Corporate Governance



Posted: Thursday, December 04, 2008

by
Iivoire Consultant

Corporate governance refers to the rules, procedures, and administration of the firm's contracts with its shareholders, creditors, employees, suppliers, customers, and sovereign governments. Governance is legally vested in a board of directors who have a fiduciary duty to serve the interests of the corporation rather than their own interests or those of the firm's management. With this simple definition, we assume that directors and managers are motivated to serve the interests of the corporation by incentive pay, by their own shareholdings and reputational concerns, and by the threat of takeover.

-The operation of the board and the remuneration of the Executive Directors are vital in maintaining and protecting the interests of the different stakeholder groups. If we accept that the shareholders collectively own the business and they have invested in it to maximise their wealth, then their main aim is to grow the overall value of their share capital and maximise returns in the form of dividends. However, there are potential conflicts of interest between this ambition and the managers/employees of the group who are looking to maximise their own wealth. Managers are appointed as agents on behalf of the shareholders of the company who have delegated this responsibility to them (Agency Theory). Therefore under the Agency Theory there needs to be a formal framework to find the best contract between both parties, who are seeking to maximise their own self interest. In the UK and the US, corporate governance mechanisms emphasise the relationship between shareholder and management. In countries such as France, Germany and the Netherland, the corporate governance mechanisms take a stakeholders approach to governance, aiming to balance the interests of owners, managers, major creditors and employees.

The main mechanisms for understanding corporate governance are the following:

1. The market for corporate control (i.e. a hostile takeover market and the market for partial control).

2. Large shareholder and creditor monitoring.

3. Internal control mechanisms, i.e. the board of directors, non-executive committees and the design of executive compensation contracts.

4. External mechanisms, i.e. product-market competition, external auditors and the regulatory framework of the corporate-law regime and stock exchange.

How governance affects firm performance?

Do firms perform better when shareholders' interests are likely to be dominant?

-Corporate control

Changes in control due to takeover or insolvency bring dramatic changes in firm personnel and strategy. CEO and board member turnover increases radically in the event the firm goes into financial distress. Managers will avoid being taking over by either increasing the firm's cash flows or by some less productive avenue.

-Board, Remuneration Committee, Pay and incentives

Research have found that the appointment of non-executives directors is associated to a company stock price increases. An Executive that wants to take the company in a direction that might be more in its personal interests could be sack. Another research has found a positive relationship between the percentage of shares owned by managers and board members and firms' market-to-book values .

-The remuneration committee is made up of non-execs, so this creates a natural control to stop the executive directors awarding themselves unjustifiable salaries and benefits. The remuneration of the Directors should be in line with other similar companies, to remain competitive and retain its top executives.

The remuneration packages are intended to align the interests of Director and Shareholders by linking cash and share incentives to performance. This approach helps address the agency theory issues discussed earlier by harnessing the Directors desire to maximise wealth to the interests of the Shareholders and Creditors.

However, some argue that the increase in share price was also associated with a decline in the value of the firm's outstanding debt. And corporate performance cannot be reliably increased simply by adding outsiders to the board of directors or by increasing the CEO's stockholdings.

Recent Corporate Scandals:

Corporate governance failures can lead to disastrous consequences beyond anyone expectations.Parmalat- a world leader in the dairy food business, entered bankruptcy protection in 2003 when investors least expected it. How the Italian group so much praised siphoned away billions of euros without its shareholders, nor its top managers suspecting it?

The problem at Parmalat was due to its ownership and control structures-There was a limited presence of shareholders and mainly linked by family ties. Parmala was a holding company with all the other companies within the group controlled by the Tanzani family. The family had the majority if not 'all' of the voting rights. As this happens, other shareholders had limited control over the activities of the group-hence limited power to block any decisions. Managers had also limited power to influence decisions taken by the family shareholders. In summary, the demise of Parmalat was a failure to fully implement the corporate governance mechanisms listed below. The Board of Directors- The ComposItion of the Board of Directors- The appointment of the non-Executive Directors-The Renumeration Commitee-A clear distinction between the Chairman and the CEO roles. A chairperson role eventually falls to a non-executive. At Parmalat the same person executed the two roles.

-Statutory auditors

Some thought that the Parmalat case was country-specific, however, Enron the giant American Energy failed victim to corporate governance problems with the help of Arthur Andersen-the US accounting firm.

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