Models and practices of corporate governance (Conf. dr.

Voicu Dragomir)

Separation of
ownership and
control

Corporate governance - Definition

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
the basic vocabulary of corporate governance literature.

 Shareholders have a role in the prosperity of the firm in six ways:

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
financial and commodity markets.

Models and practices of corporate governance (Conf. dr. Voicu Dragomir)

The role of the shareholders

 In the case that there is no single shareholder, the owners of a

company can not be regarded as a compact mass of people or
organizations with a common interest.
Interests of shareholders may conflict with: (a) the interests of
other shareholders, (b) the interests of other parties in
relation to the company, (c) the lawful operation of the
company, or (d) the managements strategic vision regarding
the running of the company.
For example, some shareholders wanting to close their
position (to exit) will support a takeover, even if it can destroy
the organization or its internal structure. Other shareholders
may be interested to purchase a high a proportion of equity to
be able to control the physical (buildings, operational sites) or
intellectual (patents, client databases) capital of the firm.

Models and practices of corporate governance (Conf. dr. Voicu Dragomir)

The interests of shareholders

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
projects with doubtful outcomes or for acquiring competitors
which prove to add little value to the group as a whole.

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, selfpromotion, putting friends and relatives in key positions,
selecting commercial partners on friendship criteria, or
financing political parties. These attitudes can become a
criminal offence when they recourse to fraud or insider trading.

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
schemes are set to trigger different types of managerial action.

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
or brokers. In general, creative accounting is said to produce
effects which are favorable to managers.