVA Human Capital Externalities

Corporate Governance Definitions

OECD – “internal means by which a corporations are operated and controlled … which involve a set of relationships between a company’s management, its board, its shareholders and other stakeholders.”

IFC – Russia Corporate Governance Manual

Corporate Governance is a system of relationships, defined by structures and process. [Shareholders – Management]

These relationships may involve parties with different and sometimes contrasting interests.

All parties are involved in the direction and control of the company

All this is done to properly distribute rights and responsibilities – and thus increase long term shareholder value.

Definitions

“Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment”, The Journal of Finance, Shleifer and Vishny [1997, page 737].

Other Definitions

"Corporate governance is about promoting corporate fairness, transparency and accountability" J. Wolfensohn, president of the Word bank, as quoted by an article in Financial Times, June 21, 1999.

“The directors of companies, being managers of other people's money than their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private co-partnery frequently watch over their own.” Adam Smith, The Wealth of Nations 1776

Corporate Governance System

Corporate Governance

Basics of Corporate Governance

By issuing corporate securities, firms sell claims to control the companies` resources The interests of the various security holders differ Separation of ownership and control implies agency

relationships. Interests of agents (management) are different from

those of security holders, particularly from those of stockholders.

Monitoring the activities of agents is costly - hence, full monitoring is not optimal.

The value forgone due to imperfect optimal monitoring is an explicit agency cost.

Legal and Economic Institutions

Legal protection of shareholders Concentrated ownership strategy

Contract Theory of Corporate Governance

Contract are arranged between principles (owners) and agent (managers)

Contracts are also made between the firm and providers of capital

Problems with contracts: Moral Hazard Incomplete contracts Adverse selection bias

Coase 1937, Jensen & Meckling 1976, Fama and Jensen 1983

Agency Problem

Managerial discretion - Business judgement

Managerial opportunism – self dealing

Duty of loyalty of management to firm

Fiduciary Duty

The fiduciary duty is a legal relationship between two or more parties (most commonly a "fiduciary" or "trustee" and a "principal" or "beneficiary") that in English common law is arguably the most important concept within the portion of the legal system known as equity.

A fiduciary will be liable to account if it is proved that the profit, benefit, or gain was acquired by one of three means:

In circumstances of conflict of duty and interest In circumstances of conflict of duty and duty By taking advantage of the fiduciary position.

Therefore, it is said the fiduciary has a duty not to be in a situation where personal interests and fiduciary duty conflict, a duty not to be in a situation where their fiduciary duty conflicts with another fiduciary duty, and not to profit from their fiduciary position without express knowledge and consent. A fiduciary cannot have a conflict of interest.

Agency Problem Duty of loyalty of management to firm

Incentive contracts that align management interests with investors

Agency costs – monitoring and compliance

Shareholder actions- shareholder democracy, proxy fights, access to the proxy ballot, derivative lawsuits

Choice of Capital Structure

Debt versus Equity as CG problem Creditor/owners ability to exert control Debt instrument can reduce the adverse

selection bias by reducing the manager’s insider information concerning repayment

Collateral value opposed to firm value decides the cost of debt

Debt provides greater protection to outsider financers – in risky CG environments there are lower costs of capital for the issuance of debt

Shleifer and Vishny’s Conclusions

Investor protection and concentrated ownership are the best

Corporate Governance system evolve to meet the current challenges of the day

The type of Large Investor matters

Four core values of the OECD corporate governance framework

Fairness: The corporate governance framework should protect shareholder rights and ensure the equitable treatment of all shareholders, including minority and foreign shareholders.

Responsibility: The corporate governance framework should recognize the rights of stakeholders as established by law, and encourage active co-operation between corporations and stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises.

OECD Core Values

Transparency: The corporate governance framework should ensure that timely and accurate disclosure is made on all material matters regarding the company, including its financial situation, performance, ownership, and governance structure.

Accountability: The corporate governance framework should ensure the strategic guidance of the company, the effective monitoring of management by the board, and the board’s accountability to the company and shareholders.

