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The Modern Corporation and Corporate Governance: An Overview

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1 The Modern Corporation and Corporate Governance: An Overview
Professor Alexander Settles Faculty of Management, State University – Higher School of Economics

2 Class Rules Students must attend all lectures and seminars. Those students that arrive late will have to wait until the break between sessions to enter and will receive credit for attendance for the second session. Students must be prepared for class, complete all readings, and be ready to take notes Students may not talk during class. Students are expected to participate in class discussion but are not to interrupt the lecturer or other students Students may not enter or leave the class during the lecture unless for emergency reasons Students must turn off or place on silent mobile phones and may NOT use computers or other devices for entertainment purposes

3 Class Overview – Schedule Settles
17.02 – Course introduction, Corporate Governance, Globalization and BRICS 24.02 –Using Management Research, topic development and group formation 10.03 – Corporate governance overview in international context 17.03 – Valuation and Corporate Governance Ratings IPO, mergers and acquisitions, and foreign market entry for Russian corporations 14.04 – Financial Crisis and SWF 21.04 – Compensation, and regulation 28.04 – Corporate Social Responsibility

4 Course Requirements Send me an email at
50% - Paper - Settles 10% - Attendance to lectures - Settles 40% - Seminar Grade (Test and attendance) - Tomoradze

5 Due Dates Proposal March 3rd Review of literature March 31st Draft paper due April 14th Final paper due May 15th Your failure to plan or act is not my problem – no action = failing grade

6 Topic Proposal Title of paper Research question Literature review
Proposed methods Anticipated results 3 pages

7 Potential Topics Cross-listing and IPO of emerging market firms (Russia and Brazil) Globalization and risk Cross-border merger and acquisitions Cross-country comparison of management and governance: Do managers have a comparative advantage?

8 Potential Topics Difference in business environment: Convergence or divergence in governance or management practices Behavior of Directors and TMT in a cross cultural context Privatization CSR: Issues and Application across three models Russia, US, and Europe

9 Shirking and Stealing: How Corporate Governance Protects Investors

10 Learning objectives Corporate Governance and Competitiveness
Investor Protection Role of Public Sector in Setting Framework for Good Corporate Governance Knowledge about theory of board operation and Role of directors Theories of board organization Regulation concerning corporate boards Practice in corporate boards

11 Why is Corporate Governance Important to Russia firms?

12 Corporate Governance Introduction
What is Corporate Governance? Definition of “Governance” vs. “Administration,” “Management,” or “Control” Corporate Governance structures Board of Directors Chair of the Board Corporate Secretary Shareholders – General Meeting of Shareholders Why is it important to corporate finance? Cost of Capital

13 What is a Corporation? “The business corporation is an instrument through which capital is assembled for the activities of producing and distributing goods and services and making investments. Accordingly, a basic premise of corporation law is that a business corporation should have as its objective the conduct of such activities with a view to enhancing the corporation’s profit and the gains of the corporation’s owners, that is, the shareholders.” Melvin Aaron Eisenberg

14 What is a Corporation? “When they [the individuals composing a corporation] are consolidated and united into a corporation, they and their successors are then considered as one person in law For all the individual members that have existed from the foundation to the present time, or that shall ever hereafter exist, are but one person in law – a person that never dies: in like manner as the river Thames is still the same river, though the parts which composite are changing every instant.” Blackstone “An ingenious device for obtaining individual profit without individual responsibility.” Ambrose Bierce, The Devil’s Dictionary

15 Corporate Form 1. limited liability for investors;
2. free transferability of investor interests; 3. legal personality (entity-attributable powers, life span, and purpose); and 4. centralized management.

16 Corporate Governance Definitions
OECD – “internal means by which a corporations are operated and controlled … which involve a set of relationships between a company’s management, its board, its shareholders and other stakeholders.”

