WEEK 1

Dellaportas et al. (2012)

What Is Corporate Governance?

- The definition of CG is based upon perspectives:

i) Business/management perspective: Emphasis on boards as per the best-

practice governance codes (The ASX CG Council’s ‘Corporate Governance
Principles and Recommendations’):
 What they do
 How they are composed
 Their effectiveness in achieving company goals
ii) Investor/Finance perspective: Emphasis on the relations between the
company and its shareholders, includes:
 Specifying what rights shareholders have
 Protection against takeover bids
 Making shareholder value the central objective in CG.
iii) Legal/Professional perspective: Focus on company and securities law as the
primary CG issue.
iv) Accounting/Financial Literature perspective: Focus on how companies are
held accountable to outside stakeholders through external publications (eg.
Annual reports).

- Corporate Governance: Encompasses the direction, control mechanisms, procedures

and relationships involved in the economic, legal and operational performance of a
corporation; ‘The system by which companies are directed and controlled (Cadbury
1992)’.
Corporate Governance vs Corporate Management
- Corporate Management: Business functions such as marketing, human resource
management and financial management.
- Corporate Governance: The control and direction of managers.

Company Structure
- Incorporation: Creation of the separate legal entity (property/assets belong to the
company and not its shareholders).
- Board of Directors (and officers): Manage the assets of the company and the daily
management performance of senior management (eg. CEOs).
- Directors: Enters into contracts for and on behalf of the company (can be liable).
- Shareholders have the power to remove a company’s directors at the AGM, however
are unable to otherwise interfere with management powers of the board.
 - Corporations Act 2001: Legislation governing the incorporation and registration of
Australian companies:

 Proprietary Companies: Those that cannot openly raise funds from the
public (majority).
 Public Companies: Stock Exchange listed companies (Minority – 2%,
however account for large impact on GDP due to consuming the majority
of equity/institutional investment funding).

Importance of Corporate Governance

- Effective CG ensures good decision making, and involves:
 Hiring the right managers
 Motivating them through reward systems
 Giving them sufficient freedom and system of checks to stop power abuse

Examples Bad Governance Good Governance

Board’s Control Function
Shareholder Activism
Executive Opportunism
Boards rubber stamping
proposals put forward by
executives.
Owners not showing up to
shareholder meetings.
Executives of banks bailed out of
trouble by governments live well
from cashing in their share
options in time.
Others act in time and replace the
CEO or veto dubious acquisitions.
Others actively seeking to
influence the direction of
companies through dialogue or
board representation.
Executives who invest in their
companies and align their future
with the shareholders experience
the same fate.

- CG acts more as a preventative measure/plan for the event in which things go

wrong, so it is largely intangible (benefits not seen in normal times).
- Increase in savings (from Super) due to ageing population has increased the
emphasis on effective CG, as it has opened up avenues for issues such as
misleading/fraudulent managers taking advantage of the vulnerable elderly.

Agency Theory and the Owner/Manager Problem

- ‘Agency Problem’: Arises from the separation between ownership and management
that occurs with incorporation.
- ‘Agency Theory’: Describes the potential opportunistic behaviour of agents
(managers) that have the capability to transfer wealth from the owners
(shareholders) to themselves.
- Assumptions of Agency Theory include:

i) Separation  Between principal and agent

 ii) Conflicting interests (selfishness)  Principal and agent have their own
utility functions.
iii) Rationality  Principal and agent are rational and rationally further their
own interests.
iv) Asymmetric Information  Agents are better informed about their own
abilities/activities and what is going on in the firm than the principles.
v) Uncertainty (Risk)  Existence of ‘other (unforeseen) factors’. There is no
one-to-one relationship between the activities of the agent and the
outcome.
vi) Risk Aversion  Performance pay will usually involve risk for the agent
(either over-pay or under-pay), and the risk averse will demand
compensation for this (risk averse agents will only want to work for fixed
pay). The risk will then be carried by principles who get a variable profit,
while their employees receive a fixed salary. The principal therefore aims
to find an optimal contract such that agents maximise their utility.

