Corporate Governance: An Introduction to Financial and Investment Decisions

Where do we stand

Riccardo Calcagno 2024-25 Politecnico di Torino - Corporate Governance and Finance - 01TUOPHWhere do we stand

• Up to now we have studied financing and investment decisions of a firm

Impact of Financial Markets

• The impact of financial markets 'frictions' on the cost of capital
• Raising equity capital and raising debt capital
• To invest considering uncertainty and flexibility (using the real option methodology)
• To invest by taking over other firms (external growth)
• But: who takes these decisions in modern corporations?
• Ownership and control are separated

. This separation leads to conflicts of interests

• Many different conflicts of interests
• Why is it difficult to solve them? Agents in the firm have different information and can take "hidden" actions
• This raises the need of a corporate governance system

Agenda

• Why do we need a governance system?

Key Aspects of Governance Systems

• The separation between ownership and control
• The risk of expropriation and the need for outside investors protection
• Other conflicts of interests: examples
• Corporate Governance (CG) mechanisms:
• Internal mechanisms
• External mechanisms
• Does CG matter?
• The relation between the quality of firm governance and firm performance

Evaluating a CG system

• CG Indexes

The separation between ownership and control

. " .. being managers rather of other people's money than of their own, it cannot be well expected, that they should watch over [the firm] with the same anxious vigilance [as owners] ... " (Adam Smith, 1776)

• Why shareholder = "owner"?

Payoff Structure

Payoff Payoff to Equity Firm defaults Payoff to fixed claimholders 0 F Value of the Firm

How did we get there?

Outside minority shareholders emerged as a consequence of the (legal) 'invention' of limited liability

• Limited liability has many advantages:
• Allows equity-holders to diversify risk -> Dramatically reduces cost of capital
• Generates incentives to innovate
• Problem: ownership dispersion transfers power to management

Who controls/manage the firm?

• Inside shareholders
• majority shareholder(s)
• owner-manager(s) or entrepreneur
• Management
• CEO
• CFO, COO, other top-management
• Board of Directors (BoD)

Protection of outside shareholders

• Outside (minority) shareholders do not have control. They should be protected ... but against what? "Expropriation"
• Expropriation can be:
• Dilution via new equity issues
• Diversion of corporate opportunities, inefficient investments
• Asset transfers
• Overpaying executives
• Perquisites consumption
• Hiring under-qualified managers (e.g. family members)
• Bribes or even frauds
• (and others ... )

An example of expropriation: inefficient investments

. Consider a firm fully financed with equity

• "inside" equity = owner-manager (in control): A > 0
• "outside" equity = investors (not in control) : I - A
• The firm has two investment opportunities (H, L). Both cost = | > A > 0
• Project H: P(success) = PH Payoff if success = R > 0; Payoff if failure = 0
• Project L: P(success) = PL <PH Payoff if success = R; Payoff if failure = 0 Payoff to owner-manager = B > 0
• Efficiency: PHR-I > 0 > PLR -I

An example of expropriation: inefficient investments

Firm is financed Choice of the project by owner- manager (not contractible/not verifiable) Verifiable profit prob. p = R prob. 1- p = 0

• The owner-manager owns quota a = = of the profit
• Owner-manager choses project H if and only if: PHAR ≥ PLAR + B a ≥ B R(PH-PL) (1) = Inside equity sufficiently high w. r. to the degree of misalignment of incentives R

An example of expropriation: inefficient investments

• Suppose condition (1) is not satisfied (a low): outside investors are expropriated!
• If (1) is not satisfied, owner-manager choses project L instead of H
• The return earned by outside investors when project H is undertaken equals: (1 - a)PHR I - A PAR > 1 PHR
• Their return with project L is negative: (1 - a)PIR I - A LR _PLR < 1
• Notice: if outside investors could anticipate expropriation, they would require the insider to invest at least a as in (1) in the first place; otherwise they would not invest in the firm

How to protect outside investors?

• Disclosure
• "Sunshine is the best disinfectant"
• Low cost of suing for restitution
• Class Actions

Other conflicts of interests

• Conflicts are not only between inside and outside equity, but through the whole firm as an organization
• Self-dealing behavior by agents with:
• Different objectives
• Different information
• Different authority
• Most actions are not contractible and not verifiable (by a third party, typically a court or a judge in case of legal suits)

"Underprovision" of effort

• Suppose the firm value TT (e) depends on the 'effort' e of one agent (manager)
• The level of effort e is decided by the manager, is not observable and not contractible
• The firm value is observable: the firm owner pays the manager w(Tt(e))
• Example: w(Tt(e)) = an(e)
• The manager pays a cost c(e) for exerting effort e
• The efficient level of effort e* maximizes the total surplus TT(e)-w(T(e))]+[w(T(e))-c(e)]
• If both functions Tt(e) and w (Tt(e)) are continuous, differentiable, profit function is concave and cost function is convex, the f.o.c. characterizes the optimal effort e* : TT'(e*) = c'(e*)

