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Chapter 2. Corporate Ownership, Goals, and Governance. Who Owns the Business?. Exhibit 2.1 distinguished between public ownership of commercial enterprises and privately owned companies.
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Chapter 2 Corporate Ownership, Goals, and Governance
Who Owns the Business? • Exhibit 2.1 distinguished between public ownership of commercial enterprises and privatelyowned companies. • Public ownership may be wholly state-owned or partially publicly traded. State Owned Enterprises (SOEs) are created for business purposes rather than for regulation or civil activities. • Private firms may be publicly traded (stock) or privately owned by partners or family.
Publicly Traded Shares • The global marketplace trades both SOEs and private firms. • Often firms “go public” via an initial public offering (IPO) and sell a portion of the firm to the public while retaining sufficient ownership to maintain control of the firm. • Conversely, some publicly traded firms go private when a single investor or group buys outstanding shares and ceases to trade. • Family-controlled firms may prove to be more profitable.
Separation of Ownership from Management • SOEs and widely held publicly traded companies typically separate management and ownership. • This raises the possibility that ownership and management may not be perfectly aligned in their business and financial objectives, the so-called agency problem.
The Goal of Management • Maximization of shareholders’ wealth is the dominant goal of management in the Anglo-American world. • In the rest of the world, this perspective still holds true (although to a lesser extent in some countries). • In Anglo-American markets, this goal is realistic; in many other countries it is not.
The Goal of Management • There are basic differences in corporate and investor philosophies globally. • In this context, the universal truths of finance become culturally determined norms.
Shareholder Wealth Maximization • In a 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. • Alternatively, the firm should minimize the level of risk to shareholders for a given rate of return.
Shareholder Wealth Maximization • The SWM model assumes as a universal truth that the stock market is efficient. • An equity share price is always correct because it captures all the expectations of return and risk as perceived by investors, quickly incorporating new information into the share price. • Share prices are, in turn, the best allocators of capital in the macro economy.
Shareholder Wealth Maximization • The SWM model also treats its definition of risk as a universal truth. • Risk is defined as the added risk that a firm’s shares bring to a diversified portfolio. • Therefore the unsystematic, or operational risk, should not be of concern to investors (unless bankruptcy becomes a concern) because it can be diversified. • Systematic, or market, risk cannot however be eliminated.
Shareholder Wealth Maximization • Agency theory is the study of how shareholders can motivate management to accept the prescriptions of the SWM model. • Liberal use of restricted stock should encourage management to think more like shareholders. • If management deviates too extensively from SWM objectives, the board of directors should replace them. • If the board of directors is too weak (or not at “arms-length”) the discipline of the capital markets could effect the same outcome through a takeover. • This outcome is made more possible in Anglo-American markets due to the one-share one-vote rule.
Shareholder Wealth Maximization • Long-term value maximization can conflict with short-term value maximization as a result of compensation systems focused on quarterly or near-term results. • Short-term actions taken by management that are destructive over the long-term have been labeled impatient capitalism. • This point of debate is often referred to a firm’s investment horizon (how long it takes for a firm’s actions, investments and operations to result in earnings).
Shareholder Wealth Maximization • In contrast to impatient capitalism is patient capitalism. • This focuses on long-term SWM. • Many investors, such as Warren Buffet, have focused on mainstream firms that grow slowly and steadily, rather than latching on to high-growth but risky sectors.
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. • In particular, labor unions are more powerful than in the Anglo-American markets. • In addition, Governments interfere more in the marketplace to protect important stakeholder groups, such as local communities, the environment and employment.
Stakeholder Capitalism Model • The SCM model does not assume that equity markets are either efficient or inefficient. • The inefficiency does not really matter, because the firm’s financial goals are not exclusively shareholder-oriented, because they are constrained by the other stake-holders. • The SCM model assumes that long-term “loyal” shareholders – those typically with controlling interests – should influence corporate strategy, rather than the transient portfolio investor.
Stakeholder Capitalism Model • The objective of the privately held firm is to maximize current and sustainable income. • Exhibit 2.2 shows distinctions between publicly traded and privately held firms. • A recent study shows that privately held firms use less financial leverage and enjoy lower costs of debt than publicly traded firms.
Stakeholder Capitalism Model • The SCM model assumes that total risk – i.e. operating and financial risk – 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.
Operational Goals for MNEs • The MNE must determine for itself proper balance between three common operational financial objectives: • maximization of consolidated after-tax income; • minimization of the firm’s effective global tax burden; • correct positioning of the firm’s income, cash flows, and available funds as to country and currency. • These goals are frequently incompatible, in that the pursuit of one may result in a less-desirable outcome in regard to another.
Public/Private Hybrids • Many firms are publicly traded but are still heavily influenced or even controlled by families. • Exhibit 2.3 illustrates how family businesses on average out-perform indexes of public companies in the United States France, Germany, and Western Europe.
