The Modern Corporation and Corporate Governance: An Overview

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

Class Rules

1. Students must attend all lectures and seminars. Those students that arrive late will have to wait until the break between sessions to enter and will receive credit for attendance for the second session.

2. Students must be prepared for class, complete all readings, and be ready to take notes

3. Students may not talk during class. Students are expected to participate in class discussion but are not to interrupt the lecturer or other students

4. Students may not enter or leave the class during the lecture unless for emergency reasons

5. Students must turn off or place on silent mobile phones and may NOT use computers or other devices for entertainment purposes

Class Overview – Schedule Settles

17.02 – Course introduction, Corporate Governance, Globalization and BRICS

24.02 –Using Management Research, topic development and group formation

10.03 – Corporate governance overview in international context

17.03 – Valuation and Corporate Governance Ratings31.03 - IPO, mergers and acquisitions, and foreign

market entry for Russian corporations14.04 – Financial Crisis and SWF21.04 – Compensation, and regulation28.04 – Corporate Social Responsibility

Course Requirements

Send me an email at asettles@hse.ru

50% - Paper - Settles 10% - Attendance to lectures -

Settles 40% - Seminar Grade (Test and

attendance) - Tomoradze

Due Dates

Proposal March 3rd Review of literature March 31st

Draft paper due April 14th

Final paper due May 15th Your failure to plan or act is not my

problem – no action = failing grade

Topic Proposal

Title of paper Research question Literature review Proposed methods Anticipated results 3 pages

Potential Topics

Cross-listing and IPO of emerging market firms (Russia and Brazil)

Globalization and risk Cross-border merger and

acquisitions Cross-country comparison of

management and governance: Do managers have a comparative advantage?

Potential Topics

Difference in business environment: Convergence or divergence in governance or management practices

Behavior of Directors and TMT in a cross cultural context

Privatization CSR: Issues and Application across three

models Russia, US, and Europe

Shirking and Stealing: How Corporate Governance Protects Investors

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

Why is Corporate Governance Important to Russia firms?

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.

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` ressources The interests of the various securityholders differ Separation of owership and control implies agency

relationships. Interests of agents (management) are different from

those of securityholders, particulary 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.

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

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.

Fiduciary Duty

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

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.

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

Accounting Scandal and Reform in the US and Western Europe

Crisis in Governance 1999 - 2002

Enron – fraud and oversight failure

Worldcom – accounting fraud

Adelphia – RPT securities violations, and accounting fraud

Arthur Anderson

More detailed list

AOL Adelphia Bristol-Myers Squibb Duke Energy Dynegy El Paso Corporation Enron Freddie Mac Global Crossing Halliburton Harken Energy

ImClone Systems Kmart Lucent Technologies Merrill Lynch Qwest

Communications Reliant Energy Sunbeam Tyco International Waste Management,

Inc. WorldCom

SOX reforms to US Corporate Governance

Auditor independence Corporate Officer Responsibility for

financial statements Internal Control Sections 404 and

302 Significant increase in monitoring

costs for PLCs

Market Size

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

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.

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 Little separation between ownership and

control Unwieldy holding structures used to hide

beneficial ownership, avoid taxes, or steal from minority owners

Reorganizations to dilute minority stakes Inexperienced Supervisory Board (Boards

of Directors)

Theory

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

Agency Problem

Control Mechanisms

Conventional Wisdom

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.

Stewardship 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.

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)

Introduction to Corporate Governance Structures

Supervisory Board (Board of Directors) Central role in Corporate Governance

framework Sets strategy, business priorities,

annual financial and business plan, and oversees managerial performance

Oversees the work of the General Director (CEO) and the Executive Board

Role of Supervisory Board

Protecting the interests of the company and its shareholders

Defining the Boards role and priorities Setting the company’s governance

framework Organizing the General Meeting of

Shareholders, Protection of company assets Resolution of conflicts Supervision of internal controls and risk

management

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.

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

O

O

O

N

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

Wimm-Bill-Dann Board of Directors

One tier board in the US / UK model Members

David Iakobachvili Chairman - non-excutive & dependent (owns 9.46%)

Sergei A. Plastinin Director, Chairman of Management Board and Head of Dairy Business Unit - Executive (owns 12.16%)

Guy de Selliers Director - non-executive and indepedent Mikhail V. Dubinin Director - executive (owns 6.83%) Michael A. O'Neil Director - non-executive and independent

(?) Alexander S. Orlov Director - executive (owns 4.39%) Vladimir N. Sherbak Director - non-excutive and dependent Victor A. Tutelyan Director - non-executive and indepedent Earnest Linwood Tipton Director - non-excutive and

indepedent Evgeny G. Yasin Director - non-excutive and independent Gavril A. Yushvaev Director - non-excutive and depedent

(owns 18.80%)

Ownership

Party to the Amended and Restated Partnership and Cooperation Agreement. Mikhail I Vishyakov (owns 2.59%) Evgeny L. Yaroslavsky (owns 1.43%) Vicktor E. Evdokimov (owns 0.42%)

Other Owners Parex Bank JSC (owns 5.29%) Templeton Strategic Emerging Markets Fund

LDC (owns 1.18%) Others own 4.74% of Russian traded shares American Depositary Receipt Holders own

32.70%

Wimm – Bill – Dann

Governance

Management

E/O - executive /owners directorsN/I – non executive directors/independentN/O – non executive directors/ ownersN/D – non executive directors/dependent

E/ON/I

N/IN/O

E/O

E/O

N/D

N/DN/I

N/I

N/I

Wimm – Bill – Dann Committees

Audit Committee – 3 independent directors

The Committee for Investment and Strategic Planning – 1 independent & 2 dependent directors

Committee for Personnel and Remuneration – 1 independent director & 1 dependent director

Compensation of Board Members

Board member receive $50,000 annually plus transportation and lodging expenses incurred in connection with board meeting attendance, and up to $2,000 per year for other expenses

Chairman of the Board is compensated $300,000

Members of the Personnel and Compensation Committee & Investment and Strategic Planning Committee receive $3,000 and each member of the Audit Committee receive $5,000 for participation in each planned direct Committee meeting.

What does the Wimm – Bill – Dann Case Indicate?

Outside investors should know the following: Board members are directors,

executives & managers Majority of ownership is controlled

through a shareholder agreement No threat of takeover without owner-

manager consent Board and committees are structured

to meet NYSE requirements for CG

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?