Financial Goals and Corporate Governance

1
Chapter 2

• Financial Goals and Corporate Governance

2
The Goals of Chapter 2

• Introduce different types of ownership of firms
• Discuss the goal of management, and introduce the
  Shareholder Wealth Maximization Model (SWM) and
  the Stakeholder Capitalism Model (SCM)
• Introduce the goals and structures of corporate
  governance
• Compare different corporate governance regimes
• Discuss the failure of corporate governance and
  the reform of corporate governance in the U.S.

3
Who Owns the Business?
2-3
4
Who Owns the Business?

• Most companies are created by entrepreneurs who
  are either individuals or a small set of partners
• Usually, founders are often the members of a
  family
• Most business begin their lives as 100 privately
  held, often by a family
• Over time, however, some firms may choose to go
  public via an initial public offering (IPO)
• Typically, only a relatively small percentage of
  the company shares is sold to the public in IPO
  (A to B in Exhibit 2.1)
• Scenario 1 Sell more and more equity shares to
  investing public and become totally public traded
  firm (B to C or D in Exhibit 2.1)
• Scenario 2 The private owners may choose to
  retain a major share, and the private owners can
  decide to have explicit control or not

5
Exhibit 2.1 Who Owns the Business?
Insert Exhibit 2.1

• ? The other impact of IPO is that firm becomes
  subject to many of the increased legal,
  regulatory, and reporting requirement in most
  countries
• ? In late 2005, a very large private firm, Koch
  Industries (U.S.), purchased all outstanding
  shares of Georgia-Pacific (U.S.), a very large
  publicly traded forest products company, and took
  Georgia-Pacific private
• Georgia-Pacific is one of the world's leading
  manufacturers and distributors of tissue, pulp,
  paper, packaging, and related chemicals

6
Who Owns the Business?

• In the U.S. and U.K., most corporations in stock
  markets are characterized by widespread ownership
  of shares
• In the rest of world, ownership of corporations
  is usually characterized by controlling
  shareholders
• Typical controlling shareholders are as follows
• Government (e.g., privatized utilities)
• Institutions (such as banks in Germany)
• Family (such as in France and Asia)
• France has the highest number of family
  businesses (about 65 of the CAC 40 firms are
  family owned)

7
Who Owns the Business?

• Consortiums (??) (such as keiretsus in Japan and
  chaebols in South Korea)
• A consortium is a huge enterprise including
  banks, industry companies, suppliers, and
  manufacturers as component firms
• Usually, the cross-shareholding strategy is
  adopted by the management to maintain the control
  power for the whole enterprise

8
Goal of Management
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9
The Goal of Management

• Maximization of shareholders wealth is the
  dominant goal of management in the Anglo-American
  world, which usually includes the U.S., the U.K.,
  Canada, Australia, and New Zealand
• In Anglo-American markets, this goal is
  realistic in many other countries it is not
  because these exists some difference in corporate
  and investor philosophies
• In this section, two kinds of models are
  introduced, the Shareholder Wealth Maximization
  Model (SWM) and the Stakeholder Capitalism Model
  (SCM)

10
Shareholder Wealth Maximization

• In the Shareholder Wealth Maximization model
  (SWM), a firm should strive to maximize the
  return to shareholders, as measured by the sum of
  capital gains and dividends, for a given level of
  risk
• In other words, the firm should minimize the
  level of risk to shareholders for a given rate of
  return
• The SWM model assumes that the stock market is
  efficient such that the performance of managers
  can be reflected from the movement of stock
  prices quickly
• That is, an equity share price is always correct
  because it incorporates new information quickly
  and thus reflects all the expectations of return
  and risk as perceived by investors

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Shareholder Wealth Maximization

• Risk is defined as the added risk that a firms
  shares bring into a diversified portfolio
• Therefore the unsystematic should not be of
  concern to investors because it can be
  diversified
• Investors care about only systematic risk, which
  cannot be eliminated through diversification
• The change in ownership from 100 privately held
  toward an increased share of publicly traded
  shares brings another impact that a firm may be
  managed by hired professionals and not the owners
• This raises the possibility that ownership and
  management may not be perfectly aligned in their
  business and financial objectives, the so called
  agency problem

