BUSINESS ECONOMICS AND MANAGERIAL DECISION MAKING

Leonid V. Volkov Associate professor at Economics and Crisis Management Department The Finance University under Government of the RF

BUSINESS ECONOMICS AND MANAGERIAL DECISION MAKING

CHAPTER 1: Corporate Governance and Business Objectives

Content
1. Introduction in the business economics and managerial decision making course 2. Ownership structures 3. Patterns of shareholding 4. Classifying firms as owner or management controlled 5. Systems of corporate control 6. Constraints of managerial discretion 7. Improving corporate governance 8. Summary

1. Introduction
The common characteristics of all firms:
Owners; Managers; Objectives; A pool of resourses (labour, physical capital, financial capital, learne skills and competences);  Administrative or organizational structures;  Perfomance assesment    

The main characteristic of firm

A firm is owned by someone or some group of individuals or organizations The shareholders
 are able to determine the objectives and activities of the firm;  appoint the senior managers (topmanagers);  bear the risks associated with operating the firm;  have the right to receive the residual income

Where ownership is dispersed

control of the firm may not lie with the shareholders but senior managers

Divorce between ownership and control

2. Ownership structures
The dominant model is LLC (the form varies between countries); In some countries the control rights of shareholders are limited by stakeholders (may share the appointment and supervision of managers and set firms objectives); There are also firms owned by members and operated as cooperative or mutual enterprises; Some firms owned by national or local government

Stakeholders
Suppliers; Customers; Workers; Local community;

Classifying firms by interest

Monistic (single interest group shareholders) (the UK and the USA); Dualistic (two interest groups shareholders and employees) (France and Germany); Pluralistic (the company serves the interests of stakeholders and not just shareholders) (Japan).

Modern tendencies
Some degree of convergence between European and Anglo-American forms of corporate organizations; Economic forces in Japan have put significant pressure on companies to reduce the long-term employment and place greater emphasis on profitibality

3. Patterns of shareholding
The pattern of share ownership varies between countries and with time. In the UK and the USA, ownership is more widely dispersed than in continental Europe and Japan where it is more concentrated.

The key features are:

The largest group of domestic owners of company shares are financial institutions. Financial institutions share of ownership increased between 1963 and 1997, but fell to 50% in 2001. Individual ownership of shares has been in long-term decline and fell to 14.8% in 2001. Overseas ownership of UK companies has increased and stood at 31.9% in 2001. This trend reflects the growing internationalisation of the asset portfolios held by financial institutions.

Shareholding in Europe
It shows that in each country the structures are different in broad terms compared with the UK:
Holdings by financial institutions are lower. Holdings by non-financial companies are more important, particularly in Germany. Individual ownership is more important in Italy and Spain, but less so in France. Foreign owners are more important in France and Spain, but less significant in Germany and Italy.

Corporate organization structure

Shareholders The board of directors (the supervisory board) The executive management (topmanagers) (the management board)

The operational management

4. Classifying firms as owner or management controlled

The pattern of share ownership at company level varies widely; 1. The UK and the USA dispersed ownership structure
 Quoted companies ownership is widely dispersed among large number of shareholders;  The largest shareholder often owns 5% or less o the stock;  The board of directors typically own a tiny proportion of the shares

4. Classifying firms as owner or management controlled

1. In France and Germany concentrated ownership structure

 In France and Germany shareholding tends to be more concentrated with greater blocks of shares held by companies and banks.  Concentrated ownership structures are more likely to be found in most countries in contrast to the dispersed ownership (typical only of the UK and the USA).

How can companies be classified as owner or managerially controlled?

If a single shareholder holds more than 50% of the stock, then they can outvote the remaining shareholders and control the company. If the largest shareholder owns slightly less than 50% of the equity then they can be outvoted if the other shareholders formed a united front. If the majority of shareholders do not form a united front or do not vote, then an active shareholder with a holding of substantially less than 50% could control the company.

Berle and Means are famous American economists

They first identified the divorce between ownership and control The Modern Corporation and Private Property (1932); A stake of more than 20% would be sufficient for that shareholder to control a company but less than 20% would be insufficient and the company would be managementcontrolled.

Other point of views

Radice (1971) used a largest shareholding of 15% to classify a firm as owner-controlled; and a largest shareholder owning less than 5% to classify a firm as managerially controlled.

Other point of views

Nyman and Silberston (1978) argued that the distribution and ownership of holdings should be examined more closely. They emphasized that there was a need to recognize coalitions of interests, particularly of families, that do not emerge from the crude data.