Business Case for Corporate Governance

Well governed companies have lower cost of capital

Reduction of risks Higher valuation of human capital in

companies that are well governed Higher share valuation

IFC Business Case

Advantages of Good Corporate Governance

Stimulating Performance and Improving Operational Efficiency Better oversight and accountability Improved decision making Better compliance and less conflict Less self-dealing Better informed Avoidance of costly litigation through

adherence to laws and regulations

Advantages of Good Corporate Governance

Improving Access to Capital Markets Transparency, accessibility, efficiency,

timeliness, completeness, and accuracy of information critical

Listing requirements Inclusion of Corporate Governance in

investment decision process

Anglo-Saxon Model

US, UK, Canada, Australia, New Zealand Shareholder value maximization “outsider” model – arms length investor Internal governance mechanisms

board of directors employee compensation

External mechanisms market for corporate control monitoring by financial institutions competition in product and input market

Reliance on legal mechanisms to protect shareholder rights

Short term financial performance key

German (Continental) Model

Co-determination - partnership between capital and labor

Social cooperation The two-tier board structure that consists of a

supervisory board and executive board – greater efficiency in separation of supervision and management

Cross–shareholding in financial – industrial groups

Role of banks as major shareholders Primary sources of capital – retained earnings

and loans

Japanese Model

Formal role of large and almost entirely executive boards – single tier board

Historical roots of the Keiretsu network interlocking business relationships

Existence of significant cross holdings and interlocking-directorships,

Lifetime employment system plays in corporate policy

Role of banks Market share maximization over shareholder

value maximization Long term perspective

Corporate Governance Framework in Russia

Concentrated Ownership The observation that there is little

separation between ownership and control

Holding structures and reorganizations used to deny free exercise of ownership rights

Inexperienced Directors Government Intervention

Market for Corporate Control

“Friendly Takeover” When a bidder makes an offer for another, it

will usually inform the board of the target beforehand. If the board feels that the value that the shareholders will get will be greatest by accepting the offer, it will recommend the offer be accepted by the shareholders.

A takeover would be considered "hostile" if 1) the board rejects the offer, but the bidder

continues to pursue it, or 2) if the bidder makes the offer without informing

the board beforehand.

Theory

Berle and Means (1932) – separation of ownership and control through modern corporation structures

Agency Problem

Agency Problem

Separation of Ownership and Control

Contract between financiers and management

Managerial discretion - Business judgement

Managerial opportunism – self dealing

Agency Problem

Duty of loyalty of management to firm

Incentive contracts that align management interests with investors

Agency costs – monitoring and compliance

Shareholder actions- shareholder democracy, proxy fights, access to the proxy ballot, derivative lawsuits

Control Mechanisms

More Theory

Conventional Wisdom (Manne 1971) : The business literature describing the

classical functions of boards of directors typically includes three important roles: (1) establishing basic objectives, corporate strategies, and board policies: (2) asking discerning questions; and (3) selecting the president.

Some Early Research (Manne 1971)

First classical role Found that boards of directors of most large

and medium-sized companies do not establish objectives, strategies, and policies however defined

These roles are performed by company management

Presidents and outside directors generally agreed that only management can and should have these responsibilities.

Some Early Research (Manne 1971)

A second classical role assigned to boards of directors is that of asking discerning questions - inside and outside the board meetings. Again it was found that directors do not, in fact, do this. Board meetings are not regarded as proper forums for discussions arising out of questions asked by board members.

A third classical role usually regarded as a responsibility of the board of directors is the selection of the president. Yet it was found that in most companies directors do not in fact select the president, except in the two crisis situations cited earlier.

Research that confirms Stewardship Theory

Muth and Donaldson (1997) challenged agency theory, which underpin conventional assumptions about the benefits of checks and balances – Boards with well connected, executive

directors perform better than those that meet the paradigms of conventional governance thinking

Also research has shown that increasing governance conformance and compliance may not add to corporate performance - it can actually detract - Donaldson and Davies (1994)

Theoretical Challenges to Agency Theory

Stewardship theory, the alternative perspective, takes an altogether broader frame of reference, being based on the original and legal view of the corporation in which directors have a fiduciary duty to their shareholders to be stewards for their interests.

Performance Governance Relationship

Yit is one of the firm performance measures, Govit is a governance rating, Xit is a vector of control variables and e it is the error term.

Russian Corporate Governance Structures

Required number of Directors

At least five directors for companies with 1,000 and fewer shareholders with voting rights;

At least seven directors for companies with more than 1,000 shareholders with voting rights;

At least nine directors for companies with more than 10,000 shareholders with voting rights.

Who can be a director?

