Tutorial Sheet 9

CORPORATE GOVERNANCE
Discussion questions
1. What is corporate governance? Why is governance necessary to control
managers’ decisions?
Corporate governance describes the activities and decisions that are made to describe
how companies operate and develop their infrastructure and framework for
competition within their markets.

It is necessary to control managers' decisions because effective corporate governance

creates alignment between the decisions taken by the managers and the interests of the
shareholders of the firm.

2. What is meant by the statement that ownership is separated from managerial

control in the corporation? Why does this separation exist?
This means that the stock or shareholders are separated from the day-to-day
operations of the business.

The above-mentioned separation typically exists in large corporations to allow

shareholders to purchase stocks and invest in companies without being involved in
any managerial decision making. It also allows managers to make effective decisions
without having to purchase any shares in the company.

The main reason for the separation between the ownership and the managerial control
in the corporation exists so that the individual interests and benefits do not influence
the decision of the managers. This is to ensure that the decisions made are in the best
interest of the organization and not biased towards anything
else.

3. What is an agency relationship? What is managerial opportunism? What

assumptions do owners of corporations make about managers as agents?
An agency relationship is one in which a specialist is hired to perform the act of
making decisions in a particular area of interest concerned with the organization.

Managerial opportunism is when self-seeking individuals act in their own personal

best interests versus that of the company's best interests.

Shareholders and owners of corporations assume that the majority of managers will
not take part in the opportunism, but that it may and will occur and certain checks and
balances have to be in place to keep an eye from time to time.

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 4. How is each of the three internal governance mechanisms— ownership
concentration, boards of directors, and executive compensation—used to align
the interests of managerial agents with those of the firm’s owners?
Ownership concentration is typically described as the grouping of large-block
shareholders of a particular company. They can be individual shareholders or
institutional shareholders like mutual fund or pension fund owners. Since this can be
quite a demanding role it has shifted from the individual to the larger institutional
type. This shift to the larger institutional type allows for tighter managerial control
and governance versus the scattered individual type of shareholder. The larger
institutions tend to have a larger amount of wealth as well, which in turn delegates
more power and control in the decision-making process.

These large groups can also have more power in the disciplining of bad managers.
The boards of directors consist of elected individuals that are put in place to manage
the owner's best interests and monitor the actions of the top-level managers. Since
these are individuals who do not work directly in management at the particular
company they can make and control decisions without peer pressure or opportunistic
issues. The board of directors’ groups are undergoing changes to further enhance their
effectiveness. The changes include further diversity in backgrounds, better accounting
systems, formalizing board evaluation processes, modifying salaries, and having ·lead
director· roles.

Executive compensation attempts to align managerial and owner interests via salary,
bonus programs, and incentives like stocks and other options. This can be particularly
difficult if depending on whether the company is domestic or international as the
interests for profitability of a company can be rather challenging. But overall the more
difficult and customized the position, the higher the pay especially in the United
States, other countries depending on culture and level of government control rate at
lower scales.

5. Discuss how can corporate governance foster ethical strategic decisions and
behaviours on the part of managers as agents?
Internal and external governance mechanisms are used to influence the top-level
managers into making the most ethical decisions for all shareholders and stakeholders.
The board of directors can take actions against any unethical behaviours as well as set
boundaries for the company as a whole.
Generally, a code of ethics is created that will communicate how the company intends
to do business. This in turn allows them to be held accountable for any infractions as
well.

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 So, the corporate governance fosters ethical decisions and behaviors on the part of
managers as agents.

Corporate governance leads to the managers being aware of the consequences

possible and trying to be as ethical as possible in their decisions and behaviors.

Case Studies
The Agency Problem: Two Infamous Examples
The agency problem occurs when agents do not appropriately represent the best interests of
principals. Principals hire agents to represent their interests and act on their behalf. Agents are
frequently hired to allow businesses to obtain new skill sets that the principals lack or to
accomplish work for the firm's investors.
These employees, from rank-and-file workers up to corporate executives, may all potentially
misrepresent the firm and act in ways described by the principal-agent problem.
The Enron Scandal
One particularly famous example of this problem is that of Enron. Ponzi schemes represent
many of the better-known examples of the agency problem, including Bernie Madoff and
Luis Felipe Perez's scams. In the case of Ponzi schemes, the agency problem can have very
real legal and financial consequences for both perpetrators and investors.
Enron's board of directors, many analysts believe, failed to carry out its regulatory role in the
company and rejected its oversight responsibilities, causing the company to venture into
illegal activity. Company leadership, including boards of directors and the executive team,
does not necessarily have the same interests as shareholders. Investors benefit from the
corporate success and expect executive employees to pursue the best interest of shareholders.
Many companies, however, do not require executives to own shares. Positive company
performance does not always directly benefit executives. Enron directors had a legal
obligation to protect and promote investor interests but had few other incentives to do so. A
lack of alignment between shareholders and directors may be the final cause of Enron's
demise.
Bernie Madoff
Bernie Madoff's name is also almost synonymous with the principal-agent problem. Madoff
created an elaborate sham business that ultimately cost investors nearly $16.5 billion in 2009.
Many small investors lost all their savings in this scandal. Ultimately, Madoff was criminally
charged and convicted for his actions. He is now serving a 150-year prison sentence.
That same year, however, more than 150 Ponzi schemes perpetrated against American
investors also collapsed. Substantial investment wealth was lost in the process.
Agency theory claims that a lack of oversight and incentive alignment greatly contribute to
these problems. Many investors fall into Ponzi schemes, thinking that taking fund
management outside a traditional banking institution reduces fees and saves money.

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 Established banking institutions reduce risk by providing oversight and enforcing legal
practices.
Some Ponzi schemes simply take advantage of consumer suspicions and fears about the
banking industry. These investments create an environment where the consumer cannot
properly ensure that the agent is acting in the principal's best interest. Many examples of the
agency problem occur away from the watchful eye of regulators and are often perpetrated
against investors in situations wherein oversight is limited or completely nonexistent.
Source: https://www.investopedia.com/ask/answers/041315/what-are-some-famous-scandals-
demonstrate-agency-problem.asp

1. Why do you think the internal governance mechanisms did not work in both cases?

2. What role does a board of directors play in preventing such scandals as in these two
cases?

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