Notes

Companies are legal entities made up of an association of members (people or other companies; the responsibilities for all the contracts are to be reconducted in the end to the CEO).

Members share resources (money, instrumental goods, work) to carry out economic activity.

The law and the company's "constitution" define the rights and duties of members, such as how company shares can be sold to others or profits are distributed.

Exist two types of companies:

• Partnerships are used by small business. Partners are personally liable for financial obligations. When business grows, risk may become too large. The biggest potential governance problem is personal conflict among members. It is more trustable, therefore it's easier to receive funds from banks, having employees and deal with suppliers.
• Corporations are legal entities in which owners (shareholders) have limited liability. The company has to be transparent, having a financial statement. Usually large firms, because the legal entity is too costly and complex for small business. Owners do not generally manage the company (directors are in charge).

The managerial component of firms it's mainly composed of Shareholders, Board of Directors and Top Managers.

Crucial is the role of the Board of Directors, composed of both Independent Non Executive Directors (INED) and Connected Non-Executive Directors (CNED), the CEO and a Chairman. Overall, the board's task is to direct the company, this activity can be seen to involve four basic elements:

• Strategy formulation, at a very broad level.
• Policy making, approves relevant proposals by CEO and other executive directors (paying dividends).
• Accountability, must report financial information and corporate activities to shareholders and other stakeholders with legitimate claims to accountability.
• Supervision of managers, collect information and act on it when necessary.

Boards of Directors can be:

• Unitary, when a company has a single governing body, the board is known as a "unitary board", they are supposed to balance between executive directors and non-executive directors.
• Two-Tier, when a company has two governing body: the upper, supervisory board, and the lower, management board or committee. The supervisory board is composed entirely of outside directors and the management board entirely of executive directors. Half of the members of supervisory boards represent the interests of the employees and are appointed through the trades' union organizations. The remaining supervisory board members represent the interest of the shareholders and are appointed by them. In practice, members of the management board attend meetings of the supervisory board, but have no vote. The executive members present their strategies, management plans, and budgets to the supervisory board for comment and approval. The power of supervisory board lies in its ability to appoint to and remove members from the executive board.

Corporate Governance - The evolution of companies At the beginning, the owner is also the manager. Then, the company grows, and owners hire professional managers. The company can also open the doors to outside shareholders (financial investors), who are not interested in controlling the company, but only in participating in profits. A further step for some companies is when they "go public", they get listed in a stock exchange. They float part of capital and commit to transparency requirements.

• Public companies, those that are listed in a stock exchange (irrespective of whether ownership is fragmented or closely held).
• Private companies, those that are non-listed.

Some small companies are listed and many big companies are private (IKEA, Ferrero, Saudi Aramco). In public companies, ownership may be fragmented among many shareholders and managers escape owners' control, because no one has a sufficient percent of shares to appoint the corporate governance, furthermore if the firm is going well.

The separation between ownership and control was first noticed by Berle & Means in 1932. Defined as a situation in which no single owner or group of owners are able to control the company. Anyway, the separation between ownership and control it is not a frequent phenomenon, the majority of family firms have no separation of ownership and control (owners are managers or keep managers under control). Concentrated ownership is possible even without families (state-owned enterprises, ENEL/ENI). However, in all corporations, the board of directors is where all big decisions are approved.

The corporate governance "is the framework by which the relationships among management, board of directors, controlling shareholders, minority shareholders and other stakeholders are balanced", therefore can be defined according to different perspectives:

• Operational perspective, "the system by which companies are directed and controlled", and further explained that boards of directors are responsible for the governance of their companies, while the shareholders' role in governance is to appoint the auditors, and you satisfy themselves that an appropriate governance structure is in place.
• Relationship perspective, "the corporate governance structure specifies the distribution of rights and responsibilities among the different participants in the organization - such as the board, managers, shareholders, and other stakeholder -- and lays down the rules and procedures for decision making.
• Stakeholder perspective, "corporate governance is the process by which corporations are made responsive to the rights and wishes of stakeholders".
• Financial economics perspective, "corporate governance deals with the way suppliers of finance assure themselves of getting a return on their investment".
• Societal perspective, "corporate governance is concerned with holding the balance between economic and social goals and between individual and communal goals. The corporate governance framework is there to encourage the efficient use of resources and equally to require accountability for the stewardship of those resources. The aim is to align as nearly as possible as the interests of individuals, corporations and society.

