CORPORATE GOVERNANCE

I. Simple definition of Corporation and shareholder A large business or organization that under the law has the rights and duties of an individual and follows a specific purpose One who owns shares of stock

Full definition of Corporation A corporation is a legal entity that is separate and distinct from its owners. Corporations enjoy most of rights and responsibilities that an individual possesses; that is a corporation has the right to enter into contracts, loan and borrow money, sue and be sued, hire employees, own assets and pay taxes. It is often referred to as a legal person

The types of corporations Public Corporations Quasi public corporations Business corporations Non-profit corporations

Public corporations They are formed to implement specific state functions. These corporations refer to the system of State machine, endowed with adequate powers and realize their functions within a defined area of country. Might be funded by principles of self-sufficiency, be profitable or unprofitable Often they are funded by Government National companies (Kegoc, Kazakhtelecom, KTG, etc)

Quasi Public Corporations are formed to coordinate provide and service a significant needs of the public Corporations which supply population with water, electricity, gas etc

Business corporations Are founded to carrying out economic activities and getting profit Represent commercial entity such as joint- stock companies

Non-profit corporations Are founded to carrying out activities including economic activities and not having goal to get a profit These include Health Corporations, Charity Organizations

Types of Corporation C CORPORATION Is a separate legal entity owned by shareholders S CORPORATION Has elected a special tax status with the State tax Department (revenue service) LIMITED LIABILITY CORPORATION Offers an alternative to corporations and partnerships by combining the corporate advantage of pass through taxation

What is a C corporation? Common business slang to distinguish a regular corporation, pays federal and state income taxes on earning. When the earnings are distributed to the shareholders as dividends this income is subject to another round of taxation

What is a S corporation? The S corporation is often more attractive to small-business owners than a standard (or C) corporation, because an S corporation has some appealing tax benefits and still provides business owners with the liability protection of a corporation

What is a LLC? Is the United States specific form of a private limited company. It is a business structure that combines the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation. It is a legal form of a company that provides limited liability to its owners in many jurisdictions

Managerial levels Top manager Middle manager First-line manager Operational employees

II. Definition of corporate Governance Corporate governance is relationship between among shareholders that is used to determine and control the direction and performance of organizations Corporate governance structure combines controls, policies and guidelines that drive the organization toward its objectives while also satisfying shareholders needs

Corporate governance receives a great deal of attention because governance mechanisms sometimes fail to adequately monitor and control top-level managers is not monitored and controlled effectively, this could mean that the firm will not be strategically competitive

Effective corporate governance is also of interest to nations. Governments want firms operating within their countries to grow and provide employment, wealth, and satisfaction. This raises standards of living and enhances social cohesion

Foundation of Effective Governance and Control Governance and control practices directly affect the manner in which management decisions are formulated, debated, ratified and implemented. They also directly affect corporate performance

Companies can build the enterprise successfully by variety of ways: 1.By imposing strict disciplines 2.By minimizing bureaucratic interference and simplifying business processes 3.By empowering executives imbued with shared values 4.By conducting endless searches for best practices 5.By playing serious attention to management selection and incentives

III. The Types of Corporate Governance Mechanisms Internal mechanism External mechanism Independent audit

The Internal Governance Mechanisms Monitor the progress and activities of the organization and take corrective actions when the business goes off track. Include: oversight of management, independent internal audits, structure of the board of directors into levels of responsibility, segregation of control and policy development

The Internal governance mechanisms 1.Ownership concentration, as represented by types of shareholders and their different incentives to monitor managers 2.The board of directors 3.Executive compensation

The external governance mechanism Are controlled by those outside an organization and serve the objectives of entities such as regulators, governments, trade unions and financial institutions External organizations such as industry associations, may suggest guidelines for best practices, and businesses can choose to follow these guidelines or ignore them

The independent audit An audit of the companys financial statements serves internal and external stakeholders at the same time. An audited financial statement and the accompanying auditors report helps investors, employees, shareholders and regulators determine the financial performance of the corporation.