Only individuals with “full dispositive capacity” can be directors. Directors should have the capacity to acquire and exercise civil law rights by their actions, be able to create civil law obligations, and fulfill these rights and obligations;

A legal entity cannot be a director, although an individual who happens to be a representative of a legal entity can be elected to the Supervisory Board. In this case, the individual elected to the Supervisory Board may only serve in his capacity as a director and not as a representative of the legal entity, i.e. he must act in the interest of the company on whose Supervisory Board he is sitting and not of the company he is representing

Who can not be a director?

Revision Commission members cannot be directors

Counting Commission members cannot be directors

An Executive Board member or the General Director of Company A can only be a director of Company B after the Supervisory Board of Company A has given its consent.

Types of Directors

a) Executive DirectorsExecutive directors can be defined as

those that also hold an executive position in the company, namely that of:The General Director;An Executive Board member; orA manager of the company who is not an

Executive Board member.

Types of Directors

b) Non-Executive DirectorsNon-executive directors are Supervisory Board

members that do not hold an executive position in the company.

c) Independent DirectorsRussian law does not define the concept of

independent directors. The Company Law does, however, refer to independent directors under specific circumstances to determine the position of individuals engaged in related party transactions and to prevent possible conflicts of interests.

Independent Director

In this respect, an independent director is defined as an individual who has not been in any of the following positions at the time of the approval of a business transaction, or during one year immediately preceding the approval of such a transaction: The General Director, the External Manager, an

Executive Board member or a member of the governing bodies (Supervisory Board, General Director and Executive Board) of the External Manager; or

A person whose spouse, parents, children, brothers, and sisters by one or both parents are the External Manager or hold a position in the governing bodies of the External Manager; or

A person whose adoptive parents or adopted children are the External Manager or hold a position in the governing bodies or the External Manager; or

An affiliated person other than a director of the company.

What is Independence?

Independence of a Director: a Director must always act in a manner independent of management and never be conflicted by any relationship to management (i.e., financial, familial, or social). Independence measurements include:

Relatedness of the Director:   - Employee (in last three years);  - Professional advisor (in last three years);  - Executive of any affiliated company;   - Other income from company;  - Kinship or social ties;• Interlocks with other Directors;• Number of Boards on which Director serves.

Independent Director

In conflict situations, an Independent Director shall be guided by the principles of increasing shareholder value and an equitable approach to the interests of all shareholder groups, and encourage the parties involved in the decision to adhere to the same principles.

An Independent Director shall not abuse his/her position to the detriment of the company or its shareholders or for the purpose of gaining direct or indirect personal advantage or advantage for any other associated person, except for the remuneration for Board membership.

Independent Director

Observance of the independence requirement is the most important aspect of the activity of an Independent Director.

(1) An Independent Director shall refrain from any actions that could lead to a loss of his/her independence. Where circumstances arise which make an Independent Director lose his/her independence, the Independent Director must immediately notify the shareholders, the management and the Association accordingly.

(2) An Independent Director shall be prepared to provide arguments in support of his/her position if he/she disagrees with the majority of members of the Board of Directors, its chairman, the president of the company, or its managing director.

Independent Director

Transparency and openness to dialog are the distinguishing characteristics of an Independent Director. (1) An Independent Director shall strive to

establish constructive dialog with the company's Board of Directors and executive management. An Independent Director's ethical standards, decision making principles and reasons for disagreeing with a proposed decision should be clear for the Board of Directors and executive management.

(2) An Independent Director is recommended to present the present Code to the company's Board and the management.

Independent Director

An Independent Director acts as an agent of all the company shareholders and therefore shall, within the limits of his/her authority, protect the rights and legitimate interests of all of the company's shareholders and help establish constructive dialog between the company's shareholders and management.

An Independent Director shall endeavor to ensure that shareholders are given access to corporation information.

Independent Director

When dealing with third parties, an Independent Director shall be loyal to the company and its shareholders and protect their interests.

When dealing with the investment community and stock market analysts, an Independent Director shall make every possible effort to enable all the parties concerned to have simultaneous access to the information disclosed.

An Independent Director shall disclose only accurate information that may be disclosed according under applicable laws and does not damage the company's business.