Underprovision of effort

But: the decision about effort is taken by the manager, who maximizes W(T(e)) - c(e)

• F.O.C .: dw -T'(e) = c'(e)
• As long as dw dr dr " > 0 and dw < 1 the effort exerted by manager is lower than e* Marginal Benefit Marginal Cost π' (e) c (e) dw -- π' (e) effort e e*

The solution to the conflicts of interest

• The solution to these conflicts of interest is difficult:
• The provision of the right incentives (to report truthfully, to take efficient decisions ... )
• Monitoring the behavior of management
• The right allocation of authority (who can decide what, on the basis of which information, ... )
• Therefore: legal mechanisms, rules and practices (Corporate Governance Codes) have been put in place to protect the interest of 'weak' parties = outside shareholders = other stakeholders ... (debate: shareholders vs stakeholders society)

CG: a Definition

"We define corporate governance as the collection of control mechanisms that an organization adopts to prevent or dissuade potentially self-interested managers from engaging in activities detrimental to the welfare of shareholders and stakeholders." Corporate Governance Matters, 2E, p. 7. The system of checks and balances meant to prevent abuse by executives

Is this all relevant?

. Do we actually see that management exploits its power of control?

Corporate Governance Failure, Fraud, & Scandal

DATA SPOTLIGHT David F. Larcker and Brian Tayan Corporate Governance Research Initiative Stanford Graduate School of Business STANFORD BUSINESS SCHOOL OF GRADUATE Corporate Governance Research Initiative

Unethical behavior

Executives are willing to engage in unethical activities to meet financial targets.

Willingness to Engage in Unethical Behavior

Would justify unethical behavior to meet financial targets 42% Would offer entertainment 24% Would change the assumptions determining valuations and reserves 16% Would make cash payment to win or retain business 13% Would offer personal gifts or services 12% Would extend the monthly reporting period 11% Would backdate contracts 7% Would justify misstating financial performance 4% 0% 10% 20% 30% 40% 50% Percent Willing to Engage in This Behavior Source: EY 14th Global Fraud Survey (2016).

Unethical behavior

Questionable behavior can take many forms ... .

Examples of Questionable Behavior

13% Lied to board, shareholders 34% Had sexual affair or relations 16% Engaged in questionable financial practices Objectionable language or behavior 16% Expressed controversial views publicly 21% Sample includes 38 incidents ethically or morally questionable behavior. Source: Larcker and Tayan (2016).

Reissuance restatements

The number of companies forced to restate their financials has fallen in recent years.

Number of Restatements Over Time

1.853 1,575 Number of Restatements 1,271 1,507 966 1,143 847 843 854 857 756 680 553 486 512 526 598 632 667 593 545 444 432 432 346 335 317 256 242 190 163 135 109 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Restatement with reissuance Restatement without reissuance Reissuance restatements are disclosed in a Form 8-K, Item 4.02, and indicate that past financial statements can no longer be relied upon and indicate that the restatement was severe. Minor restatements require no reissuance. Source: Audit Analytics (2018). 874 832 936 534 346 335

Reissuance restatements

The size of restatements has also fallen in recent years.

Largest Negative Restatements by Impact on Net Income

Fannie Mae $6,335 AIG $5.193 Tyco $4,513 $ in Millions HealthSouth $3,465 Navistar $2,377 China Unicom $1,557 JP Perrigo $1,177 TMST $671 Telecom Italia $717 ING Alphabet $1,085 $711 GE $341 UBS $357 Morgan Quicksilver csc $459 $420 $286 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Largest negative restatement per year, by impact on net income Source: Audit Analytics (2018).

Securities Class Action Lawsuits

The number of securities class action lawsuits has remained fairly stable.

Number of Cases Filed

224 203 195 181 177 174 170 Number of Cases Filed 162 154 141 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Includes cases filed in federal and state court. Source: Advisen (2017). 227

Securities Class Action Lawsuits

Settlement for these cases can be very large.

Total Settlements in Millions

$8,377 $6,118 Total Settlements ($ in Millions) $5.022 $4,243 $3,662 $3,407 $3,146 $3,133 $1,484 $1,474 $1,189 2007 N=109 2008 N=97 2009 N=99 2010 N=85 2011 N=65 2012 N=56 2013 N=66 2014 N=63 2015 N=77 2016 N=85 2017 N=81 Source: Cornerstone Research (2018).

Agenda

• Why do we need a governance system?
• The separation between ownership and control
• The risk of expropriation and need for outside investors protection
• Other conflicts of interests: examples
• Corporate Governance mechanisms:
• Internal mechanisms
• External mechanisms
• Does CG matter?
• The relation between the quality of firm governance and firm performance
• Evaluating a CG system
• CG Indexes