Publicly Traded Versus Privately Held: The Global Shift • Exhibit 2.4 illustrates how the number of U.S. publicly listed firms peaked in 1996 at 8,783. Today around 5,000 listings. • The number of publicly listed firms world wide peaked in 2008. It is not clear if this is a permanent phenomenon or just a temporary impact caused by the international financial crisis. • U.S. listings as a % of worldwide listings of publicly traded firms dropped from 33.3% in 1996 to 11% at year-end 2010.
Possible Causes in the Decline of Publicly Traded Shares • Sarbanes-Oxley has added reporting requirements • The growth of private equity markets • The growth of Electronic Communication Networks (ECNs) helped reduce transaction costs, but also made it less profitable for brokerage houses to research smaller firms. Thus trading volume on smaller firms fell off and some ceased trading at all.
Corporate Governance • Although the governance structure of any company – domestic, international, or multinational – is fundamental to its very existence, this subject has become a lightning rod for political and business debate in the past few years. • Spectacular failures in corporate governance have raised issues about the very ethics and culture of the conduct of business.
Corporate Governance • The single overriding objective of corporate governance is the optimization over time of the returns to shareholders. • In order to achieve this goal, good governance practices should focus the attention of the board of directors of the corporation by developing and implementing a strategy that ensures corporate growth and improvement in the value of the corporation’s equity.
Corporate Governance • The most widely accepted statement of good corporate governance practices has been established by the OECD: • Shareholder rights. Shareholders are the owners of the firm, and their interests should take precedence over other stakeholders. • Board responsibilities. The board of the company is recognized as the individual entity with final full legal responsibility for the firm, including proper oversight of management. • Equitable treatment of shareholders. Equitable treatment is specifically targeted toward domestic versus foreign residents as shareholders, as well as majority and minority interests.
Corporate Governance cont. • Stakeholder rights. Governance practices should formally acknowledge the interests of other stakeholders—employees, creditors, community, and government. • Transparency and disclosure. Public and equitable reporting of firm operating and financial results and parameters should be done in a timely manner, and available to all interests equitably.
Structure of Corporate Governance • The modern corporation’s actions and behaviors are directed and controlled by both internal forces and external forces (Exhibit 2.5). • The internal forces, the officers of the corporation and the board of directors, are those directly responsible for determining both the strategic direction and the execution of the company’s future. • The external forces include equity markets in which the shares are traded, the analysts who critique the company’s investment prospects and external regulators, among others.
Structure of Corporate Governance • The board of directors is the legal body that is accountable for the governance of the corporation. • The senior officers of the corporation are the creators and directors of the corporation’s strategic and operational direction. • Exhibit 2.6 illustrates how different corporate governance regimes lead to different characteristics of ownership, efficiency, and transparency.
Structure of Corporate Governance • Equity markets should reflect the market’s constant evaluation of the promise and performance of the company. • Debt markets should reflect the company’s ability to repay its debt in a timely and efficient manner. • Auditors and legal advisors are responsible for providing an external professional opinion as to the fairness, legality and accuracy of corporate financial statements. • Regulators work to ensure, among other things, that a regular and orderly disclosure process of corporate performance is conducted so that investors may evaluate a company’s investment value with accuracy.
Failures in Corporate Governance • Failures in corporate governance have become increasingly visible in recent years. • In each case, prestigious auditing firms missed the violations or minimized them, presumably because of lucrative consulting relationships or other conflicts of interest. • In addition, security analysts urged investors to buy the shares of firms they knew to be highly risky (or even close to bankruptcy). • Top executives themselves were responsible for mismanagement and still received overly generous compensation while destroying their firms.
Good Governance and Corporate Reputation • Good governance SHOULD matter. • Exhibit 2.7 describes a set of governance policies and practices • Exhibit 2.8 shows selected governance rankings by IR Global. There are several international governance ranking agencies. • Governance rankings and cost of capital do not appear to be highly correlated • Anglo-American board members do signal good corporate governance in non-Anglo-American firms.
Exhibit 2.7 The Growing Consensus on Good Corporate Governance
Corporate Governance Reform Within the United States and the United Kingdom, the main corporate governance problem is the one treated by agency theory: with widespread share ownership, how can a firm align management’s 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 theory monitoring task. Outside the U.S. and U.K., large, controlling shareholders are in the majority – these entities are able to monitor management in some ways better than the regulators can.
The Sarbanes-Oxley Act • This act was passed by the U.S. Congress, and signed by President George W. Bush during 2002 and has three major requirements: • CEOs of publicly traded companies must vouch for the veracity of published financial statements; • corporate boards must have audit committees drawn from independent directors; • companies can no longer make loans to corporate directors; and • companies must test their internal financial controls against fraud • Penalties have been spelled out for various levels of failure. • Most of its terms are appropriate for the U.S. situation, but some terms do conflict with practices in other countries.
Additional Corporate Governance Issues • Board structure and compensation issues • E.g. replacing stock options with restricted stock. • Transparency, accounting and auditing • U.S. Accounting is rule based whereas Western Europe uses conceptually based accounting. • Minority shareholder rights • Exhibit 2.9 illustrates minority shareholder responses when dissatisfied with firm performance.
Exhibit 2.9 Potential Responses to Shareholder Dissatisfaction
