Chapter 4

An Overview of Corporate Governance

4.1. Evolution of Corporate Governance
 Until the beginning of the 17th century
 Corporations were established for limited purposes: most of
corporations were chartered for specific purposes, such as banking
services.
 Corporations could only exist for a limited time, no perpetuity
 They were not allowed to make any political contributions,
 One corporation could not own stocks in other companies.
 Corporate control by shareholders was characterized by “voice”
rather than by “exit”. No possibility of free exit option.
 Investors were not attracted to purchase shares because of absence of
exit option
 The industrialization Era-19th century
 Marked by the factory system replaced the old cottage system
 Technological advances and increasingly capital-intensive (mass)
production processes increased the optimal size of many firms.
 demanded huge capital demand of new giant firms, especially in the
railroad industry
 legislators began to take corporations more into consideration:
corporations were allowed to write broader and less restrictive
charters

 Wave of privatization (Between 1895 and 1904)

 The corporation was transformed from state-controlled organisations
to unlimited private organisations with limited responsibility and
limited accountability.
 Stoke/Share market opened - Markets for the exchange of shares
opened in many capital cities at this time.
 The free exit option introduced - As share trading became easier the
shareholders as capital providers increasingly relied on the exit option
 to express their pleasure or displeasure with “their” managers’
decisions.
 Separation of ownership and management took place - control of
corporations shifted more and more into the hands of the managers
and therefore ownership and control separated
 Control via voice shifted to the boards of directors, which in turn
were dominated by managers.

 After the 20th century

 Ownership and control were separated and therefore the agency
problem – deepened. The owner and the manager were no longer one
and the same person.
 The foundations of economic activity changed. A firm’s capital
requirements can be met in the form of debt or equity because
corporations are allowed to issue debentures and sale on debt basis.

4.2. Definition of Corporate Governance

Corporate governance is a set of devices (code of conduct) that aim to

protect investors against managerial misbehavior. "Good" corporate
governance is believed to reduce the likelihood of bad or wrong
management and, as a result, to create shareholder value.
 Most of the corporate governance are voluntary
 Thus the corporate governance form and implementation are largely
left to the discretion of the firms (that is, it is voluntary mechanisms
developed and implemented by the firm).
Narrow and broad definitions
The term “Corporate Governance” is susceptible of both narrow and broad
definitions, related to the two perspectives of shareholder- and stakeholder
orientation.
 Narrowly definition:
 based on shareholder/stockholder interest protection
  Emphasis is on the primacy of ownership and property rights and focus
on returning a profit to shareholders over the long term. However,
employees, suppliers and other creditors have contractual claims on
the company.
 The corporate focus is on returning a profit to shareholders over the
long term thereby increasing shareholder value.
 Corporations meet legal obligations rather than social responsibility

Broad definition:
 corporate governance meet both legal obligations and general societal

expectations
 focus on the need to satisfy societal(stakeholders) expectations as well

as owners interest
4.3. Needs for Corporate Governance
The need for corporate governance is highlighted by the following factors:

i) Wide Spread of Shareholders

Today a company has a very large number of shareholders spread all over
the nation and even the world; and a majority of shareholders being
unorganized and having an indifferent/unresponsive/ attitude towards
corporate affairs. The idea of shareholders’ democracy remains confined
only to the law and the Articles of Association; which requires a practical
implementation through a code of conduct of corporate governance.

ii) Changing Ownership Structure

Individuals (physical persons) are no more sole owners of corporations.
The pattern of corporate ownership has changed considerably, in the
present-day-times; with institutional investors and mutual funds
becoming largest shareholders in large corporate private sector.

These investors have become the greatest challenge to corporate

managements, forcing the latter to abide by some established code of
corporate governance to build up its image in society.

iii) Corporate Scams or Scandals

Corporate scams (or frauds) in the recent years of the past have shaken
public confidence in corporate management. The need for corporate
governance is, then, imperative/vital for reviving and attracting investors’
confidence in the corporate sector towards the economic development of
society.

iv)Greater Expectations of Society of the Corporate Sector

Society of today holds greater expectations of the corporate sector in terms
of reasonable price, better quality, pollution control, best utilization of
resources etc. To meet social expectations, there is a need for a code of
corporate governance, for the best management of company in economic and
social terms.

v) Hostile Take-Overs
Hostile takeovers of corporations witnessed in several countries put a
question mark on the efficiency of managements of take-over (target)
companies. This factor also points out to the need for corporate
governance, in the form of an efficient code of conduct for corporate
managements.

