FB5690 Corporate Governance

Prof. Yangyang Chen

Office: LAU 13-202
Phone: 3442 8725
Email: [email protected]
Expected outcomes
• Theoretical framework and literatures in corporate governance
• Local or international issues in corporate governance
• Industry experience sharing related to any topic in corporate
governance
• Leadership skill, communication skill, and presentation skill
• Innovation and critical thinking
• Great networking opportunities
Class Rundown
• Topics of Corporate Governance: concepts, frameworks,
theories, literatures

• Case Analyses and Group Discussion: different groups with

different leaders, randomly for each class; less than 30 minutes
group discussion for each case

• Group Presentation: less than 10 minutes presentation by each

group
 Assessment Criteria
 Participation (15%)
 Attendance (5%)
 Case discussion and presentation (10%)
 Mid-term examination (40%): Nov. 30, 2021; content of Class 1 to Class 5
 Group project and presentation (45%)
 3-5 students per group
 Project (30%) : Written report submitted by Dec 31, 2021
 Presentation (15%): Every team member should participate
 Requirement:
• Select a listed company for analysis;
• Identify strengths and weaknesses in corporate governance of the company and discuss
related ethical issues;
• Suggest ways to strengthen corporate governance.
Class Schedule
Lecture Date Topic
1 Nov 9 Introduction to corporate governance
2 Nov 12 Executives: Incentives and compensation
3 Nov 16 Directors: Duties and effectiveness
4 Nov 19 Governance role of shareholders
5 Nov 23 Financial reporting and external audit
6 Nov 26 The market for corporate control and securities
regulation
7 Nov 30 Mid-term examination
8 Dec 3 Stakeholder theory and corporate governance
9 Dec 7 Governance issues in mainland
10 Dec 10 Governance issues in Hong Kong
11 Dec 14 Student presentation
12 Dec 17 Student presentation
 Lecture One

Introduction to
Corporate Governance
HealthSouth Corp.
 Accused
of overstating earnings by at least $1.4 billion between 1999 and 2002 to
meet analyst targets.

 CEO paid a salary of $4.0 million, cash bonus of $6.5 million, and granted 1.2
million stock options during fiscal 2001.

 Former CFO and others pleaded guilty to a scheme of artificially inflating financial
results.

 CEOsold 2.5 million shares just weeks before the firm revealed that regulatory
changes would hurt earnings, battering its stock price.
HealthSouth Corp.
 What was the board of directors doing?
• Compensation committee met only once during 2001.

 What was the external auditor (E&Y) doing?

• Audit committee met only once during 2001.
• President and CFO were previously auditors for E&Y.
• Audit fee = $1.2 million

 What were the analysts doing?

• UBS analyst had a “strong buy” on HealthSouth.
This Is Not an Isolated Incident
U.S. Companies Non-U.S. Companies
 AIG  Ahold
 Adelphia  Parmalat
 Bear Stearns  Royal Dutch/Shell
 Enron  Satyam
 Global Crossing  Seimens
 Lehman Brothers etc…
 Tyco U.S. and Non-U.S.
 WorldCom companies are equally
likely to have to
 etc… restate earnings
The Root of the Problem
“Self-Interested” Executives

 The owners of the company are separate from the management of the company.

 Agency problem: management takes self-interested actions that are not in the interest of
shareholders.

 Agency costs: shareholders bear the cost of these actions.