17 IFC – Russia Corporate Governance Manual
Corporate Governance is a system of relationships, defined by structures and process. [Shareholders – Management] These relationships may involve parties with different and sometimes contrasting interests. All parties are involved in the direction and control of the company All this is done to properly distribute rights and responsibilities – and thus increase long term shareholder value.

18 Definitions “Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment”, The Journal of Finance, Shleifer and Vishny [1997, page 737].

19 Other Definitions "Corporate governance is about promoting corporate fairness, transparency and accountability" J. Wolfensohn, president of the Word bank, as quoted by an article in Financial Times, June 21, 1999. “The directors of companies, being managers of other people's money than their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private co-partnery frequently watch over their own.” Adam Smith, The Wealth of Nations 1776

20 Corporate Governance System


22 Corporate Governance

23 Basics of Corporate Governance
By issuing corporate securities, firms sell claims to control the companies` ressources The interests of the various securityholders differ Separation of owership and control implies agency relationships. Interests of agents (management) are different from those of securityholders, particulary from those of stockholders. Monitoring the activities of agents is costly - hence, full monitoring is not optimal. The value forgone due to imperfect optimal monitoring is an explicit agency cost.

24 Contract Theory of Corporate Governance
Contract are arranged between principles (owners) and agent (managers) Contracts are also made between the firm and providers of capital Problems with contracts: Moral Hazard Incomplete contracts Adverse selection bias

25 Agency Problem Managerial discretion - Business judgement
Managerial opportunism – self dealing Duty of loyalty of management to firm

26 Fiduciary Duty The fiduciary duty is a legal relationship between two or more parties (most commonly a "fiduciary" or "trustee" and a "principal" or "beneficiary") that in English common law is arguably the most important concept within the portion of the legal system known as equity. A fiduciary will be liable to account if it is proved that the profit, benefit, or gain was acquired by one of three means: In circumstances of conflict of duty and interest In circumstances of conflict of duty and duty By taking advantage of the fiduciary position. Therefore, it is said the fiduciary has a duty not to be in a situation where personal interests and fiduciary duty conflict, a duty not to be in a situation where their fiduciary duty conflicts with another fiduciary duty, and not to profit from their fiduciary position without express knowledge and consent. A fiduciary cannot have a conflict of interest.

27 Fiduciary Duty

28 Agency Problem Duty of loyalty of management to firm
Incentive contracts that align management interests with investors Agency costs – monitoring and compliance Shareholder actions- shareholder democracy, proxy fights, access to the proxy ballot, derivative lawsuits

29 Four core values of the OECD corporate governance framework
Fairness: The corporate governance framework should protect shareholder rights and ensure the equitable treatment of all shareholders, including minority and foreign shareholders. Responsibility: The corporate governance framework should recognize the rights of stakeholders as established by law, and encourage active co-operation between corporations and stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises.

30 OECD Core Values Transparency: The corporate governance framework should ensure that timely and accurate disclosure is made on all material matters regarding the company, including its financial situation, performance, ownership, and governance structure. Accountability: The corporate governance framework should ensure the strategic guidance of the company, the effective monitoring of management by the board, and the board’s accountability to the company and shareholders.

31 Advantages of Good Corporate Governance
Stimulating Performance and Improving Operational Efficiency Better oversight and accountability Improved decision making Better compliance and less conflict Less self-dealing Better informed Avoidance of costly litigation through adherence to laws and regulations

32 Advantages of Good Corporate Governance
Improving Access to Capital Markets Transparency, accessibility, efficiency, timeliness, completeness, and accuracy of information critical Listing requirements Inclusion of Corporate Governance in investment decision process

33 Accounting Scandal and Reform in the US and Western Europe

34 Crisis in Governance 1999 - 2002 Enron – fraud and oversight failure
Worldcom – accounting fraud Adelphia – RPT securities violations, and accounting fraud Arthur Anderson

35 More detailed list AOL Adelphia Bristol-Myers Squibb Duke Energy
Dynegy El Paso Corporation Enron Freddie Mac Global Crossing Halliburton Harken Energy ImClone Systems Kmart Lucent Technologies Merrill Lynch Qwest Communications Reliant Energy Sunbeam Tyco International Waste Management, Inc. WorldCom

