Corporate Governance and Control

Definitions

•  It deals with the collective action problem among the widely dispersed shareholders in monitoring and controlling the management.
  
•  It deals with the conflict of interests between investors and managers. It is also referred to deal with the principal and agent problem. 

It is generally assumed that the maximization of the shareholders’ wealth is the primary objective of the corporate governance.  Is it an efficient (economic) outcome???

 It is a Pareto efficient – if

·        The ‘firm’ is viewed as a nexus of contracts; more precisely, is viewed as the nexus of complete contracts with creditors, suppliers, clients and employees; and open contracts with shareholders who has claim on the residual returns

·        There are no principal agency problem i.e., the interests of the managers are optimally aligned to the interests of the multiple principals.

If the above two conditions are satisfied, the maximization of shareholders’ wealth is Pareto efficient. But there are some arguments: Managers exclusively working for the shareholders’ wealth maximization may lead to certain inefficiencies:

• Excess risk taking by the managers in the presence of high leverage
• Underinvestment in the case of the debt overhang.

Sound governance mechanism reduces the cost of equity, in a way good corporate governance is in the interests of the firm itself.  Then why do we need external regulation??

• Block holders (institutional investors) may keep the higher bargaining power with them.  Eg. Block holders may go for the anti takeover policies which will not benefit the small or minority shareholders.
• Managers may lobby for the more discriminatory powers.
• To ensure the interests of the all the stakeholders

Why do the investors dispersed so widely?             

• Individuals’ wealth in relation to the investments is small
• Investors may want to diversify their risk by investing their limited wealth in various firms
• Investors’ may concern for the liquidity – a large amount of stock is very harder to sell instantaneously in the secondary market.
• Regulations on individual shareholding

So dispersion is inevitable.         

There are two oversimplified corporate governance mechanisms.

1. Anglo-American Model (market based model) -

Nurtured by USA and UK.

• Accords absolute priority to the shareholders
• Shareholders monitor the performance of the management through market mechanism
• As shareholders are open contract holders and having less contractual protection, the rules are framed to protect them.
•  Short term perspective
• Criticized as it encourages the management to get obsessed with the performance appraisal and pursue short term goals over long term objectives.

2. Long term Large Investor Model (Bank based Model) –

Nurtured and followed mainly by Japan, to some extent by Germany.

• Managements are monitored by the large investors, financial institutions
• Financial institutions do participate in decision making process
• Ensures low cost of capital
• Long term perspective
• Other stakeholders have more protection than shareholders.