This document provides an introduction to corporate governance. It begins by defining corporate governance and discussing the key theoretical models, including: 1) Principal-agent theory, which describes the conflicts of interest that can arise between managers (agents) and shareholders (principals) due to information asymmetries. 2) The separation of ownership and control in modern corporations, where professional managers control companies owned by dispersed shareholders. 3) The agency problems that can result from this separation, such as managers prioritizing their own interests through perks or empire building rather than maximizing shareholder value. The document then discusses alternative forms of corporate organization beyond public companies, such as mutual organizations, before concluding with definitions

1. INTRODUCTION TO
CORPORATE GOVERNANCE
Stephen Ong, BSc(Hons) Econs (LSE),
MBA International Business(Bradford)
Visiting Fellow, Birmingham City University
Visiting Professor, Shenzhen University
MBA1034 GOVERNANCE, LAW & ETHICS

2. • Defining Corporate
Governance1
• Key Theoretical Models2
• CASESTUDY : Goldman
Sachs and its Reputation3
Today’s Overview

3. Lecture Aims
• This lecture aims to introduce you to the subject
area of corporate governance.
• the various definitions of corporate governance,
reviews the main objective of the corporation
and explains how corporate governance
problems change with ownership and control
concentration.
• the main theories underpinning corporate
governance.
• forms of organisations including public listed
entities, mutual organisations, cooperatives and
partnerships.

4. Learning Outcomes
• By the end of this lecture, you should be able to:
1. Contrast the different definitions of
corporate governance
2. Critically review the principal–agent model
3. Discuss the agency problems of equity and
debt
4. Explain the corporate governance problem
that prevails in countries where corporate
ownership and control are concentrated
5. Distinguish between ownership and control.

5. The Basics
• In what follows, we focus on stock-exchange listed
firms.
• These firms are typically in the form of stock
corporations that have equity stocks or shares
outstanding.
• Stocks or shares are certificates of ownership that
frequently confer control rights, i.e. voting rights.
• Voting rights enable their holders, the shareholders,
to vote at the annual general shareholders’ meeting
(AGM).

6. The Basics (Continued)
• Voting shares confer the right to appoint the
members of the board of directors.
• The board of directors is the ultimate governing
body within the firm.
• Its role, in particular that of the non-executive
directors, is to look after the interests of all the
shareholders.
• It may also look after the interests of other
stakeholders such as the employees and the
firm’s creditors.

7. The Basics (Continued)
• More precisely, it is the non-executives’ role
to monitor the firm’s top management,
including its executives.

8. Defining Corporate Governance
• Most definitions are based on implicit or explicit
assumptions about the main objective of the
firm.
• However, there is no universal agreement as to
what this objective should be.
• For example, Andrei Shleifer and Robert Vishny
define corporate governance as “the ways in
which suppliers of finance assure themselves of
getting a return on their investment”.
• This definition assumes that the main objective
of the firm is to maximise shareholder value.

9. Defining Corporate Governance …
• They justify this focus by the argument that
investments in the firm by the shareholders
(as well as the debtholders) are sunk funds.
• In contrast, the other stakeholders can easily
walk away from the firm without losing their
investments.
• Hence, the shareholders are the residual risk
bearers or the residual claimants to the firm’s
assets.

10. Defining Corporate Governance …
• If the firm enters financial distress, the claims
of all the other stakeholders will be met first
before the claims of the shareholders can be
met.

11. Defining Corporate Governance …
• In contrast, Marc Goergen and Luc Renneboog’s
definition allows for differences across countries
in terms of the main objective of the firm:
“A corporate governance system is the
combination of mechanisms which
ensure that the management … runs the
firm for the benefit of one or several
stakeholders... Such stakeholders may
cover shareholders, creditors, suppliers,
clients, employees and other parties with
whom the firm conducts its business.”

12. Defining Corporate Governance …
• For example, German corporate law
explicitly includes other stakeholder
interests in the firm’s objective function.
• The German Co-determination Law of
1976 requires firms with more than
2,000 employees to have half of the
supervisory board seats held by
employee representatives.

13. Figure 1 – Whose company is it?
Notes: The number of firms surveyed is 50 for France, 100 for Germany, 68
for Japan, 78 for the UK and 82 for the USA.
Source: Yoshimori, M. (1995), “Whose Company is It? The Concept of the
Corporation in Japan and the West”, Long Range Planning 28, p.34.