12
Shareholder Wealth Maximization

• Agency problems Conflicts of interest between
  managers and stockholders
• Empire building, avoid good but risky projects,
  or overconsume luxuries
• Possible solutions
• Compensation plans (bonus linked with the
  performance of the stock or executive stock
  options)
• Penalty for underperformance (the board of
  directors can replace the manager)
• Specialist monitoring (analysts, fund managers,
  banks)
• Discipline of the capital market (takeovers by
  other firms)

13
Shareholder Wealth Maximization

• Long-term vs. short-term value maximization
• Long-term value maximization can conflict with
  short-term value maximization as a result of
  compensation systems focused on near-term results
• The other reason for seeking short-term value
  maximization for public firms is the requirement
  of periodical earning report (quarterly in the
  U.S.)
• Short-term actions taken by management that are
  destructive over the long-term have been labeled
  impatient capitalism
• In contrast to impatient capitalism is patient
  capitalism, which focuses on long-term SWM
• Note that the long-term or short-term is a
  relative notion compared with a firms investment
  horizon (how long it takes for a firms actions,
  investments, and operations to result in earnings)

14
Stakeholder Capitalism Model

• In the non-Anglo-American markets, controlling
  shareholders also strive to maximize long-term
  returns to equity
• However, they are more constrained by other
  powerful stakeholders
• For example, labor unions are more powerful than
  in France and South Korea, banks have significant
  influence on firms decision in Germany, etc.
• In addition, governments interfere more in the
  market place to protect important stakeholder
  groups, such as local communities, the
  environment, and the employment
• The SCM model does not assume that equity markets
  are either efficient or inefficient
• The inefficiency does not really matter, because
  the firms financial goals are not exclusively
  shareholder-oriented due to the constraints
  imposed by other stakeholders

15
Stakeholder Capitalism Model

• The SCM model assumes that long-term loyal
  shareholderstypically controlling
  shareholdersshould influence corporate strategy,
  rather than the transient (short-term) portfolio
  investor
• The SCM model assumes that total risk, which is
  reflected from both the operating and financial
  risks, does count
• It is a specific corporate objective to generate
  growing earnings and dividends over the long run
  with as much certainty as possible
• In this case, risk is measured more by product
  market variability than by short-term variation
  in earnings and share price

16
SWM vs. SCM

• The SWM could nurture some short-run oriented and
  impatient capital, but SCM can avoid this flaw
• In the SCM, trying to meet the desires of
  multiple stakeholders leaves management without a
  clear goal
• The SWM gets increasing focus in recent years
• As more non-Anglo-American countries try to
  privatize their industries, focusing on the
  shareholder wealth seems a better strategy to
  attract international capital
• Many shareholder-based MNEs are increasingly
  dominating their industry

17
Operational Objectives for MNEs

• The MNE must determine for itself proper balance
  between three common operational financial
  objectives
• Maximization of consolidated after-tax income
  (primary goal)
• Minimization of the firms effective global tax
  burden
• Correct positioning of the firms income, cash
  flows, and available funds as to country and
  currency
• Consolidated income is the total amount of the
  incomes of all subsidiaries in different local
  currencies expressed in the currency of the
  parent company
• These objectives are frequently incompatible, in
  that the pursuit of one may result in a
  less-desirable outcome in regard to another
• E.g., the first objective focuses on the current
  earnings, but the third objective focuses on
  generating sustainable cash flows in the future

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Goals and Structures of Corporate Governance
2-18
19
Failures in Corporate Governance

• For any company the corporate governance is
  fundamental to its existence
• Moreover, many studies have continued to show the
  linkages between good governance (at both country
  and corporate level) and the lower cost of
  capital and higher corporate profitability
• Spectacular failures in corporate governance
  again highlighted the importance of the corporate
  governance, e.g., the accounting scandals and
  questionable ethics in Enron and WorldCom
• Enron (2001) (referring to the Mini-case in Ch 2)
• Enron was one of the world's leading electricity,
  natural gas, communications and pulp and paper
  companies, with claimed revenues of nearly 101
  billion in 2000
• Using special purpose entities to hide debt in
  its own books