Best Practices: Election of Board Members

Shareholders should receive sufficient information to determine the ability of Supervisory Board nominees to fulfill their duties and, if applicable, to ascertain their independence. Some useful items of information include:• The identity of the candidate;• The identity of the shareholder (or the group of

shareholders) that nominated the candidate;• The age and educational background of the

candidate;• The positions held by the candidate during the last

five years;• The positions held by the candidate at the moment

of his nomination;• The nature of the relationship the candidate has with

the company;

Best Practices: Election of Board Members continued

• Other Supervisory Board memberships or official positions held by the candidate;

• Other nominations of the candidate for a position on the Supervisory Board or official positions;

• The candidate’s relationship with affiliated persons of the company;

• The candidate’s relationship with major business partners of the company;

• Information related to the financial status of the candidate, and other circumstances that may affect the duties and independence of the candidate as a Board member; and

• The refusal of the candidate to respond to an information request of the

company.

The Election of Directors

All directors must be elected with cumulative voting. Cumulative voting is a system that helps minority

shareholders pool their votes to elect a representative for the Supervisory Board. The election of directors cannot be done if a GMS is held by written consent.

How Cumulative Voting Works: Candidates for the Supervisory Board are voted on

collectively, i.e. as a group; Each shareholder has a maximum number of votes equal to

the number of directors that must be elected (according to the charter or a decision of the GMS) multiplied by the number of voting shares held;

Shareholders can allocate their votes to one candidate or divide them among several candidates as they please;

The top X candidates with the most votes are considered elected, whereby X equals the number of Supervisory Board members to be elected as specified by the charter or the decision of the GMS.

Cumulative Voting: Minimum number of votes to elect one director

where D — the number of directors to be elected, S — the number of outstanding votingshares and n — the total number of directors the majority shareholder wants to elect

Company Practices in Russia

Representatives of major shareholders (35%),management and employees (30%) are the most common types of directors,

Independent directors (18%) and minority shareholder representatives (9%) still constitute a minority on most Supervisory Boards.

A positive correlation exists between the number of shareholders in a company and the number of representatives of majority shareholders on the Supervisory Board. Hence, Supervisory Boards of large companies with many shareholders tend to include more representatives of large shareholders.

Governance is Different from Management

Governance

Management

Governance and Management

Management runs the business the board ensures that the business

is well run and run in the right direction

Functions of the board

Outwardlooking

InwardLooking

ProvidingAccountability

Strategy Formulation

Monitoring and Supervising

Policy Making andRevising

Approve and work through the CEO

Past and present focused Future Focused

All Executive Board

Governance

Management

O - executive directors

OO

O

O

O

Majority – executive board

Governance

Management

O - executive directorsN – non executivedirectors

OO

O

O

N

N

N

Majority – non executive board

Governance

Management

O - executive directorsN – non executivedirectors

OO

O

O

N

N

N

Two – tier board

Governance

Management

O - executive directorsN – non executivedirectors

O

O

O

O

N

N

N

O

NN

NN

N N

Majority – executive board

Governance

Management

O - executive directorsN – non executivedirectors

O

O

O

N

N

N

NN

Corporate Governance and Initial Public Offerings

Corporate Governance is a principle variable in evaluating risk / setting discount for IPOs

Firms reaching the market make significant CG changes to their board structure and practices to conform to market expectations

Role of the Board in a Public Company IPO / Listing Experience

The Board Effectiveness Talents and background of board

members Tying board remuneration closely to

performance Strategic thinking by the Board Managing risk effectively

Role of the Board in Listing - IPO

Developing a robust audit committee

Taking corporate social responsibility on board

Encouraging and active dialogue with shareholders

The Effective Board

Clear strategy aligned to capabilities Vigorous implementation of strategy Key performance drivers monitored Effective risk management Sharp focus on views of the capital

market and other key stakeholders Regular evaluation of board

performance

What does the market look for in a board member?

Asks the difficult questions Works well with others Has industry awareness Provides valuable input Is available when needed Is alert and inquisitive

What does the market look for in a board member?

Has business knowledge Contributes to committee work Attends meetings Speaks out appropriately at board

meetings Prepares for meetings Makes long-range planning contribution Provides overall contribution

Implementing effective strategy and change programs

The blueprint for the strategy The business case The transformation program A mobilized organization A ‘transformation map’

The audit committee’s main responsibilities

To monitor the integrity of the financial statements

To review the company’s internal financial controls, internal control and risk management systems.

To monitor/review the effectiveness of the internal audit function.

To make recommendations to the board on the appointment/removal of the external auditor

The audit committee’s main responsibilities

To monitor/review the external auditor’s independence/objectivity and the effectiveness of the audit process.

To develop/implement policy on the engagement of the external auditor to supply non-audit services

To review arrangements by which staff may raise concerns about possible improprieties (‘whistleblowing’)

Flotation – who ends up steering the boat?