To meet Wall Street estimates:

 80% of CFOs would reduce discretionary spending
 60% would delay investment in a valuable new project
 40% would accelerate recognition of revenue
 40% would provide incentives to customers to buy early
Examples of Agency Costs
 Insufficient time and effort on building shareholder value
 Inflated compensation
 Overstated financial results to increase bonus or stock price
 Excessive risk taking to increase short-term results and bonus
 Failure to groom successors
 Uneconomic acquisitions to “grow the empire”
Business Organizations
• Sole proprietorship: one owner, unlimited liability,
(e.g., restaurant)

• Partnership: more than one owner but less than a

limited number (e.g., <20), unlimited or limited
liability (e.g., auditing firms, law firms)

• Corporation: numerous owners, limited liability,

(e.g., IBM, HSBC, APPLE)
Corporations: the dominant form of business today
--In the U.S., they account for about 90% of total
business revenues.
 Modern Corporation: some characteristics
• Limited liabilities: a company’s liabilities are not its shareholders’ liabilities; the
maximum loss a shareholder bear is the capital he or she contributed to the
corporation

• Transferability of interest: an investor can freely transfer his or her shares; stock
trading

• Legal personality: perpetual life, sue or be sued

 Modern Corporation
• Separation of ownership and control (the root of agency problem):
• ownership is dispersed
• shareholders: not directly participate in management
• board of directors: determine the overall direction
• Executives, who own little stake, control the companies
 Shareholders
Shareholders

Board of
Directors

CEO

Operations Legal Risk Finance Treasury Purchasing Human Marketing

Management Suppliers Resources Sales
Alliances
 Agency Theory
• Jensen and Meckling (1976)

• Human beings are selfish and their objectives are to maximize their own
interest

• Principal-agent relationship (agency relationship) : a contract under which

one or more persons (the principal) engage another person (the agent) to
perform some service on their behalf which involves delegating some
decision making authority to the agent.
 Agency Theory
• Problem: The principal expects the agent to work to maximize the principal’s
welfare but the agent may take self-dealing actions, i.e., actions to increase her
own interest but hurt the principal’s interest.
• Stockholders: the principal
• Executives: the agent
• Stockholders’ objective: maximize value of shares

• Adam Smith, the Wealth of Nations (1776) :

Being the managers of other people’s money rather than of their own, it cannot
well be expected that they should watch over it with the same anxious vigilance
with which the partners in a private copartnery frequently watch over their own.
 Agency Theory
• Executives self-interest actions
Over pay themselves
Shirk (i.e., not work hard)
Consume excess perks
Build empires
Entrench (i.e., try to keep their own positions although they know they are
not suitable or capable)
 Agency Theory

• How to make sure managers to work for shareholders interest?

• We need corporate governance!

 What is Corporate Governance?
• The process of supervision and control intended to ensure that the company’s
management acts in accordance with the interests of shareholders (Parkinson,
1994).

• The governance role is not concerned with the running of the business of the
company per se, but with giving overall direction to the enterprise, with
overseeing and controlling the executive actions of management and with
satisfying legitimate expectations of accountability and regulation by interests
beyond the corporate boundaries (Tricker, 1984).
 What is Corporate Governance?
• Corporate governance is the set of processes, customs, policies, laws and
institutions affecting the way in which a corporation is directed, administered or
controlled.

• Corporate governance also includes the relationships among the many players
involved (the stakeholders) and the goals for which the corporation is governed.

• The most important players are the shareholders, management and the board of
directors. Other stakeholders include employees, suppliers, customers, banks and
other lenders, regulators, the environment and the society.
 What is Corporate Governance?
• Narrow definition in plain words:
Internal and external mechanisms used to motivate or monitor managers to work
for shareholders’ interest.
 Major Governance Mechanisms
• Executive incentives (Class Two)
Used to align managers’ interest with shareholders’ so that managers
maximize their own interest when they maximize shareholders’
Short-term and long-term components
Hard to design
Performance measure issues
Induce managers’ opportunistic behavior
 Major Governance Mechanisms
• Board of directors (Class Three)
Elected by shareholders
Supposed to work for shareholders
Select and appoint executives, make strategic decisions
Executives are usually board members as well
Non-executive, independent directors are critical
 Major Governance Mechanisms
• Investor (Class Four)
Shareholder rights
Collective action problem
Block shareholders
Institutional investors
Creditors