20
Failures in Corporate Governance

• WorldCom (2002)
• The U.S.s second largest long distance phone
  company (after ATT)
• Classifying expenses as investments
• Failures in corporate governance have become
  increasingly visible in recent years
• In each case, prestigious auditing firms, such as
  Arthur Andersen, missed the accounting principle,
  possibly because of profitable consulting
  business with their client, that causes conflicts
  of interest with their original auditing business
• The most strange is that top executives
  themselves should be responsible for
  mismanagement, but they still received overly
  generous compensation while destroying their
  firms

21
Goals of Corporate Governance

• The most widely accepted statement of good
  corporate governance practices are established by
  the OECD (Organization for Economic Cooperation
  and Development) (?????????)
• Protect shareholders rights
• Ensure the equitable treatment of all
  shareholders, especially for minority and foreign
  shareholders
• Recognize the right of stakeholders, and involve
  stakeholders in corporate governance
• Ensure that timely disclosure is made
  transparently on all matters regarding the
  corporation
• Transparency is defined as the degree to which an
  investor can discern the true activities and
  value drivers of a company from the disclosures
• Ensure the effective monitoring of management by
  the board and the boards accountability to the
  company and the shareholders

22
Structure of Corporate Governance

• The overview of various parties and their
  responsibilities associated with the corporate
  governance

23
Different Corporate Governance Regimes
2-23
24
Comparative Corporate Governance Regimes

• The origins of the need for corporate governance
• The separation of ownership from management
• The significance of the roles of various
  stakeholders in different cultures
• ? Firms facing different conditions of the above
  two factors will adopt different corporate
  governance regimes as follows

25
Comparative Corporate Governance Regimes

• The preferred regimes are a function of at least
  four major factors as follows
• 1. Financial market development
• The market that grows slowly (the emerging
  markets), or have industrialized rapidly by
  utilizing neighboring capital market (West
  Europe), might not form large public equity
  market systems
• Thus, their ownership shares are highly
  concentrated such that major shareholders have
  enough power to monitor or affect the management,
  so few disciplined processes of governance are
  developed
• 2. Separation between management and ownership
• In some countries, the ownership and the
  management is integrated, so the agency problem
  issues is not important
• In some countries, the ownership is widely
  dispersed and separated from management, aligning
  the goal of management and stockholders is much
  more difficult

26
Comparative Corporate Governance Regimes

• 3. Disclosure and transparency
• The disclosure regarding the operation and
  financial conditions and the transparency for the
  decision-making process vary across countries
• Due to the degree of ownership that is public,
  the degree to which government protects
  stakeholders rights versus ownership rights, and
  the extent to which family-based and
  government-affiliated business remains central to
  the culture, the degrees of required disclosure
  and transparency are different
• 4. Historical development of the legal system
• Investor protection is better in countries in
  which English common law is the basis of the
  legal system (in the U.S. and U.K.), compared to
  the codified civil law that is typical in France
  and Germany
• In countries with weak investor protection,
  controlling shareholder ownership is often a
  substitute for a lack of legal protection
• That is, the controlling shareholder can decide
  the direction of the firm or he is the management
  of the firm. In order to protect his interest,
  the controlling shareholder should maintain a
  well corporate governance and exploit his asset
  in the best way

27
Family Ownership and Corporate Governance

• Although market-based regimes seem to be the
  mainstream of corporate governance, family-based
  regimes are more common than market-based regimes
• In a study of 5,232 corporations in Western
  Europe in 2002, family-controlled (wildly-held)
  firms represented 44 (37) of the sample
• Opposed to popular belief, family-owned firms in
  some highly developed economies typically
  outperform publicly owned firms
• In SP 500, family firms outperform nonfamily
  firms, and a CEO from the family also perform
  better than those with outside-CEOs
• In Norway, based on a 120-firm sample,
  founding-family-controlled firms are with higher
  value than non-founding-family-controlled firms,
  regardless of firm age, board independence, and
  number of share classes

28
Good Corporate Governance does Matter

• A McKinsey study in 2002 surveyed more than 200
  institutional investors as to the value they
  place on good governance