- If professional managers ae not compensated adequately, they may have little

incentive to engage the company in activities that increase shareholder wealth  In
these circumstances, they tend to spend company money on things that benefit
them without scrutinising the costs.
- As a result of separation of ownership, specialisation of resources occurs such that:
i) Principal/owner/investor  Supplier of finance
ii) Agent/manager  Supplier of human capital (management skills)

Examples of Agency Problems

i) Embezzlement: (Stealing) includes misappropriation of shareholder funds, such
as theft and fraud. An example includes ‘self-dealing’ – managers using company
money for personal gain.
ii) Excess Expenditure: Expenditure incurred that is not for legitimate business – a
form of ‘self-dealing’ (can be a grey area).
iii) Empire Building: Managers like to build their own empires since they prefer to
lead a growth company and one of large size  higher pay and protection from
mergers and acquisitions. However, shareholders are often not phased by
mergers and acquisitions since they often fail to create value for the acquiring
company. Another example is over-investment (eg. OneTel oil prices).
iv) Entrenchment: Where managers create barriers which make it difficult for them
to be fired, and consequently stay for too long, often at the expense of
shareholder value.
v) Shareholder Value: A term created by Alfred Rappaport (1986) and Jensen (1993)
– not covering cost of capital is an example of losing money for shareholders (eg.
GM losing $100 billion in the 1980s  sustained loss must be attributed to
agency problems and not just bad luck.
The Extended agency Problem
- There are various stakeholders who create additional pressures on companies,
making the agency problem more complicated:

i) Board of Directors: A group of people are elected to the board (by the owners) to
sanction major decisions and monitor manager performance (occurs in most
major organisations).
ii) Suppliers of Credit: Businesses that companies do business with can influence
corporate governance  Eg. Banks when companies request refinance can issue
debt covenants (what the firm should/shouldn’t do), sanction investment
projects and make demands on the composition of the board.
iii) Suppliers of Labour: Employees, as owners or investors, may sometimes be
entitled to elect board members and can influence strategic direction of the
company, particularly where unions are present.
iv) Raw Input Suppliers: Suppliers can play a role in CG as owners of firms  Eg. In
cooperatives where farmers jointly own the slaughterhouses/dairies to which
they sell their product.
v) Customers and Competition: Customers can influence CG through competition 
In competitive markets, the job of ‘controlling managers’ is essentially taken over
by the competition as managers have to work to stay ahead of their competition.
Shareholders can then base the performance of their CEO with others similarly
situated in the competitive market.
vi) Government: Can impose regulatory systems and increased disclosure
requirements  Making rules that influence the way companies operate. Can
also play a direct role as owners of business enterprises.
vii) Media: Media shapes public awareness and concern for certain issues, which has
an impact on CG since managers and shareholders fear negative public exposure.
viii) External Stakeholders: These parties provide information to shareholders and
other stakeholders, such as auditors, analysts, stock exchanges and lawyers.
Types of Agency Problems
i) Type 1 Agency Problems: Arise between shareholders (principle) and managers
(agent), as a result of the managers not always acting in the interests of the
shareholders.
Managers and the firm are responsible to the controlling owners.
ii) Type 2 Agency Problems: Arise between majority and minority investors if there
are conflicts of interest between the two shareholder groups. The family
(majority) in charge acts as agent on behalf of its investors, and the minority
investors are the principals.
Similarly, the objectives of different institutional investors (eg. Banks and
insurance companies) might differ in nature and duration (eg. Pension vs hedge
fund).
Responsibility is extended to all shareholders (not just controlling ones).
 iii) Type 3 Agency Problems: Arise between shareholders and stakeholders 
shareholders make self-interested decisions which influence the welfare of
stakeholders. For example, if shareholders decide to close a factory, the welfare
of employees, suppliers, local government and customers may be harmed.
Responsibility is extended to cover all stakeholders (including shareholders).
INFORMATION ASSYMETRY
- A situation where one party in transaction has superior information over the other
(eg. Seller know more than the buyer).
- Information asymmetry is typically a cause of inefficient markets since not all
information is available to all parties in the decision-making process.
- The two most common forms include:

i) Adverse Selection: (As defined by George Akerlof)

- Arises from hidden knowledge, where an element in the situation is known to the
agent but not the principal (such as the true capability/value of a new manager).
- Proper screening/monitoring of new applicants, as well as incentive-based payment
schemes, can be solutions.
- Adverse selection can also occur in firms that go public through IPO. Firms may go
public to raise new capital, cash out or sell out if business is bas  Difficult for the
investor to determine the true reason.
- Adverse selection can also occur with banking in relation to credit quality  Difficult
for lenders to distinguish between good and bad loans, as the lendee may be using
the money for other purposes (ie. gambling). Banks charge a risk premium for this
reason.

ii) Moral Hazard:

