What is corporate governance? A system of principles, policies, procedures, and clearly defined responsibilities and accountabilities used by stakeholders to overcome the conflicts of interest inherent in the corporate form. the ways in which suppliers of finance assure themselves of getting a return on their investment Why is it needed? In most corporations, the owners (shareholders) do not manage the company’s operations. Corporate governance is needed to ensure that the managers are compelled to return some of the firm’s profits to investors, or that managers do not steal the capital or invest it in bad projects.

Two major objectives of corporate governance: To eliminate or mitigate conflicts of interest, particularly those between managers and shareholders To ensure that the assets of the company are used efficiently and productively and in the best interests of its investors and other stakeholders

Most common sources of conflict in agency relationships within a corporation: Manager-Shareholder conflicts Management may use funds to increase their job security, power, and salaries Managers may give themselves a lot of perks (e.g. use of corporate jet, $200,000 bathroom, etc) Managers may take on risky ventures that benefit themselves, but not necessarily the shareholders

Duties of the Board of Directors: Establish corporate values and governance structures for the company Ensure that all legal and regulatory requirements are met and complied with fully and in a timely fashion Establish long-term strategic objectives for the company with a goal of ensuring that the best interests of shareholders come first Establish clear lines of responsibility and a strong system of accountability and performance measurement Hire the CEO, determine the compensation package, and periodically evaluate the officer’s performance Ensure that the management has supplied the board with sufficient information Meet frequently enough to adequately perform its duties, and meet in extraordinary session as required by events

Director-Shareholder conflicts Boards are supposed to represent the interests of the shareholders, by monitoring managers and making sure their actions are in the best interests of shareholders. Conflicts arise when directors come to identify with the managers’ interests rather than those of the shareholders. This can happen when: Board members are not independent (e.g. they are employees of the firm, they have business dealings with the firm as consultants, lenders, suppliers, etc., they are family members or friends of the managers) Board memberships are inter-linked, e.g., CEOs serve on other companies’s boards

Evaluating Corporate Governance Evaluating the power of the CEO Is the CEO the chairman of the board? Does the CEO have ownership in the company? In what form (stocks, options)? How long has (s)he been CEO? How much is the CEO’s compensation? Difference between the next highest paid officer? Difference between the average compensation of other top management?

Evaluating Corporate Governance Evaluating the board of directors Board composition and independence Independent chairman of the board Qualifications of directors Annual election of directors Annual board self-assesment Separate sessions of independent directors Audit committee and audit oversight Nominating committee Compensation committee Board’s independent and legal counsel Statement of governance policies Disclosure and transparency Insider or related-party transactions Responsiveness of the board to shareholder proxy votes

Evaluating Corporate Governance Assessing shareholder power Voting rights (i.e., are there different classes of shares with different voting rights? Who owns the shares with the voting rights?) Is the top manager a founder/owner? Institutional shareholders Stockholders with competing interests (e.g. employee ownership) Corporate cross-holdings

Other corporate governance issues Conflict between shareholders and bondholders Environmental, social, and governance issues

Sources: Clayman, Fridson, Troughton. Corporate Finance. Damodaran Sources: Clayman, Fridson, Troughton. Corporate Finance. Damodaran. Applied Corporate Finance, 2nd ed.