• Auditing (Class Five)

Information asymmetry
Financial reporting
External auditors
 Major Governance Mechanisms
• Market for corporate control (Class Six)
Hostile takeover
A costly mechanism
Anti-takeover strategies
 Other Governance Issues

• Stakeholder theory and business ethics (Class Eight)

• Governance issues in China mainland (Class Nine)

• Governance issues in Hong Kong) (Class Ten)

 Is Governance Important? Evidence
from prior literatures
• Gompers, Ishii, and Metrick (2003): governance and firm value

Construct an index to measure the strength of corporate governance for

about 1500 largest firms in US
Firms with strong governance have higher market valuation, better stock
returns, higher profits and sales growth, fewer corporate acquisitions
Is Governance Important? Evidence from
prior literatures
• Beasley (1996): governance and financial fraud

Examine financial statement fraud in the U.S.

Outside directors matter
Compared with companies without fraud, companies with
financial frauds tend to have
• A smaller portion of outside directors on the board
• Lower outside director equity ownership
• Longer director tenure
• Busier outside directors (i.e., their outsider directors on average hold
more directorships in other companies)
Good Practice of Corporate Governance
• Provide investors with a real opportunity to exercise their rights in
relation to the company
• Provide for the equitable treatment of all shareholders
• Provide for the accountability of the board to shareholders
• Ensure that executives manage the day-to-day activities without undue
interference, in good faith, and solely in the interests of the company
• Provide for full, timely, and accurate disclosure of all material
information to shareholders
• Ensure compliance with applicable laws
• Encourage the consideration of the interests of stakeholders
 Enron: An Overview
• https://www.youtube.com/watch?v=Mi2O1bH8pv
w
 Enron: An Overview
• Enron was once among 10 largest firms in the US
• It filed for bankruptcy protection in late 2001, which is the largest bankruptcy
case in the history until then
• A lot of accounting fraud and corporate governance weaknesses were revealed
• Countries were shocked and began to examine their own corporate governance
• The passage of Sarbanes-Oxley Act in US, the most significant securities
regulation since 1930s
 Enron: The Rise
1985 2000

No. of Employee 15,076 21,000

Business Coverage 4 > 40
Total assets (Billion) 12.1 65.5
Sales (Billion) > 100
<5
Rank in ‘Fortune’ top 500
18
-
Reproduced from Akhigbe, Madura, and Martin (2005)
 Enron: The Collapse
•Aug 14, 2001, CEO Jeffrey Skilling resigned, citing ‘personal
reasons’.

•Oct 12, 2001, Enron disclosed a $638 million loss in its third
quarter for this fiscal year.

•Nov 8, 2001, Enron restated its financial statements to reduce

earnings by an additional $586 million over the past four years.
 Enron: The Collapse
•Enron announced it must pay $690 million in debt, with another $6
billion by next year

•Nov 19, 2001, S&P downgraded Enron’s debt to ‘junk status’.

•Dec 2, 2001, Enron filed for the largest bankruptcy protection in

U.S. history.

•Enron’s stock price at last close: 67 cents, total shareholder value

lost: $63 billion.
 Enron: Governance Issue

• It is revealed later that

The CEO has unfettered power
The internal audit committee did not function at all because of serious
conflicts of interest
• The chairman’s husband is a senate who receive substantial political donation from Enron;
• A former committee member had a consulting contract with Enron when he was on the
committee
External auditors had very close relationship with management
 Enron: Long-term Impact
• Arthur Anderson, the auditor for Enron, was forced to close
down

• A global attention on corporate governance

• The passage of Sarbanes-Oxley Act which main provisions

aim to cure corporate governance weakness revealed in
the Enron case
 Discussion Questions

• What lessons could we learn from Enron’s collapse? Please propose

some reforms to avoid such scandal in relation to any perspectives,
such as stock exchange, regulator, auditing practice, investors, or
board of directors.