A hostile takeover is the acquisition of a target company by another

company (referred to as the acquirer) by going directly to the target company’s
shareholders, either by making a tender offer or through a proxy vote. The
difference between a hostile and a friendly takeover is that, in a hostile
takeover, the target company’s board of directors do not approve of the
transaction. That is a hostile takeover occurs when an acquiring company
attempts to take over a target company against the wishes of the target
company's management.

 Take-over takes place mostly because the take-over company (target

company) failure to become competitive in the industry.
Example of a Hostile Takeover

For example, Company A is looking to pursue a corporate-level strategy

and expand into a new geographical market.

1. Company A approaches Company B with a bid offer to purchase

Company B.
2. The board of directors of Company B concludes that this would not
be in the best interest of shareholders in Company B and rejects the
bid offer.
3. Despite seeing the bid offer denied, Company A continues to push
for an attempted acquisition of Company B.

In the scenario above, despite the rejection of its bid, Company A is still
attempting an acquisition of Company B. This situation would then be
referred to as a hostile takeover attempt.

Hostile Takeover Strategies

There are two commonly-used hostile takeover strategies: a tender offer or

a proxy vote.

1. Tender offer
 A tender offer is an offer to purchase stock shares from Company B
shareholders at a premium to the market price. For example, if
Company B’s current market price of shares is $10, Company A could
make a tender offer to purchase shares of company B at $15 (50%
premium).
 The goal of a tender offer is to acquire enough voting shares to have a
controlling equity interest in the target company. Ordinarily, this means
the acquirer needs to own more than 50% of the voting stock. In fact,
 most tender offers are made conditional on the acquirer being able to
obtain a specified amount of shares. If not enough shareholders are
willing to sell their stock to Company A to provide it with a controlling
interest, then it will cancel its $15 a share tender offer.

2. Proxy vote
A proxy vote is the act of the acquirer company persuading existing
shareholders to vote out the management of the target company so it will be
easier to take over. For example, Company A could persuade shareholders
of Company B to use their proxy votes to make changes to the company’s
board of directors. The goal of such a proxy vote is to remove the board
members opposing the takeover and to install new board members who are
more receptive to a change in ownership and who, therefore, will vote to
approve the takeover.

vi)Huge Increase in Top Management Compensation packages

It has been observed in both developing and developed economies that
there has been a great increase in the monetary payments (compensation)
packages of top level corporate executives. There is no justification for
exorbitant/excessive/ payments to top ranking managers out of corporate
funds, which are a property of shareholders and society. This factor
necessitates corporate governance to contain the ill-practices of top
managements of companies.

vii) Need to globalize the companies

Desire of more and more companies to get listed on international stock
exchanges also focuses on a need for corporate governance. In fact,
corporate governance has become a buzzword in the corporate sector.
There is no doubt that international capital market recognizes only
companies well-managed according to standard codes of corporate
governance.
4.4. Corporate Governance Mechanisms
Corporate governance can be separated into two mechanisms that are:
 firm internal or
 firm-external.
4.6.1. Internal Corporate Governance Mechanisms:

i) Board of director
 The board of directors is elected by the shareholders at the general

assembly meeting and represents the shareholders’’ interests.

 Consequently, its most important task is to monitor management on the

shareholders’ behalf.
 This implies that its primary responsibility, upon which its legitimacy

rests, is to reduce agency costs. As such, the directors’ responsibility is

to fire bad managers and to reject unprofitable long-term investments.
ii)Shareholders
 Shareholders do, at least partially, monitor the management
themselves.
 They have the right to vote on important corporate decisions, especially

on who is appointed to the board of directors.

iii) Executive compensation

 Executive compensation can be used to incentivize the management.

Managers’ compensation is considered as an incentive for efficient use of

resources.
 Variable compensation ("pay-for-performance") can align the interests

of both the management and the shareholders. Compensation that is

contingent upon performance may induce managers to undertake
profitable investment projects.
 It is considered that in the long run the competition in the product

market would force firms to reduce their cost including executive

compensation.

iv) Audit Committee

 The company shall form an independent audit committee that:
 Oversee the company’s financial reporting process and the disclosure of its
financial information to ensure that the financial statement is correct,
sufficient and credible.
 Recommend the appointment and removal of external auditor.
 Reviewing the company’s financial and risk management policies.
4.6.2. External Corporate Governance Mechanisms

i) Market for corporate control

The market for corporate control, is a natural mechanism that also discipline
the management. Stock prices in the market reflect the ability of the
management. The reputed and capable company’s share price is higher.
 In another words, poor managerial decisions lead to falling prices and,
thereby, increase the probability of the firm becoming a takeover target.
Thus, managers adopt actions that sustain firm value.