- A situation where a party (agent) tends to take undue risks because someone else
(principal) will bear the costs of failure (term originated from insurance literature).
- As shareholders, it is difficult to see what managers are actually doing, that is, the
agent’s actions are hidden from the principal, and the principle will suffer from
manager inadequacy (the moral hazard)/
- Insurance companies tried to get around this by charging an excess, to spread some
of the liability. Likewise, managers can be incentivised through a performance-based
reward scheme, as they risk lower pay if they underperform.
EXTENDING AGENCY THEORY
Psychology – Explaining the deviation from rationality
i) Cognitive Biases:
- Confirmation Bias: Decision -makers look for information which confirms their own
ideas and past decisions (Wason, 1968)
- Entrapment Bias: Aversion to admitting mistake (strengthens confirmation bias).
- Small Sample Bias: Decision-makers will often make decisions based on small
samples (1-2 observations). Related to Base Rate Bias (underestimating/ignoring
statistical information) and Visibility Bias (putting more stock in data highly visible to
them – such as past experience).
- Illusory Patterns and Correlations Biases: Decision-makers see patterns even when
there are none  Can reinforce superstitions, leading to ‘superstitious learning’
(Skinner, 1938).
- Fundamental Attribution Error: People tend to see their own failures as a result of
bad luck or external causes, while attributing success to their performance/ability.
- Anchoring Bias: Using reference points when assessing situations  Human
judgement/decisions will depend on how decisions/propositions are framed by
skilful managers to the board/shareholders for example (Framing Bias).
- Emotional Stress: Can lead to decision-making that is even more biased in times of
crisis  ‘fight or flight’ mentality may make decision-makers aggressive when their
position is threatened and act in denial.
- Hindsight Bias: Successful decisions that seem obvious after a decision is made (the
manager ought to have known better).

ii) Personality Biases:

- People/leaders differ in terms of extroversion/introversion,
agreeableness/criticalness, stability/neuroticism etc.
- The expectation is that leaders are extroverted, emotionally stable, conscientious
and open (Judge et al., 2002).
- However, great leaders can also be introverted and subordinate their own
personality to organisational goals (Collins. 2001)
- Negative personality orientations that are easily recognisable from CG cases include:
a) Exploitative/sadistic characters (manipulative)
b) Hoarding characters (protect what they have/resistant to change)
c) Marketing characters (concerned with image and derive success from admiration)
d) Receptive/Masochistic characters (self-effacing and loyal, though pass responsibility
to others)
e) Authoritarian characters (dominating, intolerant to deviations).

iii) Group Psychology:

- Relevant since boards are essentially small groups and subject to group-think.
- It is important that the psychological characteristics of board members complement
each other, though members may vary in how they contribute, such as:
 Completer (meeting schedules)
 Planter/introducer of ideas
 Implementer
 - Group-think: Defending/rationalising the group’s own decisions, brushing away
criticism from radicals and thereby preserving an image of moral superiority which
pressures members to conformity and supressing disagreements.
- Organisations with a long successful history and a strong leader are most at risk 
denotes how an individual’s attitudes yield to the consensus of the group.
Social Networks
- Social network theory in CG refers to a set of agents (firms, board members, owners)
connected by a set of ties (ownership, board interlocks).
- Network theory states that network structure determines behaviour and
performance rather than individual attributes, however, does not rule out individual
influence on behaviour (complements individualistic agency models).
- Often leads to uniformity, which can lead to group-think  can be mitigated by
introducing more diversity to the team.
Law
- A set of enforceable rules for society, crucial to governance  Eg. Contract Law to
uphold agreed commitments to third parties, and Securities Law is necessary to
establish and reinforce investor confidence.
- There are however costs to over-regulation, which makes firms more bureaucratic
and risk-averse, thereby lowering innovation and company performance.
Stakeholder Prominence
- Stakeholder theory emphasises how a company is part of the social system in which
it recognises a variety of internal and external groups of importance to the company
in addition to shareholders.
- Internal stakeholders: Employees, customers and resource providers.
- External stakeholders: Government bodies, trade unions, customers, general public.
- Effective CG means that all stakeholders be considered (particularly employees and
customers who are the most essential internal/external stakeholders).
- Hill and Jones (1992) proposed the idea of ‘stakeholder-agency theory’, which aims
to make managers accountable to shareholders and stakeholders.
CORPORATE GOVERNANCE AND THE GFC
- Largely caused by poor CG (Kirkpatrick, 2009).
- Poor incentive systems such as short-terms bonuses which induced managers
(bankers) to take risks  Boards should have been more cautious/competent,
however were likely also insufficiently informed.
- Solutions include:
i) Extending bonuses to longer periods of time (3-5 years instead of quarterly).
ii) Risk-adjust management compensation (dependent on spreads which reveal
the market’s risk assessment.
iii) Rely more on share ownership than stocks since they are less sensitive to
downside risk.
1.2 SHAREHOLDERS AND STAKEHOLDERS - Mallin (2016)

