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Overview of Corporate Governance

Prof. Jun “QJ” Qian

Boston College

Advanced Summer Training Program in Finance

Tsinghua University

Chengdu, China

July 6, 2007

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Foundation for Corporate Governance: Ownership Structure

• Who owns the firm (types of firms)?– Publicly owned, listed and traded, privately owned firms; non-

profit or government-owned organizations/institutions;

– Ownership structure (disperse or concentrated; debt or equity)

– Transfer/transition of ownership (IPO, LBO; changes in

government ownership)

• Who works for the firm?– Owners themselves (Principals);

– Managers and employees (Agents);

– What problems can arise when owners do not “work” for the firm

on a regular basis? (Agency problems)

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Foundations: Ownership (cont’d)

• What are the goals of the firm and what type of decisions do firms

make to realize these goals?

– Maximize profits for owners;

– Reputation (collectively and individually); social goals;

– Decisions: Investment, financing, payout policies, risk management, etc.

• How do the owners of the firm ensure that their objectives are

properly carried out by the managers & employees?

– Corporate governance mechanisms;

• Are US firms operate in the same ways as firms in other countries?

– Comparing financial systems.

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Who Owns the Firm: Microsoft(Based on Proxy Statement of July 21, 2006)

Microsoft Corp.

Bill Gates(Founder/former CEO;

9.77%)

Steve Ballmer(CEO; 4.10%)

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Who Owns the Firm: Google (Proxy 5/11/06)

(Dual Class Shares: Class A, one-vote/share; Class B, 10 votes/share)

Google Inc.

Sergey Brin,Co-founder:

0.02% A, 35.40%B;28.7% votes

Larry Page,Co-founder:

0.2% A, 35.50% B;28.8% votes

Capital Research& Mgmt Co.(Pacific Life):7.90% A, 0 B;1.5% votes

Entities affiliated with Fidelity:11.20% A, 0 B;2.1% votes

Eric Schmidt,Chair & CEO:

0.02% A, 13.9%B;11.3% votes

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Who Owns the Firm: GE(Proxy Statement of 4/26/06; no 5% or larger

owner)

General Electric Co.

Jeffrey Immelt(Chairman & CEO;

0.06%)

Dennis Dammerman(Vice Chairman;

0.06%)

Robert Wright(Vice Chairman,

CEO NBC Universal;0.07%)

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Who Owns the Firm: GM(Proxy Statement of June 6, 2006)

General Motors Corporation

State Street Bank &Trust Co.

(Subsidiary of State Street Corp;

16.50%)

Capital Research& Mgmt Co.;(14.30%)

Brandes InvestmentPartners, L.P.(10.60%)

Southeastern AssetMgmt. Inc.(7.10%)

Tracinda Corp.(Private investment

co. owned by Kirk Kirkorian;

9.90%)

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Ownership Structure: Publicly Listed Firms in the U.S. and U.K.

• Disperse ownership among many “small” owners;

• Wealthy individuals (including executives) own a lot of

stocks;

• Commercial banks do not own a lot of stocks;

• Important role of institutional investors (asset

management companies, non-profit organizations, etc).

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Who Owns the Firm: Daimler-Benz(Based on Shleifer et al. (1999); prior to merger with Chrysler)

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Ownership Structure: Germany & Other Continental European Countries

• Ownership is more concentrated among a few “large”

owners;

• (Universal) Banks own a lot of equity and participate

more actively in firms’ decisions;

• Individual investors do not own a lot of stocks

(directly);

• Cross-holding of equity among firms and institutions.

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Who Owns the Firm: Toyota(Based on Shleifer et al. (1999))

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Who Owns the Firm: Samsung Electronics

(Based on Shleifer et al. (1999))

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Ownership Structure: Japan & Other Asian Countries

• Ownership is also more concentrated among a few

“large” owners;

• Banks (keiretsu in Japan) own a lot of equity and

participate more actively in firms’ decisions;

• Cross-holding of equity among firms and institutions;

• Family (publicly listed) firms;

• For more details, see Claessens et al. (2000 JFE; 2002

JF)

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Agency Problem and Solutions• Separation of ownership and control:

– In most publicly owned firms, firms are run by professional managers; small owners are passive;

– Agency problem (Jensen & Meckling 1976): Managers/employees may pursue other (personal) goals rather than max. owners’ profits

• Role of managers and employees in public firms:– In the US: (Recent years) they enter ownership thru. company’s

grants of their own stocks and stock options;

– Pros and cons: Align their incentives with the owners’; but their portfolios may be under diversified, and managers may have perverse incentives;

– In Germany and Japan: Don’t own company’s stocks, but employees’ goals are recognized; more active participation.

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Corporate Governance Mechanisms

• Definition: A set of formal mechanisms (in the

U.S.) to ensure that owners’ goals are carried

out properly by managers and employees:

– Board of Directors

– Executive compensation

– Active markets for corporate control (mergers & acquisitions)

– Information disclosure and transparency

– The use of debt/cash in firm’s capital structure and payout

policies

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Governance I: Board of Directors

• Represents the interests of (equity) owners;

• Voting mechanisms: One-share, one-vote (vs. dual class

shares), accumulative voting; proxy contests;

• Appoint and contract with firm’s top managers;

• Composition of the Board:

– Size and the number of outside (independent) members;

• Problems:

– CEO usually sits on the Board and can influence the

appointment of outside board members;

– Costs involved with proxy fights (e.g., “staggered boards”).