ii) Using Hostile-Takeover Defenses

To deter the unwanted takeover, the target company's management may
have preemptive/preventive/ defenses in place or it may employ reactive
defenses to fight back. Some of these defenses may include:

 Differential Voting Rights (DVRs) - this is where stock with less voting
rights pays a higher dividend. This makes shares with a lower voting
power an attractive investment while making it more difficult to
generate the votes needed for a hostile takeover if management owns a
large enough portion of shares with more voting power.
 Employee Stock Ownership Program (ESOP) - involves plan in which
employees own a substantial interest in the company. Employees may be
more likely to vote with management. As such, this can be a successful
defense.
 Poison Pill (a shareholder rights plan). It allows existing shareholders
to buy the newly issued stock at a discount if one shareholder has
bought more than a stipulated percentage of the stock, resulting in a
dilution/weakening) of the ownership interest of the acquiring
company. The buyer who triggered the defense, usually the acquiring
company, is excluded from the discount.
 Crown Jewel Defense– is the case where a provision of the company's
bylaws requires the sale of the most valuable assets if there is a hostile
takeover, thereby making it less attractive as a takeover opportunity.
 Supermajority amendment: An amendment to the company’s charter
requiring a substantial majority (67%-90%) of the shares to vote to
approve a merger.
 Golden parachute: An employment contract that guarantees expensive
benefits be paid to key management if they are removed from the
company following a takeover. The idea here is, again, to make the
acquisition prohibitively expensive.
 Greenmail: The target company repurchasing shares that the acquirer
has already purchased, at a higher premium, in order to prevent the
shares from being in the hands of the acquirer. For example, Company A
purchases shares of Company B at a premium price of $15; the target,
Company B, then offers to purchase shares at $20 a share. Hopefully, it
can repurchase enough shares to keep Company A from obtaining a
controlling interest.
 Pac-Man defense: The target company purchasing shares of the
acquiring company and attempting a takeover of their own. The acquirer
will abandon its takeover attempt if it believes it is in danger of losing
control of its own business. This strategy obviously requires Company B
to have a lot of money to buy a lot of shares in Company A. Therefore,
the Pac-Man defense usually isn’t workable for a small company with
limited capital resources.

iii) Capital Structure

 The configuration of the capital structure can also be a means for
disciplining the management.
 High debt and pre-determined interest payments, in contrast to the
residual claims by shareholders, put pressure on the management and
make them economize resources.
 In short, interest payments reduce the free cash available for
investments in negative net present value projects.
 Furthermore, the credit ratings of debt-issuing firms can reduce
information asymmetry between managers and debtholders. However,
conflicts of interest between debt- and shareholders can arise.

iv)Competition
Competition is a natural mechanism that prevents wasting money and acts
on three main markets.
 Firstly, as discussed before, the market for corporate control (share
prices on stock market) exposes badly/poorly run companies to the
danger of a hostile takeover.
 Secondly, the managerial labor market allows managers to signal their
ability in order to increase their market value and prestige.
 Thirdly, competition in the product market leads to an economization of
resources in order to remain competitive in the market.

4.5. Determinants of Corporate Governance

Effective corporate governance has to be adequately structured in line with
the firm’s environment. The firm’s environment includes three broad
areas.

5.1 Legal Environment

A firm’s legal environment is defined primarily by the written legislation
and the law enforcement by the state which includes contract law,
company law, and securities law and specifies the firm’s leeway in
structuring corporate governance.

The legal frame work/environment sets the under and upper bounds of
discretionary leeway in creating firm-specific governance.

5.2 Corporate Governance Environment

The general corporate governance pattern cans actively influence the
relative strength of various institutions within a firm (e.g., shareholders or
debt holders).
 Shareholders can influence corporate governance as they can elect the
directors and vote for a change in the firm’s articles of incorporation.
 Strong investors can mitigate the problems between managers and
shareholders, but they can equally instigate issues between themselves
and other investors.
 In addition, takeover defenses implemented by boards hamper
/basket/ shareholder action and insulate them from the hazards
presented by the market for corporate control.
 Hence, the general corporate governance of a firm influences the relative
importance of other corporate governance devices.
5.3 Operational/Economic Environment
The operational or economic environment specifies the firm’s
requirements/needs set for corporate governance. Corporate governance
should be adapted to the firm’s needs. Small and fast-growing companies
in specific industries may have other corporate governance requirements
than those suited to large, mature, and diversified firms.