? Generally speaking, for countries with less
development of the corporate governance,
institutional investors would like to pay more
premium for the shares of corporations with good
corporate governance
29
Good Corporate Governance does Matter

• Exhibit 2.5 compares the premiums that
  shareholders are willing to pay for the voting
  right in selected markets with different ratings
  of accounting standard

? The idea to examine the premium paid for voting
shares is that if the country is perceived to
have good corporate governance, investors would
not need to obtain voting rights to try to
protect their investment
30
Good Corporate Governance does Matter

• Exhibit 2.6 compares the premiums that
  shareholders are willing to pay for the voting
  right in selected markets with different ratings
  of law enforcement

? Generally speaking, for countries with better
accounting standard and law enforcement, the
premium paid for voting shares over non-voting
shares decreases
31
Corporate Governance Reform
2-31
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Corporate Governance Reform

• Within the U.S. and U.K., the main corporate
  governance problem centers around the agency
  problem with widespread share ownership, how can
  a firm align managements interest with that of
  the shareholders?
• Because individual shareholders do not have the
  resources or the power to monitor management, the
  U.S. and U.K. markets rely on regulators to
  assist in the agency monitoring task
• Outside the U.S. and U.K., controlling
  shareholders are usually in the majoritythese
  entities are able to monitor management in some
  ways better than the regulators can
• After the failure of corporate governance of
  Enron and WorldCom, some regulatory reform of
  corporate governance started in 2002 in the U.S.

33
Corporate Governance Reform

• The Sarbanes-Oxley Act was passed by the U.S.
  Congress, and signed by President George W. Bush
  during 2002 and has four major requirements
• 1. CEOs of publicly traded companies must vouch
  for the veracity of published financial
  statements
• This provision tried to instill a sense of
  responsibility and accountability in senior
  management
• Many companies requires business unit managers
  and directors at lower levels to sign their
  financial statements as well
• 2. Corporate boards must have audit committees
  drawn from independent directors
• In Germany, however, supervisory board must
  include employee representatives, but according
  to the U.S. law, employees are not independent

34
Corporate Governance Reform

• 3. Companies can not make loans to corporate
  directors
• 4. Companies must test their internal financial
  controls against fraud
• In order to meeting the new regulations, firms
  spends too much on modifying internal controls to
  combat fraud, rather than operating the firm
• The cost is disproportionately high especially
  for smaller firms
• Thus, more smaller firms choose to stay private
  or to sell out to larger firms instead of going
  the initial public offering (IPO) route because
  it costs too much to comply the law for public
  firms
• In summary, most of the terms in Sarbanes-Oxley
  Act are appropriate for the U.S. situation, but
  some terms do conflict with practices in other
  countries
• As a consequence, this act hinders many foreign
  companies to list their shares on the exchanges
  in the U.S.

35
Corporate Governance Reform

• Possible reforms for board structure and
  compensation issues (learned from European
  standards)
• CEOs cannot be the chairman of the board
• More than 80 of the companies in the Fortune
  500, the CEO is also the chairman of the board
• Adopt two-tiered structure in Germany
• Supervisory board (mostly outside, non-executive
  directors and typically large, e.g., Siemens has
  18 members)
• Management board (predominantly inside, executive
  directors and smaller, e.g., Siemens has 8
  members)
• Change the compensation schemes to replace stock
  options with restricted stock shares
• If the performance of stock is poor, the
  management with stock options will not feel any
  real loss since they just loss some potential
  future benefit

36
Corporate Governance Reform

• Restricted stock to the management cannot be sold
  publicly until after a specified period of time
• For poor stock performance, the recipient (the
  management) has actually lost money
• The remaining problems of the accounting process
• The U.S. system is characterized as strictly rule
  based, rather than conceptually based, as is
  common in Western Europe
• There are constantly more clever accountants find
  ways to follow the rule, yet not meet the
  underlying purpose for which the rule were
  intended, e.g., using SPE in the Enron case
• Another debate of the accounting process is the
  roles of the accounting firm and the companies
  itself
• Is it logical for the current practice that
  companies pay accounting firms to investigate
  whether their reporting practices consistent with
  generally accepted accounting principles (GAAPs)?

37
Actions of Minority Shareholders

• Minority shareholder rights