Models and practices of corporate governance (Conf. dr.

Voicu Dragomir)
Ownership and
Separation of

Control
 Models and practices of corporate governance (Conf. dr. Voicu Dragomir)
What is corporate governance?
• Corporate governance is the mechanism through which the
providers of capital to companies are assured that they will
receive the remuneration for their investment (Shleifer & Vishny, 1997)
• Consequently, corporate governance refers to the way in which
companies (i.e. the managers) are bound to return the funds
offered by the investors and to attract other funds in a
sustainable manner.
• This narrow definition is characterized as “orthodox” (Tirole, 2006)
and is specific to the area of corporate finance, where the
theory of governance has emerged.
• Corporate governance is a particular case of agency theory, and
the notions which are specific to this theory are to be found in 2
the basic vocabulary of corporate governance literature.
 Models and practices of corporate governance (Conf. dr. Voicu Dragomir)
An overview of relationships
The General Meeting Legal framework
of Shareholders

The corporation

The Board of Directors

Internal audit and

risk management

Banks Suppliers Market Financial Unions and

and other investors audit the public 3
creditors
 Models and practices of corporate governance (Conf. dr. Voicu Dragomir)
The constituents
• The need for corporate governance rests on the idea that when
separation exists between the ownership of a company and its
management, self-interested executives have the opportunity
to take actions that benefit themselves, with shareholders and
stakeholders bearing the cost of these actions.
• At a minimum, a governance system consists of a board of
directors to oversee management and an external auditor to
express an opinion on the reliability of financial statements. In
most cases, however, governance systems are influenced by a
much broader group of constituents, including owners of the
firm, creditors, labor unions, customers, suppliers, investment
analysts, the media, and regulators who all influence
managerial behavior. 4
 Models and practices of corporate governance (Conf. dr. Voicu Dragomir)
The Anglo-Saxon model
• The Anglo-Saxon model is shareholder-centric (meaning that
the primary purpose of the corporation is considered to be
the maximization of shareholder value), with a single board of
directors, management participation on the board
(particularly the CEO), and an emphasis on transparency and
disclosure through audited financial reports.
• The viewpoint that the primary obligation of the organization
is to maximize shareholder value. Actions such as improving
labor conditions, reducing environmental impact, and treating
suppliers fairly are seen as desirable only to the extent that
they are consistent with improving the long-term financial
performance of the firm.
5
 Models and practices of corporate governance (Conf. dr. Voicu Dragomir)
The roles of the shareholders
1. Equity contributions – for those which buy shares directly from
the company, on public offerings;
2. The increase in equity diminishes the cost of borrowing and
improves the debt ratios of the firm;
3. Shareholders can play the role of external monitors, by
sanctioning the performance of managers and demanding
long-term growth;
4. The share valuation mechanism is a consequence of the fact
that shares are freely tradable and that owners have a residual
interest in the firm;
5. The separation of ownership and control can avoid deadlocks
in decision-making and can facilitate overseeing.
6. Shareholders can provide expertize and positive signaling for 6
financial and commodity markets.
 Models and practices of corporate governance (Conf. dr. Voicu Dragomir)
Moral hazard (I)
• In modern corporations, distant and diffuse stockholders
coexist with concentrated management. In this arrangement,
there are several ways in which managers are said to act
against the interests of the providers of capital (e.g. the
shareholders, which are the holders of residual interest and
are the last to be remunerated for their investments):
• Insufficient effort: managers do not involve themselves in
negotiating contracts with firm partners, do not supervise
their employees, do not implement an adequate system of
internal control or simply neglect the daily run of the
company. These managers usually resist to implementing a
restructuring plan, whenever the need arises.
• Extravagant investments: large expenditure on research 7
projects with doubtful outcomes or for acquiring competitors
which prove to add little value to the group as a whole.
 Models and practices of corporate governance (Conf. dr. Voicu Dragomir)
Moral hazard (II)
• Managerial entrenchment: managers tend to invest in projects
which would make them indispensable, manipulate
performance indicators associated with such projects or resist
hostile takeovers which would eventually vacate their position.
Creative accounting is a mechanism which is specific to
managerial entrenchment and which usually hides a worsening
of firm performance. Managers will be extremely appetent or
averse to risk, usually investing in projects which are not viable,
in either direction.
• Personal satisfaction: managers will be interested to maximize
their own advantages related to their position: luxury, self-
promotion, putting friends and relatives in key positions,
selecting commercial partners on friendship criteria, or
financing political parties. These attitudes can become a 8
criminal offence when they recourse to fraud or insider trading.
 Models and practices of corporate governance (Conf. dr. Voicu Dragomir)
Governance dysfunctions (I)
• Managerial behavior is just “the tip of the iceberg” when it
comes to moral hazard. There are also other elements of
dysfunction governance presented below:
• The lack of transparency: investors and other partners are not
properly informed regarding the remuneration level for
management, here including the share options granted to
managers.
• Managerial remuneration: includes basic salaries, bonuses and
variable elements. There is a fundamental discrepancy
between the level of managerial remuneration and the
earnings of other categories of employees. The complexity of
the components of remuneration packages imply the fact that
the long-term effect of certain financial instruments (share
options) is not a matter of certainty. Certain remuneration 9
schemes are set to trigger different types of managerial action.
 Models and practices of corporate governance (Conf. dr. Voicu Dragomir)
Governance dysfunctions (II)
• The defective link between company performance and
managerial remuneration: the remuneration package can be
badly structured, when the variable components (bonuses,
shares and share options) are linked to indicators which are
not under managerial control. In this case, managers can take
advantage and sell their action at a chosen time, just before
the announcement of bad results or knowing in advance the
unfavorable perspectives of the firm.
• Accounting manipulations: the selection of accounting
options and policies is legal, but only when necessary. The
manipulation of accounting numbers using available options is
called “creative accounting”. The complexity of such elements
makes them hard to identify, considering that this usually
takes place with the complicity of external auditors, bankers
10
or brokers. In general, creative accounting is said to produce
effects which are favorable to managers.
 Models and practices of corporate governance (Conf. dr. Voicu Dragomir)
Resources and quiz
• Berle, A. A., & Means, G. C. (1932). The Modern Corporation
and Private Property. New Brunswick: Transaction Publishers,
pp. 3-7.

Quiz
• Berle and Means consider that “a large body of security
holders […] exercise virtually no control over the wealth […]
contributed to the enterprise”. Would you invest in a largely
held corporation? Why or why not?
• Give one example of a firm which is a good investment
prospect, and one which is the opposite. 11