14. Defining Corporate Governance …
• A more neutral definition is that corporate
governance deals with conflicts of interests
between
– the providers of finance and the managers;
– the shareholders and the stakeholders;
– different types of shareholders (mainly the large
shareholder and the minority shareholders)
and the prevention or mitigation of these
conflicts of interests.
• This is the definition adopted by this module.

15. Corporate Governance Theory
“It is in the interest of every man to live as
much at his ease as he can; and if his
emoluments are to be precisely the same,
whether he does, or does not perform
some laborious duty, it is certainly his
interest, at least as interest is vulgarly
understood, either to neglect it altogether,
or, if he is subject to some authority
which will not suffer him to do this, to
perform it in as careless and slovenly a
manner as that authority will permit.”
Smith, A. (1776), An Inquiry into the Nature and Causes of the Wealth of
Nations, reprinted in K. Sutherland (ed.) (1993), World’s Classics, Oxford:
Oxford University Press.

16. Corporate Governance Theory …
• This quote illustrates the conflict of interests
that may exist between an agent and the
agent’s principal.
• Michael Jensen and William Meckling
formalised these conflicts of interests in their
principal–agent theory.
• While the agent has been asked by the
principal to carry out a specific duty, the
agent may not act in the best interest of the
principal once the contract has been signed.

17. Corporate Governance Theory …
• The agent may rather prefer to act in his own
interest.
• Economists call this moral hazard.
• Moral hazard is not just an issue in corporate
governance, but it is also a major issue for
insurance companies.
• One way of addressing principal–agent
problems is via so called complete contracts.

18. Corporate Governance Theory …
• Complete contracts are contracts which specify
exactly what
– the managers must do in each future contingency of
the world; and
– what the distribution of profits will be in each
contingency.
• In practice, contracts are unlikely to be complete
as
– it is impossible to predict all future contingencies of
the world;
– such contracts would be too complex to write; and
– they would be difficult or even impossible to
monitor and reinforce by outsiders such as a court of
law.

19. Corporate Governance Theory …
• A necessary condition for moral hazard to exist
and for complete contracts to be impossible is
the existence of asymmetric information.
• Asymmetric information refers to situations
where one party, typically the agent, has more
information than the other party, the principal.
• If both parties had access to the same
information at all times, then there would be
no moral hazard problem.

20. Corporate Governance Theory …
• Moral hazard exists because the principal
cannot keep track of the agent’s actions at all
times.
• Even ex post, it is sometimes difficult for the
principal to judge whether failure is due to the
agent or external circumstances.
• Jensen and Meckling’s principal–agent model
also assumes that there is a separation of
ownership and control.

21. Corporate Governance Theory …
• Adolf Berle and Gardiner Means were the first to
point out this separation in their 1932 book The
Modern Corporation and Private Property.
• A firm starts off as a small business, fully owned
by its founder, typically an entrepreneur.
• At this stage, there are no conflicts of interests
as the entrepreneur both owns and runs the
firm.
• As the firm grows, it becomes more and more
difficult for the entrepreneur to provide all the
financing.

22. Corporate Governance Theory …
• Eventually, the entrepreneur will need
to raise outside finance.
• Once outside finance has been raised,
the entrepreneur’s incentives to work
hard have been reduced.
• Ultimately, the entrepreneur will sell out
and the firm ends up being run by
professional managers on behalf of its
shareholders.

23. Corporate Governance Theory …
• Hence, there is a clear division of labour in the
modern corporation with
– the manager, the agent, having the expertise to run
the firm, but not the funds to finance it; and
– the shareholders, the principal(s), having the
required funds, but not the skills to run the firm.
• In practice, control lies with the managers who
run the day-to-day operations of the firm
whereas the firm is owned by the shareholders.
• Hence the separation of ownership and control.

24. Corporate Governance Theory …
• However, the agent may prefer to run the firm in
his own interests rather than those of the
principal.
• This is the principal–agent problem (agency
problem).
• The main consequence of this problem is agency
costs.
• These are the sum of
– the monitoring expenses incurred by the principal;
– the bonding costs accruing to the agents; and
– any residual loss.

25. Agency Problems
• The two main types of agency problems are
– perquisites and
– empire building.
• Perquisites or perks consist of on-the-job
consumption by the managers.
• While the benefits from the perks accrue to the
managers, their costs are borne by the
shareholders.
• Examples of perks are CEO mansions financed by
the firm and personal usage of corporate jets.

