Overview of Corporate Governance

1. Overview of Corporate Governance Prof. Jun “QJ” Qian Boston College Advanced Summer Training Program in Finance Tsinghua University Chengdu, China July 6, 2007

2. Foundation for Corporate Governance: Ownership Structure • Who owns the firm (types of firms)? • Publicly owned, listed and traded, privately owned firms; non-profit or government-owned organizations/institutions; • Ownership structure (disperse or concentrated; debt or equity) • Transfer/transition of ownership (IPO, LBO; changes in government ownership) • Who works for the firm? • Owners themselves (Principals); • Managers and employees (Agents); • What problems can arise when owners do not “work” for the firm on a regular basis? (Agency problems)

3. Foundations: Ownership (cont’d) • What are the goals of the firm and what type of decisions do firms make to realize these goals? • Maximize profits for owners; • Reputation (collectively and individually); social goals; • Decisions: Investment, financing, payout policies, risk management, etc. • How do the owners of the firm ensure that their objectives are properly carried out by the managers & employees? • Corporate governance mechanisms; • Are US firms operate in the same ways as firms in other countries? • Comparing financial systems.

4. Who Owns the Firm: Microsoft(Based on Proxy Statement of July 21, 2006)

5. Who Owns the Firm: Google (Proxy 5/11/06)(Dual Class Shares: Class A, one-vote/share; Class B, 10 votes/share)

6. Who Owns the Firm: GE(Proxy Statement of 4/26/06; no 5% or larger owner)

7. Who Owns the Firm: GM(Proxy Statement of June 6, 2006)

8. Ownership Structure: Publicly Listed Firms in the U.S. and U.K. • Disperse ownership among many “small” owners; • Wealthy individuals (including executives) own a lot of stocks; • Commercial banks do not own a lot of stocks; • Important role of institutional investors (asset management companies, non-profit organizations, etc).

9. Who Owns the Firm: Daimler-Benz(Based on Shleifer et al. (1999); prior to merger with Chrysler)

10. Ownership Structure: Germany & Other Continental European Countries • Ownership is more concentrated among a few “large” owners; • (Universal) Banks own a lot of equity and participate more actively in firms’ decisions; • Individual investors do not own a lot of stocks (directly); • Cross-holding of equity among firms and institutions.

11. Who Owns the Firm: Toyota(Based on Shleifer et al. (1999))

12. Who Owns the Firm: Samsung Electronics(Based on Shleifer et al. (1999))

13. Ownership Structure: Japan & Other Asian Countries • Ownership is also more concentrated among a few “large” owners; • Banks (keiretsu in Japan) own a lot of equity and participate more actively in firms’ decisions; • Cross-holding of equity among firms and institutions; • Family (publicly listed) firms; • For more details, see Claessens et al. (2000 JFE; 2002 JF)

14. Agency Problem and Solutions • Separation of ownership and control: • In most publicly owned firms, firms are run by professional managers; small owners are passive; • Agency problem (Jensen & Meckling 1976): Managers/employees may pursue other (personal) goals rather than max. owners’ profits • Role of managers and employees in public firms: • In the US: (Recent years) they enter ownership thru. company’s grants of their own stocks and stock options; • Pros and cons: Align their incentives with the owners’; but their portfolios may be under diversified, and managers may have perverse incentives; • In Germany and Japan: Don’t own company’s stocks, but employees’ goals are recognized; more active participation.

15. Corporate Governance Mechanisms • Definition: A set of formal mechanisms (in the U.S.) to ensure that owners’ goals are carried out properly by managers and employees: • Board of Directors • Executive compensation • Active markets for corporate control (mergers & acquisitions) • Information disclosure and transparency • The use of debt/cash in firm’s capital structure and payout policies

16. Governance I: Board of Directors • Represents the interests of (equity) owners; • Voting mechanisms: One-share, one-vote (vs. dual class shares), accumulative voting; proxy contests; • Appoint and contract with firm’s top managers; • Composition of the Board: • Size and the number of outside (independent) members; • Problems: • CEO usually sits on the Board and can influence the appointment of outside board members; • Costs involved with proxy fights (e.g., “staggered boards”).