Crucial for corporate governance are the role of Auditors and Audit Committees, now required by all the codes of good practice in corporate governance. For public listed companies, the stock market and their listing rules are, clearly, vitally significant to corporate governance. The rules that govern the stock market on which the company's shares are listed and in particular the requirements laid down for listing are fundamental to the effective governance of listed companies.

In the original model of the corporation, shares were held by individual shareholders who interacted directly with their company. Today, although individual investors do have a significant share in some markets, institutional investors play a very significant part in most. A further complication can arise if the financial institution holding shares lend them as security for other transactions. This situation can make it difficult for companies to know who their voting shareholders are, and for those shareholders to exercise their proxy votes and to take part in the governance of the company.

The disadvantages in huge fragmented listed companies are, for example, the inability of small shareholders to express their opinion in the board, therefore small shareholders tend to walk away (selling shares) when they do not like managers, instead of trying and replace them.

Board of directors collect proxies (please give me the proxy to vote in support of...) from existing shareholders who are not interested in control and propose directors.

The agency theory describes the principal -- agent relationship (transfer of responsibility).

Since corporate governance could be seen as a set of remedies to problems that arise when ownership and control are separated, we can define these problems as Agency Costs (Type I and Type II). The basic agency problem arises because of a separation between decision making, which is carried out by professional managers, and the bearing of residual risk by shareholders; difficulties faced by financiers in ensuring that their funds ae not expropriated or wasted on unattractive projects.

• Type I agency costs, they arise because of conflicts between shareholders and managers (managerial opportunism). They can be seen as the value loss to shareholders arising from the cost of minimizing divergences of interests between company shareholders and corporate managers. They arise because managers enjoy advantages that put them in the position to pursue their own interest instead of the interest of shareholders, like managerial discretion, information asymmetries, a compensation that is never strictly linked to outcomes.
  • The sources of conflict can be
    • Moral Hazard, when someone has incentives to under perform (overcompensation, related-party transaction, insider trading, etc.)
    • Earnings Retention, managers usually prefer growing the firm instead of paying dividends.
    • Time Horizon, managers usually spend a short period of their careers in a firm; therefore they're searching for short-term profits in order to gain success as individual, exchanging the long-term stability and sustainability of the firm.
    • Risk Aversion, usually managers' income is linked to firm's performances, therefore managers may pursue investments and financing policies that minimize the risk of their company's equity.
• Type II agency costs, they arise because of conflicts between majority and minority shareholders. Firms' majority shareholders are the only able to appoint Board of Directors. Consequences of this fact are information asymmetries, because majority shareholders tend to be insiders and to identify with the company. Results are typical forms of opportunism such as related-party transactions, overcompensation and fringe benefits, appropriation of assets.

What can be done to prevent this agency problems, is paid through agency costs:

• Monitoring costs include attempts at improving managerial behaviour, such as auditing, definition of compensation, searching for right managers. (Payed by Principal).
• Bonding costs are payed to guarantee that behaviour is correct such as reporting and procedures. (Payed by Managers).
• Residual Loss includes all damages caused by managers behaviour which haven't been prevented. (Payed by Principal).

Corporate governance duty is to minimize the sum of all these costs.

Agency cost are reduced by corporate governance mechanisms, which depend on a mix of regulation and monitoring of managerial behaviour, reactions by shareholders and other parties to agency costs, interest alignment between managers and shareholders.

The mechanisms able to do so are:

• Board composition, shareholders should assure that non-executive directors monitor managers.
• Concentration of Ownership (blockholding), reduces managerial discretion, but creates risk of type II agency costs.
• Active Ownership, investors who try to use ownership rights to change managers' behaviour. This technique could also be used by speculators to generate short-term profits (Carl Icahn & Apple 500 million $ investment).
• Incentives, connect managerial pay to outcomes (bonuses, stock options, stock grants), to align the interests of managers and shareholders. Disadvantages of this incentives could be excessive risk taking, short-termism and self-dealing.
• Control Mechanisms, internal auditing (including board committees), external auditing, financial markets regulation.
• Reputation, name and shame managers who behave improperly, including codes of conduct (golden rules of management), codes of conduct are voluntary but those who deviate from them must provide an explanation.
• Market for corporate control, the stock price of underperforming companies drops, making easy for other companies or investors to buy them, concentrate ownership and remove inefficient managers.