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Governance II: Executive Compensation

• Typical CEO pay package (in the U.S.):

– Base salary, accounting-based bonus; restricted stock grants and

– Stock options: granted at-the-money; long-term (10 years expiration) ;

– Restrictions: Vesting period, no sale or transfer (can only exercise);

– Use of stocks and stock options increased dramatically in 1990s,

coincided with the technology boom (bubble)

• Role of stocks and stock options:

– If designed properly: Can provide strong incentives for executives to

improve performance, and save cash;

– But, not fully disclosed, (used to) not counted as expenses like salary;

incentive to manipulate stock price and accounting reports;

– CEO usually member of Compensation committee

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Governance III: Markets for Corporate Control

• Markets for corporate control (M&As):

– Allow better firms to take control of bad firms’ assets;

– Types of action: Proxy contests, friendly mergers (e.g., stock swaps), and hostile takeovers;

– M&As very active in the U.S.;

– Hostile takeovers provide the strongest discipline for firm’s managers as following M&As they usually lose control

• Problems with hostile takeovers:

– Antitakeover measures by target management;

– Merger wave in the 1990s: Friendly stock-based mergers;

– Overall efficiency improvement of M&As: No clear evidence that M&As create values for (combined firms’) shareholders

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Governance IV: Transparency and the Use of Debt

• Information disclosure:– Publicly listed firms in the U.S. face most stringent disclosure

requirements;

– Disclosure requirements for financial institutions (e.g., Reg FD, auditor responsibilities);

– The more disclosure, the better? Not necessarily!

– Problems: Earnings management and accounting frauds; more rules almost always lead to more loopholes in the system

• Role of debt in disciplining managers:– Difference between debt and equity: Debt – fixed income securities;

– Free cash flow: reduce managers’ squandering of firm’s resources;

– Problems: Many large US firms use little debt; can create other perverse incentives for managers when firms facing distress.

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Central Questions of the Course

• Do better governed firms have better performance?

• Are there alternative mechanisms in addition to the formal mechanisms listed above?

• How does the practice of governance vary across countries?

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An Example: Toyota vs. GM and Ford

• GM and Ford: Strong corporate governance on paper;

• Toyota measured by standard governance mechanisms:

– Board of Directors: 65 members, only 1 outside member;

– Executive compensation: Paid much less than US counterparts;

rarely use stock-based compensation; high job security;

– Very few hostile takeovers in Japan due to ownership structure;

– Quality of accounting disclosure: Opaque, not very informative;

– Capital structure: No debt; $40 billion cash on balance sheet

– Many other successful Asian and continental European firms

share the same characteristics as Toyota.

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Comparing Toyota, GM, and Ford: Buy-and-hold Returns (1972-2006)

0

10

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TOYOTA GM FORD S&P500

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Alternative Corporate Governance Mechanisms

• Work for all types of firms everywhere!

• Competition in product and input markets;

• Institutions based on reputation, relationships, and

trust:– Traders organizations in 11th century (Grief 1989, 93, 94);

– Cultural/religious influence (Stulz & Williamson 2003)

• Family-run vs. professionally managed firms:– The degree of separation of ownership and control and legal

environment;

• Cooperation and mutual monitoring within the

firm/organization

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• US/UK-style market-based financial system:– Large and advanced financial markets; pricing system is based on

“marked to market”;

– (Commercial) banks are much less important

• German/Japan-style bank-based financial system:– Most wealth is in the banking system with “universal” banks;

– Financial markets are (relatively) not well developed;

• These two systems are distinctly different:– Both have advantages and disadvantages

• Other countries (e.g., France) are in between:– More than 2/3 of countries have banking-based systems

(Demirgüç-Kunt and Levine 2001);

– More details see Allen and Gale (2000 book)

Comparing Financial Systems

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Law, Finance, and Economic Growth

• ‘Conventional wisdom’ on explaining the differences in financial systems and in financial/economic ‘outcomes’

• An important view is to link law and finance (LLSV and others):

– Countries with English common-law (French civil-law) system provide strong (weak) protection of investors; and

– Have & low (high) concentration of ownership, strong (weak and narrow) capital markets, and better institutions (e.g., less corruption) and outcomes

• Relation between finance and growth:

– The development of financial system (stock market & banking sector) contributes to economic growth (e.g., McKinnon 73, King & Levine 93)

– Evidence at industry- and firm-levels (e.g., Jayaratne and Strahan 1996)

• Literature on law, finance, and growth:

– Country level evidence: Levine (99); industry level (Beck and Levine 02) and firm level (Demirgüç-Kunt & Maksimovic 98)

• Is conventional wisdom correct?

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Summary• Much more to be learned about corporate governance

• The benchmark is publicly traded firms in the US: A

focus of the course, but

• There are many other successful firms in the U.S. and

other parts of the world that operate very differently

• We need to expand our knowledge on how alternative

systems work in different environments, in order to

improve firm performance and overall economy’s

efficiency and stimulates growth