36 SOX reforms to US Corporate Governance
Auditor independence Corporate Officer Responsibility for financial statements Internal Control Sections 404 and 302 Significant increase in monitoring costs for PLCs

37 Market Size

38 Anglo-Saxon Model US, UK, Canada, Australia, New Zealand
Shareholder value maximization “outsider” model – arms length investor Internal governance mechanisms board of directors employee compensation External mechanisms market for corporate control monitoring by financial institutions competition in product and input market Reliance on legal mechanisms to protect shareholder rights Short term financial performance key Sha

39 Market for Corporate Control
“Friendly Takeover” When a bidder makes an offer for another, it will usually inform the board of the target beforehand. If the board feels that the value that the shareholders will get will be greatest by accepting the offer, it will recommend the offer be accepted by the shareholders. A takeover would be considered "hostile" if 1) the board rejects the offer, but the bidder continues to pursue it, or 2) if the bidder makes the offer without informing the board beforehand.

40 German (Continental) Model
Co-determination - partnership between capital and labor Social cooperation The two-tier board structure that consists of a supervisory board and executive board – greater efficiency in separation of supervision and management Cross–shareholding in financial – industrial groups Role of banks as major shareholders Primary sources of capital – retained earnings and loans

41 Japanese Model Formal role of large and almost entirely executive boards – single tier board Historical roots of the Keiretsu network interlocking business relationships Existence of significant cross holdings and interlocking-directorships, Lifetime employment system plays in corporate policy Role of banks Market share maximization over shareholder value maximization Long term perspective

42 Corporate Governance Framework in Russia
Concentrated Ownership Little separation between ownership and control Unwieldy holding structures used to hide beneficial ownership, avoid taxes, or steal from minority owners Reorganizations to dilute minority stakes Inexperienced Supervisory Board (Boards of Directors)

43 Theory Berle and Means (1932) – separation of ownership and control through modern corporation structures Agency Problem

44 Control Mechanisms

45 Conventional Wisdom The business literature describing the classical functions of boards of directors typically includes three important roles: (1) establishing basic objectives, corporate strategies, and board policies: (2) asking discerning questions; and (3) selecting the president.

46 Some Early Research (Manne 1971)
First classical role Found that boards of directors of most large and medium-sized companies do not establish objectives, strategies, and policies however defined These roles are performed by company management Presidents and outside directors generally agreed that only management can and should have these responsibilities.

47 Some Early Research (Manne 1971)
A second classical role assigned to boards of directors is that of asking discerning questions - inside and outside the board meetings. Again it was found that directors do not, in fact, do this. Board meetings are not regarded as proper forums for discussions arising out of questions asked by board members. A third classical role usually regarded as a responsibility of the board of directors is the selection of the president. Yet it was found that in most companies directors do not in fact select the president, except in the two crisis situations cited earlier.

48 Stewardship theory Stewardship theory, the alternative perspective, takes an altogether broader frame of reference, being based on the original and legal view of the corporation in which directors have a fiduciary duty to their shareholders to be stewards for their interests.

49 Stewardship Theory Muth and Donaldson (1997) challenged agency theory, which underpin conventional assumptions about the benefits of checks and balances – Boards with well connected, executive directors perform better than those that meet the paradigms of conventional governance thinking Also research has shown that increasing governance conformance and compliance may not add to corporate performance - it can actually detract - Donaldson and Davies (1994)

50 Introduction to Corporate Governance Structures
Supervisory Board (Board of Directors) Central role in Corporate Governance framework Sets strategy, business priorities, annual financial and business plan, and oversees managerial performance Oversees the work of the General Director (CEO) and the Executive Board

51 Role of Supervisory Board
Protecting the interests of the company and its shareholders Defining the Boards role and priorities Setting the company’s governance framework Organizing the General Meeting of Shareholders, Protection of company assets Resolution of conflicts Supervision of internal controls and risk management


53 Types of Directors a) Executive Directors
Executive directors can be defined as those that also hold an executive position in the company, namely that of: The General Director; An Executive Board member; or A manager of the company who is not an Executive Board member.