17. Governance II: Executive Compensation • Typical CEO pay package (in the U.S.): • Base salary, accounting-based bonus; restricted stock grants and • Stock options: granted at-the-money; long-term (10 years expiration) ; • Restrictions: Vesting period, no sale or transfer (can only exercise); • Use of stocks and stock options increased dramatically in 1990s, coincided with the technology boom (bubble) • Role of stocks and stock options: • If designed properly: Can provide strong incentives for executives to improve performance, and save cash; • But, not fully disclosed, (used to) not counted as expenses like salary; incentive to manipulate stock price and accounting reports; • CEO usually member of Compensation committee

18. Governance III: Markets for Corporate Control • Markets for corporate control (M&As): • Allow better firms to take control of bad firms’ assets; • Types of action: Proxy contests, friendly mergers (e.g., stock swaps), and hostile takeovers; • M&As very active in the U.S.; • Hostile takeovers provide the strongest discipline for firm’s managers as following M&As they usually lose control • Problems with hostile takeovers: • Antitakeover measures by target management; • Merger wave in the 1990s: Friendly stock-based mergers; • Overall efficiency improvement of M&As: No clear evidence that M&As create values for (combined firms’) shareholders

19. Governance IV: Transparency and the Use of Debt • Information disclosure: • Publicly listed firms in the U.S. face most stringent disclosure requirements; • Disclosure requirements for financial institutions (e.g., Reg FD, auditor responsibilities); • The more disclosure, the better? Not necessarily! • Problems: Earnings management and accounting frauds; more rules almost always lead to more loopholes in the system • Role of debt in disciplining managers: • Difference between debt and equity: Debt – fixed income securities; • Free cash flow: reduce managers’ squandering of firm’s resources; • Problems: Many large US firms use little debt; can create other perverse incentives for managers when firms facing distress.

20. Central Questions of the Course • Do better governed firms have better performance? • Are there alternative mechanisms in addition to the formal mechanisms listed above? • How does the practice of governance vary across countries?

21. An Example: Toyota vs. GM and Ford • GM and Ford: Strong corporate governance on paper; • Toyota measured by standard governance mechanisms: • Board of Directors: 65 members, only 1 outside member; • Executive compensation: Paid much less than US counterparts; rarely use stock-based compensation; high job security; • Very few hostile takeovers in Japan due to ownership structure; • Quality of accounting disclosure: Opaque, not very informative; • Capital structure: No debt; $40 billion cash on balance sheet • Many other successful Asian and continental European firms share the same characteristics as Toyota.

22. Comparing Toyota, GM, and Ford:Buy-and-hold Returns (1972-2006)

23. Alternative Corporate Governance Mechanisms • Work for all types of firms everywhere! • Competition in product and input markets; • Institutions based on reputation, relationships, and trust: • Traders organizations in 11th century (Grief 1989, 93, 94); • Cultural/religious influence (Stulz & Williamson 2003) • Family-run vs. professionally managed firms: • The degree of separation of ownership and control and legal environment; • Cooperation and mutual monitoring within the firm/organization

24. Comparing Financial Systems • US/UK-style market-based financial system: • Large and advanced financial markets; pricing system is based on “marked to market”; • (Commercial) banks are much less important • German/Japan-style bank-based financial system: • Most wealth is in the banking system with “universal” banks; • Financial markets are (relatively) not well developed; • These two systems are distinctly different: • Both have advantages and disadvantages • Other countries (e.g., France) are in between: • More than 2/3 of countries have banking-based systems (Demirgüç-Kunt and Levine 2001); • More details see Allen and Gale (2000 book)

25. Law, Finance, and Economic Growth • ‘Conventional wisdom’ on explaining the differences in financial systems and in financial/economic ‘outcomes’ • An important view is to link law and finance (LLSV and others): • Countries with English common-law (French civil-law) system provide strong (weak) protection of investors; and • Have & low (high) concentration of ownership, strong (weak and narrow) capital markets, and better institutions (e.g., less corruption) and outcomes • Relation between finance and growth: • The development of financial system (stock market & banking sector) contributes to economic growth (e.g., McKinnon 73, King & Levine 93) • Evidence at industry- and firm-levels (e.g., Jayaratne and Strahan 1996) • Literature on law, finance, and growth: • Country level evidence: Levine (99); industry level (Beck and Levine 02) and firm level (Demirgüç-Kunt & Maksimovic 98) • Is conventional wisdom correct?

26. Summary • Much more to be learned about corporate governance • The benchmark is publicly traded firms in the US: A focus of the course, but • There are many other successful firms in the U.S. and other parts of the world that operate very differently • We need to expand our knowledge on how alternative systems work in different environments, in order to improve firm performance and overall economy’s efficiency and stimulates growth