- Stakeholder refers to any individual or group on which the activities of the company
have an impact.
- Shareholder refers to an individual, institution, firm or other entity that owns shares
in a company, whose rights are generally protected by law.
- Shareholders have a vested interest ensuring resource are used to maximum effect,
which would benefit them (through returns) and society in general.
Stakeholder Groups
- These may be directly or indirectly related to the company, and include the
following:
Employees
- Currently, employees are concerned with pay and working conditions, and how the
company’s strategy will impact these.
- Going forward, employees are concerned with the long-term growth and prosperity
of the company (employees may also buy shares for future earning potential).
- In return, companies need to work along with employee trade unions who act as
conduits for employee views, and comply with employee legislation relating to equal
opportunity, WHS, etc (company should also facilitate whistle-blowing initiatives).
Providers of Credit
- Includes banks and other financial institutions
- They want to be confident that the company they lend to will repay their debt 
Will access management accounts and annual reports to determine this and
continue lending if confident in the company.
Suppliers
- Having supplied the company with goods/services, they want to be sure that they
are remunerated in a timely manner, particularly as some suppliers provide
specialised goods for companies and are reliant on it to be paid.
- They are also interested in the company as they wish to continue supplying to them
such that they have a sustainable outlet for their goods/services.
Customers
- Customers want to be assured that they can repeatedly buy from the company 
Sometimes it is necessary for a product made by the customer.
- Company wants to retain customers through marketing activities.
- Customers also increasingly want to be assured the company acts ethically and
considers social and environment factors in its operations.
Local Communities
- Companies will be employing large numbers of people from the local community.
 - In the event of the company’s wealth declining, unemployment may rise, forcing
skilled labour away from the community  Flow on effect on schools and housing
markets.
- Concerned about environmental impacts of the company as it may impact quality of
life and sustainability of natural resources in the community.
Environmental Groups
- These groups will assure that companies operate according to national and
international environmental standards, which can also be profitable for the company
in the long run.
- More specifically, this includes not polluting the environment and using recyclable
materials where possible.
Government
- Responsibility to assure company is behaving in socially, ethically and
environmentally friendly ways.
- Government will analyse corporate trends for purposes such as employment levels,
monetary/fiscal policy and market supply/demand for commodities.
- Will also monitor taxation raised from the company.
Guidance on Shareholders’ and Stakeholders’ Interests
- Revolves around how the CG system can accommodate the interests of these parties
in a company.
OECD
- OECD (1998) report on CG: Improving Competitiveness and Access to Capital in
Global Markets  Recognises that the company’s central mission is long term
enhancement of shareholder value, but since companies operate in the larger
society, non-financial objectives must too be met.
- OECD Principals of Corporate Governance (1999): The rights of stakeholders should
be recognised by law or mutual agreement, and companies should engage with its
stakeholders in creating wealth, jobs and the sustainability of the enterprise.
Royal Security of Arts (RSA) and Tomorrow’s Company
- The RSA is a UK multidisciplinary independent body. Their ‘Tomorrow’s Company
Report (2005) recognised that interdependence exists between employees,
investors, suppliers and customers  Businesses need to take a long term view and
not a short-term one on increasing shareholder value.
Hampel (UK 1998)
- The Hampel Report reflected the idea that whilst management should develop
relationships with its stakeholders, it should too have regard to the overall objective
of the company (preserve and enhance shareholder value over time.
EU Action Plan 2012: European Company Law and CG
- The EU Commission believes that employees’ interest in the sustainability of their
company is an element that ought to be considered in the design of any well-
functioning governance framework  Can be through employee information,
consultation and participation in the board.
Companies Act 2006
- Directors’ duties (‘Enlightened shareholder value): CLR proposed that the basic goal
for directors should be the success of the company for the benefit of its members as
a whole.
- Directors need to take a properly balanced view of the implication of decisions over
time and foster effective relationships with employees, customers, suppliers and the
community.
- Directors’ report must contain a ‘business review’ component which assesses the
company’s development in stablishing relationships with its stakeholders and
shareholders using KPI’s.
King Report (2002, 2009)
- Devised in South Africa: States that there should be an integrated approach to CG
that takes into account the various stakeholder groups, where the company should
define its purpose, values and stakeholders when developing strategies for achieving
corporate objectives.
Roles of Shareholders and Stakeholders
- Will depend largely on national laws/customs, as well as the individual company.
- It is common for shareholder interests to be prioritised, however it is fundamental
that stakeholder interests cannot be ignored.
- However, as companies all operate in the wider society, the interests of shareholders
and stakeholders are often intertwined, and shareholders are often drawn from
stakeholder groups (eg. Pension fund stakeholders whose assets are drawn from half
the workforce and invested to provide retirement income).