54 Types of Directors b) Non-Executive Directors c) Independent Directors
Non-executive directors are Supervisory Board members that do not hold an executive position in the company. c) Independent Directors Russian law does not define the concept of independent directors. The Company Law does, however, refer to independent directors under specific circumstances to determine the position of individuals engaged in related party transactions and to prevent possible conflicts of interests.

55 Independent Director In this respect, an independent director is defined as an individual who has not been in any of the following positions at the time of the approval of a business transaction, or during one year immediately preceding the approval of such a transaction: The General Director, the External Manager, an Executive Board member or a member of the governing bodies (Supervisory Board, General Director and Executive Board) of the External Manager; or A person whose spouse, parents, children, brothers, and sisters by one or both parents are the External Manager or hold a position in the governing bodies of the External Manager; or A person whose adoptive parents or adopted children are the External Manager or hold a position in the governing bodies or the External Manager; or An affiliated person other than a director of the company.

56 What is Independence? Independence of a Director: a Director must always act in a manner independent of management and never be conflicted by any relationship to management (i.e., financial, familial, or social). Independence measurements include: Relatedness of the Director:   - Employee (in last three years);   - Professional advisor (in last three years);   - Executive of any affiliated company;   - Other income from company;   - Kinship or social ties; • Interlocks with other Directors; • Number of Boards on which Director serves.

57 The Election of Directors
All directors must be elected with cumulative voting. Cumulative voting is a system that helps minority shareholders pool their votes to elect a representative for the Supervisory Board. The election of directors cannot be done if a GMS is held by written consent. How Cumulative Voting Works: Candidates for the Supervisory Board are voted on collectively, i.e. as a group; Each shareholder has a maximum number of votes equal to the number of directors that must be elected (according to the charter or a decision of the GMS) multiplied by the number of voting shares held; Shareholders can allocate their votes to one candidate or divide them among several candidates as they please; The top X candidates with the most votes are considered elected, whereby X equals the number of Supervisory Board members to be elected as specified by the charter or the decision of the GMS.

58 Cumulative Voting: Minimum number of votes to elect one director
where D — the number of directors to be elected, S — the number of outstanding voting shares and n — the total number of directors the majority shareholder wants to elect

59 Company Practices in Russia
Representatives of major shareholders (35%),management and employees (30%) are the most common types of directors, Independent directors (18%) and minority shareholder representatives (9%) still constitute a minority on most Supervisory Boards. A positive correlation exists between the number of shareholders in a company and the number of representatives of majority shareholders on the Supervisory Board. Hence, Supervisory Boards of large companies with many shareholders tend to include more representatives of large shareholders.

60 Governance is Different from Management

61 Governance and Management
Management runs the business the board ensures that the business is well run and run in the right direction

62 Functions of the board Strategy Formulation Outward looking Providing
Accountability Approve and work through the CEO Inward Looking Monitoring and Supervising Policy Making and Revising Past and present focused Future Focused

63 All Executive Board Governance O O O O O O - executive directors

64 Majority – executive board
Governance N N N O O O O O - executive directors N – non executive directors Management

65 Majority – non executive board
Governance N N N N O O O O - executive directors N – non executive directors Management

66 Two – tier board Governance N N N N N N N N N O - executive directors
N – non executive directors O O O Management O O

