The Modern Corporation and Corporate Governance: An Overview

1. The Modern Corporation and Corporate Governance: An Overview Professor Alexander Settles Faculty of Management, State University – Higher School of Economics Email: asettles@hse.ru

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 31.03 - 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 asettles@hse.ru • 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 thecompanies` ressources • The interests of the various securityholders differ • Separation of owership and control implies agency relationships. • Interests of agents (management) are different from those ofsecurityholders, particulary from those of stockholders. • Monitoring the activities of agents is costly - hence, full monitoringis not optimal. • The value forgone due to imperfect optimal monitoring is an explicitagency 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. 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 More detailed list

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

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