26. Agency Problems (Continued)
• The former CEO of Tyco International
had his company fund his wife’s 40th
birthday party in Sardinia at a cost of
US$1 million.
• “Former Merrill CEO John Thain spent
$1.2 million to renovate his offices,
including installation of a $35,000
toilet.” Source: The Gazette, 28 March
2009, p. B1.

27. Agency Problems (Continued)
• While perks can cause public outrage, especially
when they are combined with lacklustre
performance, they tend to be modest compared to
empire building.
• Empire building consists of managers pursuing
growth rather than shareholder-value
maximisation.
• While there is a link between the two, growth does
not necessarily generate shareholder value and
vice-versa.
• Empire building is also referred to as Jensen’s free
cash flow problem.

28. Agency Problems (Continued)
• The free cash flow problem consists of managers
investing beyond the point where investment
projects earn an adequate return given their risk.
• So why would managers be tempted by empire
building?
• Managers derive benefits from increasing the size of
their firm.
• Such benefits include increased power and social
status.
• Managerial remuneration has also been shown to
depend on firm size.

29. Agency Problems of Debt and Equity
• So far, we have focused on the agency problem of
equity, i.e. the agency problem between the
managers and the shareholders.
• However, there also exists an agency problem of
debt.
• When there is very little equity left (e.g. when the
firm is in financial distress), the shareholders may
be tempted to gamble with the debtholders’ money.
• They may do so by investing the firm’s funds into
high-risk projects.

30. Agency Problems of Debt and Equity
(Continued)
• If the project fails, the major part of the costs
will be borne by the debtholders.
• If the project is successful, most of its payoff
will go to the shareholders given that the
debtholders’ claims have a limited upside.

31. Figure 2 – Firm value
Value of
debt
Value of
equity
Financial
Firm value
distress
Value of debt and
equity

32. Agency Problems of Debt and Equity
• Jensen and Meckling argue that, given that
there are agency costs from both debt and
equity, there is an optimal mix of debt and
equity which minimises the sum of the
agency costs of debt and equity.

33. Figure 3 – Agency costs of debt and equity

34. The Expropriation of Minority
Shareholders
• The principal–agent model is based on the
Berle-Means premise that, as firms grow,
ownership eventually separates from control.
• However, this is only an accurate description of
the Anglo-American system of corporate
governance.
• In the rest of the world, most stock-exchange
listed firms have large shareholders exerting
significant control over the firm.
• Hence, the main conflict of interests is between
the large shareholder and the minority
shareholders.

35. • Minority shareholders may face the danger of
being expropriated by the large shareholder
via e.g.
– tunnelling;
– transfer pricing;
– nepotism; and
– Infighting.
• Tunnelling consists of the large shareholder
transferring the firm’s assets or profits into
his own pockets.
The Expropriation of Minority Shareholders…

36. • The large shareholder may also expropriate the
minority shareholders via transfer pricing, i.e. by
overcharging the firm for services or assets
provided.
• Tunnelling and transfer pricing involving the
large shareholder are also sometimes referred to
as related-party transactions.
• Large shareholders may be even more tempted
to engage in related-party transactions in the
presence of ownership pyramids.
The Expropriation of Minority Shareholders …

37. Figure 4 – Expropriation of the minority
shareholders by the large shareholder
Large shareholder
Firm A Firm B
51% 100%

38. Figure 5 – Leveraging control and increasing
the potential for expropriation
Large shareholder
Holding Co. Firm B
51%
51%
100%
Firm A

39. • Other forms of minority shareholder
expropriation include nepotism and infighting.
• Nepotism consists of the large family
shareholder appointing family members to top
management positions rather than the most
suitable candidates on the job market.
• Infighting may not necessarily be a wilful form
of expropriating the firm’s minority
shareholders, but nevertheless is likely to deflect
management time as well as other firm
resources.
The Expropriation of Minority
Shareholders …

40. Nepotism

41. Alternative Forms of Organisation
and Ownership
• The main alternative to the stock corporation
is the mutual organisation.
• A mutual organisation is owned by and run
on behalf of its members.
• For example, a mutual bank is owned by its
savers and borrowers.
• Both stock corporations and mutual
organisations are likely to suffer from the
principal–agent problem.

42. Alternative Forms of Organisation
and Ownership …
• However, this problem may be more severe
in mutual organisations given that stock
corporations benefit from a range of
mechanisms that mitigate agency problems.
• These include
– the threat of a hostile takeover
– monitoring by large shareholders
– ownership of stock options and stocks by
managers and employees
– a market price for the stocks.