Separation of ownership and managerial control The growth of the large, modern public corporation is based primarily on the efficient separation of ownership and managerial control

The Critical Issues for family- controlled firms Owner-managers may not have access to all of the skills needed to effectively manage the growing firm and maximize its returns for the family. Thus, they may need outsiders to help improve management of the firm. Owners-managers may need to seek outside capital and thus give up some of the ownership control

IV. Corporate Governance in Merges and Takeovers

Merges and Acquisitions 1+1=3 The key principle is to create shareholder value over and above that of the sum of the two companies. Two companies together are more valuable than two separate companies Strong companies will act to buy other companies to create a more competitive, cost- efficient company. Because of these potential benefits, target companies will often agree to be purchased when they know they cant survive along

Distinction between Mergers and Acquisitions Although they are used as synonymous, the terms M&A mean slightly different things. When one company takes over another and clearly established itself as the new owner, the purchase is called an acquisition.

Distinction between Mergers and Acquisitions A merger happens when two firms, often of about the same size, agree to go forward as a single new company rather than remain separately owned and operated For example, both Daimler-Benz and Chrysler ceased to exist when the two forms merged and a new company, DaimlerChrysler, was created

A purchase deal will often be called a merger when both CEOs agree than joining together is in the best interest of both of their companies. But when the deal is unfriendly – when the target company doesnt want to be purchased – it is always regarded as an acquisition

Synergy Is the magic force that allows for enhanced cost efficiencies of the new business. Synergy takes the form of revenue enhancement and cost saving

Synergy has following benefits: Staff reductions – mergers tend to mean job losses. Consider all the money saved from reducing the number of staff members from different departments Economies of scale – mergers also translate into improved purchasing power to buy equipment and office supplies – when placing larger orders, companies have a greater ability to negotiate prices with their suppliers

Acquiring new technology – to stay competitive, companies need to stay on top of technological developments and their business applications. By buying a smaller company with unique technologies, a large company can maintain or develop a competitive edge Improved market reach and industry visibility – companies buy companies to reach new markets and grow revenues and earnings. A merge may expand two companies marketing and distribution giving them new sales opportunities

Varieties of Mergers Mergers Horizontal Market- extension Conglome- ration Product extension Vertical

Vertical mergers – a customer and company or a supplier and company. A cone supplier merging and an ice cream maker. Horizontal merger – two companies that are in direct competition and share the same product lines and markets Market extension merger – two companies that sell the same products in different markets

Product extension merger – two companies selling different but related products in the same market Conglomeration – two companies that have no common business areas

All mergers and acquisitions have one common goal: they are all meant to create synergy that makes the value of the combined companies greater than the sum of the two parts. The success of a merger or acquisition depends on whether this synergy is achieved

with the active market for corporate control, shareholders of poorly governed companies can Sell their shares Lowering share prices in market Incentive for outsiders to accumulate control rights Replace the incumbents Restructure the firm

Good governance after M&A Human rights Labor conditions Environment Anti- corruption

V. CONFLICT OF INTEREST AND THE AGENCY PROBLEM

The Agency Relationship Is relationship between business owners (principals) and decision-making specialists (agents) herd to manage the principals operations and maximize their returns on investments

Conflict of Interest Is a situation in which a corporation or person with a vested interest in a company becomes unreliable because of the clash between personal interests and professional interests

A conflict of interest arises when a person chooses personal gain over the duties to an organization in which he is a stakeholder

Common Conflicts of Interest Conflict of interest Self- dealing Nepotism Gift issuance

Self-dealing Occurs when a management-level professional accepts a transaction from another organization that benefits the manager and harms the company

Gift Issuance Occurs when a corporate manager or officer accepts a gift from the client or similar type of person. Companies normally circumvent this issue by prohibiting gifts from clients