Other point of views

Cubbin and Leech (1983) argued that control was a continuous variable that measures the discretion with which the controlling group is able to pursue its own objectives without being outvoted by other shareholders.

Control of a company is a function of the following factors:

The size of the largest holding. The size and distribution of the remaining shares. The willingness of other shareholders to form a voting block. The willingness of other shareholders to be active and to vote against the controlling group.

5. SYSTEMS OF CORPORATE CONTROL

The differences between countries in shareholder ownership patterns influence the nature of their corporate governance systems. There are fundamental differences between the corporate control systems:
 the UK and the USA outsider systems;  France, Germany and Japan insider systems.

Insider systems
relatively few quoted companies; concentrated ownership; dominance of corporate and/or institutional shareholders and reciprocal shareholding; shares are infrequently traded, but when they are they often involve large blocks; takeover activity is largely absent, and where mergers take place they are largely done by agreement.

Insider systems
More active owner participation; Owners and other stakeholders are represented on the boards of companies, and there is active investor participation in controlling the company; Ownership lies within the corporate sector rather than with a multiplicity of individual shareholders.

Insider systems
Directors are representatives of other companies and interest groups; A two-tier board structure allows a wider group of stakeholders to offer the company a broader spectrum of advice tending to reinforce longer term goals and stability for the company.

Insider systems
Information about the firms problems and performance is available more readily to corporate or institutional shareholders than to individual shareholders;

Germany is an example of an insider system

Around 800 quoted companies compared with nearly 3,000 in the UK Ownership is much more concentrated with 85% of the largest quoted companies having a single shareholder owning more than 25% of the voting shares. Large ownership stakes tend to rest in the hands of families or companies with interconnected holdings.

Germany is an example of an insider system

For example, the largest shareholder in BMW is the Quandt family which owns 46% of the voting equity. Stefan Quandt is one of four deputy chairmen, and his sister Susanne is a member of the supervisory board. Head of the family is Joanna Quandt, who is the majority owner of Altana, a pharmaceutical manufacturer; this makes them the controllers of two of Germanys top 30 companies.
The supervisory board appoints the management board. When the companys acquisition of British Leyland was deemed unsuccessful the chairman of the management board and two other directors were quickly dismissed by insider action.

Outsider systems
are characterized by dispersed share ownership, with the dominant owners being nonbank financial institutions and private individuals. Owners and other stakeholders are not represented on the boards of companies. Shareholders are seen as passive investors (they are rarely interested about the way in which a company is being operated).

Outsider systems
Shares are easily sold and tend to be held for investment purposes, as part of a diversified portfolio, rather than for control purposes; This discourages active participation in company affairs since shares are easily traded. Dissatisfaction with the performance of a company leads the shareholder to sell shares, rather than initiate moves to change the management or company policies.

Outsider systems
Dispersed ownership is assumed to mean managerial control; this is particularly true when financial institutions hold numerous small stakes. While such institutional investors may have information advantages, they do not use this to influence management directly but to maintain the value of their investment portfolios on behalf of clients.

Insider and outsider systems

In insider systems -- The monitoring of managers is said to be superior in insider systems, with deteriorating performance more quickly acted on. In the outsider system, changing management and policies is a slower process and may involve the takeover of the failing business by other enterprises.

6. Constraints of managerial discretion

The degree of discretion that senior executive managers have in setting objectives is limited by both external and internal constraints.

6. Constraints of managerial discretion

External constraints arise from the active market in company shares; Internal constraints arise from the role of non-executive board members and stakeholders, trying to align the managers and the owners interests by the rules shaping corporate governance.

External constraints
There are five sources of external constraint on managerial behaviour in any system of corporate control:
 1) Holders of large blocks of shares who use or threaten to use their voting power to change management or their policies if they become dissatisfied.  2) Acquirers of blocks of shares sold by existing shareholders unhappy with the performance of management.

External constraints
There are five sources of external constraint on managerial behaviour in any system of corporate control:
 3) Bidders in the takeover process who promise to buy all the voting shares of the enterprise.  4) Debtors/Investors, particularly in times of financial distress, who act to protect their interests in the company.  5) External regulators and auditors.

External constraints
In outsider systems, external control is exercised mainly through the workings of the stock market rather than voting.  In the stock market, the price of shares reflects the relative numbers of buyers and sellers and their willingness to buy or sell.  A fall in the share price will make management more vulnerable to shareholder activism either in selling shares or in voting at shareholder meetings.