67 Wimm-Bill-Dann Board of Directors
One tier board in the US / UK model Members David Iakobachvili Chairman - non-excutive & dependent (owns 9.46%) Sergei A. Plastinin Director, Chairman of Management Board and Head of Dairy Business Unit - Executive (owns 12.16%) Guy de Selliers Director - non-executive and indepedent Mikhail V. Dubinin Director - executive (owns 6.83%) Michael A. O'Neil Director - non-executive and independent (?) Alexander S. Orlov Director - executive (owns 4.39%) Vladimir N. Sherbak Director - non-excutive and dependent Victor A. Tutelyan Director - non-executive and indepedent Earnest Linwood Tipton Director - non-excutive and indepedent Evgeny G. Yasin Director - non-excutive and independent Gavril A. Yushvaev Director - non-excutive and depedent (owns 18.80%)

68 Ownership Party to the Amended and Restated Partnership and Cooperation Agreement. Mikhail I Vishyakov (owns 2.59%) Evgeny L. Yaroslavsky (owns 1.43%) Vicktor E. Evdokimov (owns 0.42%) Other Owners Parex Bank JSC (owns 5.29%) Templeton Strategic Emerging Markets Fund LDC (owns 1.18%) Others own 4.74% of Russian traded shares American Depositary Receipt Holders own 32.70%

69 Wimm – Bill – Dann Governance N/O N/I N/I N/D N/I
E/O - executive /owners directors N/I – non executive directors/independent N/O – non executive directors/ owners N/D – non executive directors/dependent N/D N/I E/O N/I E/O E/O Management

70 Wimm – Bill – Dann Committees
Audit Committee – 3 independent directors The Committee for Investment and Strategic Planning – 1 independent & 2 dependent directors Committee for Personnel and Remuneration – 1 independent director & 1 dependent director

71 Compensation of Board Members
Board member receive $50,000 annually plus transportation and lodging expenses incurred in connection with board meeting attendance, and up to $2,000 per year for other expenses Chairman of the Board is compensated $300,000 Members of the Personnel and Compensation Committee & Investment and Strategic Planning Committee receive $3,000 and each member of the Audit Committee receive $5,000 for participation in each planned direct Committee meeting.

72 What does the Wimm – Bill – Dann Case Indicate?
Outside investors should know the following: Board members are directors, executives & managers Majority of ownership is controlled through a shareholder agreement No threat of takeover without owner-manager consent Board and committees are structured to meet NYSE requirements for CG

73 Corporate Governance and Initial Public Offerings
Corporate Governance is a principle variable in evaluating risk / setting discount for IPOs Firms reaching the market make significant CG changes to their board structure and practices to conform to market expectations

74 Role of the Board in a Public Company IPO / Listing Experience
Effectiveness Talents and background of board members Tying board remuneration closely to performance Strategic thinking by the Board Managing risk effectively

75 Role of the Board in Listing - IPO
Developing a robust audit committee Taking corporate social responsibility on board Encouraging and active dialogue with shareholders

76 The Effective Board Clear strategy aligned to capabilities
Vigorous implementation of strategy Key performance drivers monitored Effective risk management Sharp focus on views of the capital market and other key stakeholders Regular evaluation of board performance

77 What does the market look for in a board member?
Asks the difficult questions Works well with others Has industry awareness Provides valuable input Is available when needed Is alert and inquisitive

78 What does the market look for in a board member?
Has business knowledge Contributes to committee work Attends meetings Speaks out appropriately at board meetings Prepares for meetings Makes long-range planning contribution Provides overall contribution

79 Implementing effective strategy and change programs
The blueprint for the strategy The business case The transformation program A mobilized organization A ‘transformation map’ What would happen if there were no change? What is the value that will be created by the new strategy? When, and how, can that be tracked?

80 The audit committee’s main responsibilities
To monitor the integrity of the financial statements To review the company’s internal financial controls, internal control and risk management systems. To monitor/review the effectiveness of the internal audit function. To make recommendations to the board on the appointment/removal of the external auditor

81 The audit committee’s main responsibilities
To monitor/review the external auditor’s independence/objectivity and the effectiveness of the audit process. To develop/implement policy on the engagement of the external auditor to supply non-audit services To review arrangements by which staff may raise concerns about possible improprieties (‘whistleblowing’)

82 Flotation – who ends up steering the boat?

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