14 Corporate Governance Around the World Outline lGovernance and the Public Corporation: Key Issues lThe Agency Problem lRemedies for the Agency Problem lLaw and Corporate Governance lConsequences of Law lCorporate Governance Reform lThe Dodd-Frank Act 2 Governance and the Public Corporation: Key Issues lThe public corporation, which is jointly owned by a multitude of shareholders protected with limited liability, is a major organizational innovation of vast economic consequences. lIt is an efficient risk sharing mechanism that allows corporations to raise large amounts of capital. 3 lA key weakness is the conflict of interest between managers and shareholders. lIn principle, shareholders elect a board of directors, who in turn hire and fire the managers who actually run the company. lIn reality, management-friendly insiders often dominate the board of directors, with relatively few outside directors who can independently monitor the management. Governance and the Public Corporation: Key Issues 4 lIn the case of Enron and other dysfunctional corporations, the boards of directors grossly failed to safeguard shareholder interests. lFurthermore, with diffused ownership, most shareholders have strong enough incentive to incur the costs of monitoring management themselves. nIts easier to just sell your shares, a.k.a. “The Wall Street Walk.” Governance and the Public Corporation: Key Issues 5 The Agency Problem lShareholders allocate decision-making authority to the managers. lThats why the managers are hired in the first place. lMany shareholders are not qualified to make complex business decisions. lA shareholder with a diversified portfolio would not have the time to devote to making the numerous decisions at each of his many companies anyway. 6 The Agency Problem lHaving short-term control of the firms assets, managers might be tempted to act in the managers short-term best interest instead of the shareholders long-term best interest. nConsumption of lavish benefits is one example. nOutright stealing is another example. uSome Russian oil companies are known to sell oil to manager- owned trading companies at below-market prices. uEven at that, they dont always bother to collect the bills! 7 The Agency Problem at Enron lEnron had about 3,500 subsidiaries and affiliates. Many of these were run and partly owned by Enron executives. lIn retrospect, conflict of interest should have been an obvious concern. nThe partnerships performed hundreds of millions of dollars of transactions with Enron itself, in some cases buying assets from the company or selling assets to it. lThe problem is this: Where did the executives loyalties lie? Are they trying to negotiate the best deal for the company that employs them and the shareholders who own the company, or the best deal for the partnership where they had an ownership stake? 8 The Agency Problem at Enron lThe board of directors claimed that these partnerships with executive ownership allowed the firm to speed up contracting. lTo protect itself in dealings with these partnerships, the company supposedly set up safeguards that required top company officers and the board to review and approve deals between Enron and the partnerships. lClearly these safeguards were insufficient. 9 Remedies for the Agency Problem lIn the U.S., shareholders have the right to elect the board of directors. lIf the board remains independent of management, it can serve as an effective mechanism for curbing the agency problem. 10 Corporate Boards lThe structure and legal charge of corporate boards vary greatly across counties. nIn Germany the board is not legally charged with representing the interests of shareholders, but is instead charged with representing the interests of stakeholders (e.g. workers, creditors, etc.). 11 Corporate Boards lThe structure and legal charge of corporate boards vary greatly across counties. nIn England, the majority of public companies voluntarily abide by the Code of Best Practice on corporate governance. It recommends that there should be at least three outside directors and that the board chairman and the CEO should be different individuals. 12 Corporate Boards lThe structure and legal charge of corporate boards vary greatly across counties. nIn Japan, most corporate boards are insider-dominated and primarily concerned with the welfare of the keiretsu to which the company belongs. 13 Incentive Contracts lIt is difficult to design a compensation scheme that gives executives an incentive to work hard at increasing shareholder wealth. lAccounting-based schemes are subject to manipulation. nArthur Andersens involvement with the Enron debacle is an egregious example. lExecutive stock options are an increasingly popular form of incentive compatible compensation. 14 Management Ownership 15 Concentrated Ownership lAnother way to alleviate the agency problem is to concentrate shareholdings. lIn the United States and the United Kingdom, concentrated ownership is relati