External constraints
In outsider systems, shareholders are inclined to sell underperforming shares to maintain a balance in their diversified share portfolios. In insider systems the selling of shares is more difficult and, therefore, shareholders are more likely to use their voting power to influence management.

External constraints
In outsider systems the working of the stock market makes it feasible to acquire blocks of shares by purchase and to make a bid for all the equity of a company, thereby threatening the tenure of the existing management. Other external constraints:
 company law;  independent auditing of accounts ;  the lodging of company accounts with the regulators.

Internal constraints
There are groups who may be able to influence management to change policies.
 Independent non-executive directors;  The owners or shareholders;  Stakeholders within the company.

Independent non-executive directors

They are appointed to the boards of UK companies to oversee the behavior of the executive directors. They are often few in number and can be outvoted by executive directors. One of the objectives of corporate governance reform in the UK is to make non-executives more effective. In the German system the supervisory board plays this role by influencing the management board, but its membership is more wideranging.

The owners or shareholders

They can exercise their authority at meetings of the company or informally with management. Directors are elected at the annual general meeting of the company. Dissatisfied shareholders can vote against the re-election of existing executive directors They can also vote against resolutions proposed by the executive of the company, such as those relating to executive remuneration.

The stakeholders within the company

employees of the firm; customers, suppliers, lenders the local community. They may do this by expressing their criticisms/concerns either directly to the executives or indirectly by informing shareholders, the media and outside experts.

The stakeholders within the company

Investment banks and stockbrokers offer advice to shareholders on the potential future earnings of the company, and such comments may help to influence attitudes toward managers.

Aligning the interests of managers and shareholders

The discretion executive managers exercise can be limited by the development of incentive mechanisms to ensure that the interests of managers and owners are more closely aligned. If we assume that shareholders wish to maximize profits, then managers may be encouraged to do so by the payment of profitrelated bonuses in addition to their basic salary and/or by rewarding successful performance with share options in the company.

7. IMPROVING CORPORATE GOVERNANCE

The final sources of constraint on the behaviour of executive directors are the rules that determine the governance structures and procedures of companies. The meaning of the term is corporate governance

Corporate governance
The Cadbury Committee, which was set up in 1991 to investigate corporate governance in the UK, defined it as the system by which companies are directed and controlled.

The Codes of Corporate Governance

Across the world, many countries have developed voluntary codes of practice to encourage good corporate practice.
 The website of the European Corporate Governance Network listed codes for 19 countries together with those agreed by the OECD (Organization for Economic Cooperation and Development) and various nongovernmental organizations

The Combined Code of Corporate Governance (1998)

It requires each company to have:  A non-executive chairman and chief executive with a clear division of responsibilities between them.  Each board of directors to have at least: Three non-executive directors independent of management. An audit committee including at least three nonexecutive directors. A remuneration committee made up mainly of non-executive directors to determine the reward of directors. A nomination committee composed wholly of nonexecutive directors to appoint new directors.  Requirements to the annual report

The requirements to the annual report

A narrative account of how they apply the broad principles of the Code, explain their governance policies and justify departures from recommended practice. Payments to the chief executive and highest paid director to be disclosed in the annual report. Directors should receive appropriate training to carry out their duties.

The requirements to the annual report

The majority of non-executive directors should be independent, and boards should disclose in their annual report which of the nonexecutive directors are considered to be independent The roles of chairman and chief executive should normally be separated, and companies should justify a decision to combine the roles. The names of directors submitted for reelection should be accompanied by biographical details, and directors who resign before the expiry of their term should give an explanation.

The Combined Code of Corporate Governance (1998)

Compliance with the Code is one of the requirements for listing on the London Stock Exchange and noncompliance requires an explanation in the annual company report. The Code, however, does not guarantee good conduct on the part of executives and compliance with the Code does not necessarily improve the companys profitability.

8. Summary
The ownership structures of firms and the pattern of shareholdings in different countries. The divorce between ownership and control led to the distinction between owner controlled and managerially controlled enterprises.

8. Summary
The nature of control in different countries was examined. In whose interests firms are operated was also examined.
 In the UK and the USA, where share ownership is widely dispersed, there are outsider systems of control using market mechanisms. In continental Europe and Japan, where share ownership is more concentrated, there are insider control systems.

8. Summary
The major constraints on managerial discretion come through either external mechanisms, essentially through the Stock Exchange, or internal constraints where shareholders and stakeholders use their power of control within the formal and informal structures of the firm.

THANKS!!!