43. • As each member of a mutual organisation has
only one vote, this prevents the emergence of
powerful owners.
• Through the 1980s/90s, a number of UK mutual
building societies went through a
demutualisation.
• They changed their legal status to a stock
corporation and applied for a stock exchange
listing.
• At the time, it was thought that this would result
in a major improvement in the efficiency of
these organisations.
Alternative Forms of Organisation
and Ownership …

44. • However, roughly 20 years later
several of the demutualised building
societies had to be nationalised as a
result of the subprime mortgage
crisis.
• Northern Rock was the object of the
first bank run on a British financial
institution for more than 150 years.
• Overall, it is still unclear which of
the two organisational forms is
superior.
Alternative Forms of Organisation
and Ownership …

45. • One of the potential benefits of the mutual
form is that it avoids conflicts of interests
between owners and customers.
• These conflicts tend to be severe for long-
term products and services as the owners
may be tempted to expropriate the
customers.
• For these products and services the mutual
form is superior as it merges the functions of
owner and customer.
Alternative Forms of Organisation
and Ownership …

46. • While mutual organisations are not subject to
the disciplining role of the stock market, they
have their own disciplinary mechanism.
• The members of a mutual organisation are
allowed to withdraw their funds at any time.
• Such withdrawals reduce the financial basis
of the mutual.
• In contrast, stock corporations do not see
their funds shrink when shareholders sell
their shares.
Alternative Forms of Organisation
and Ownership …

47. • Some commercial organisations are in the form of
partnerships and owned by their employees
– Goldman Sachs
– John Lewis Partnership.
• Sanford Grossman, Oliver Hart and John Moore’s
theory of property rights predicts when
employees should have ownership of their firm.
• Employees should be given property rights if they
have to make investments in their human capital
which are highly specific (idiosyncratic) to the
firm.
Alternative Forms of
Organisation and Ownership ..

48. Defining Ownership and Control
• Ownership is defined as ownership of cash
flow rights.
• Cash flow rights give the holder a pro rata
right to the firm’s assets and earnings.
• Control is defined as ownership of control
rights.

49. CASE DISCUSSION :
GOLDMAN SACHS
AND ITS
REPUTATION

50. Cases - Goldman Sachs and Its
Reputation
• Goldman Sachs is a bank, but it does not take
deposits, issue credit cards, make mortgage
loans, or interact with consumers
• Goldman was the most prestigious and most
profitable of the investment banks
• Goldman Sachs had been a major participant in
the events leading up to the financial crisis
• During the financial crisis Goldman performed
much better than other banks

51. The Nonmarket Environment of the
Financial Services Industry
Issues
Interests
Institutions
Information

52. Conclusions
• The link between the objective of the firm
and the definition of corporate governance.
• The principal–agent model.
• The expropriation of minority shareholders.
• Conflicts of interests as the definition of
corporate governance adopted by this
module.
• Ownership versus control.

53. Idea for Discussion
Brendan McSweeney, (2008),"Maximizing
shareholder-value: A panacea for
economic growth or a recipe for economic
and social disintegration?", critical
perspectives on international business,
Vol. 4 Iss: 1 pp. 55 – 74

54. Further Reading
• Solomon, Jill (2010) Corporate Governance and Accountability
3rd Edition, Wiley, UK. Ch.1-3
• Larcker, David & Tayan, Brian (2011) Corporate Governance
Matters, FT Press/Pearson New Jersey. Ch.1
• Goergen, Marc (2012) International Corporate Governance,
Pearson. Ch.1
• Monks, A.G. & Minow, N. (2011) Corporate Governance, 5th
Edition, Wiley. Ch.1
• Johnson, Gerry, Whittington, Richard & Scholes, Kevan (2011),
9th edition, FT Prentice Hall/Pearson UK..Ch.4
• CIMA - Performance Strategy: Study Text (2011) BPP Learning
Media Ltd. Part B : 3
• Baron, David P.(2013) Business and its environment, 7th
Edition, Pearson

55. Casestudy : AIG
1. View the video “Capitalism : A Love story”
and assess Big Banks and AIG’s role in the
global subprime crisis.
2. Read and prepare the Casestudy on AIG
(Monks & Minow (2011)) for discussion
next class. Analyse using PELE and 4i
analysis and identify the corporate
governance issues that AIG faced.

56. QUESTIONS?