Nepotism Arises when confidential information is collected by a company. Any information of this type used for personal gain by an employee is a huge conflict of interest. Finally the hiring or a relative or spouse can result in a potential conflict of interest

The Agency Problem An agency relationship occurs when a principal hires an agent to perform some duty. A conflict, known as an agency problem arises when there is a conflict to interest between the needs of the principal and the needs of the agent

The Managerial Opportunism Seeking self-interest with guile Company managers enjoy a high degree of knowledge about the business activities they supervise. This creates a conflict of interest, with self-serving managers making decisions that benefit them rather than the company owners or shareholders. When managers use employer information for personal gain, the event is considered a case of managerial opportunism

Two Primary Agency Relationships Managers and stockholder Managers and creditors

Some examples of Agency Relationship Executive Shareholder Client Consultant Insurer Insured Employee Manager

Stockholders vs Managers If the manager owns less than 100% of the firms common stock, a potential agency problem exists Managers may make decisions that conflict with the best interests of the shareholders For example, managers may grow their firms to escape a takeover attempt to increase their own job security. However, a takeover may be in the shareholders best interest

Stockholders vs Creditors Creditors decide to loan money to a corporation based on the riskiness of the company, its capital structure and its potential structure. All of these factors will affect the companies potential cash flow, which is a creditors main concern Since Stockholders will make decisions based on their best interests, a potential agency problem exists between the stockholders and creditors For example, managers could borrow money to repurchase shares to lower the corporations share base and increase shareholder return. Stockholders will benefit, however, creditors will be concerned given the increase in debt that would affect future cash flows

VI. The Knowledge problem

Knowledge is extremely valuable in seeing opportunity and making related strategic and operational decisions. It comes in two forms: general knowledge and specific knowledge

General Knowledge Can be aggregated and communicated easily Prices, wages, quantities, product costs, industry grows rates, the profitability of a business

Specific Knowledge Is on-the-spot, idiosyncratic knowledge – of machines, customers, particular organizations, the competitive dynamics of distinct markets. Such knowledge can result in the design and manufacture of superior products, the development of highly productive work systems, or the reduction of risk. These knowledge can create the competitive and financial advantages for firms

Unfortunately, the ability of individual managers to access, analyze and absorb specific knowledge is quite limited. They lose many of the advantages and often relying on automatic decisions rules.

Skilled Incompetence Another knowledge barrier which means by inability of successful managers to learn how to learn from failure. Having spent much of their lives mastering a broad range of skills and applying them successfully in the real world, they rarely experience failure and therefore do not know how to learn from it

VII. Solution to the Agency and Knowledge Problems

Governance and Control Systems have three key components A system for allocating decisions rights among individuals A performance measurement and evaluation system for those holding decision rights A reward and punishment system

Allocating Decisions Rights

Motivating Managers to act in Shareholders Best Interests Managerial compensation Threat of takeovers Threat of firing Direct intervention by stockholders

Managerial Compensation Managerial compensation should be constructed not only to retain competent managers, but to align managers interests with those of shareholders as much as possible

Managerial Compensation 1. This is typically done with an annual salary + performance bonuses + company shares 2. Company shares are typically distributed to managers either as: performance shares, where managers will receive a certain number shares based on the companys performance Executive stock options, which allow the manager to purchase shares at a future date and price. With the use of stock potions, managers are aligned closer to the interest of stockholders as they themselves will be stockholders

Direct intervention by stockholders Today, the majority of a companys stock is owned by large institutional investors, such as mutual funds and pensions. As such, these large institutional stockholders can exert influence on managers and, as a result the firms operation

Threat of Firing If stockholders are unhappy with current management, they can encourage the existing board of directors to change the existing management, or stockholders may re-elect a new board of directors that will accomplish the task

Threat of Takeovers If a stock price declines because of managements inability to run the company effectively, competitors or stockholders may take a controlling interest in the company and bring in their own managers