Hamid MeranOctober 18, 2004

Issues in Corporate Governanceand Disclosure

Federal Reserve Bank of New York

Central Banking SeminarPreparatory Workshop in Financial Markets,

Instruments and Institutions

Corporate Governance: Definition

• The term “corporate governance” essentially refers to the relationships among management, the board of directors, shareholders, and other stakeholders in a company.

• These relationships provide a framework within which corporate objectives are set and performance is monitored.

Stakeholders

• Managers• Investors—equity holders and bondholders• Board of Directors• Accounting Board• Securities and Exchange Commission (SEC)• Listed Exchanges• Regulators—states, supervisors in banking,

insurance and public utilities

Managers• Are likely to be self-interested and may

make decisions that are not in the shareholders’ best interest.– They may: waste corporate resources,

diversify the firm, not pay dividends, and not issue debt.

– Solution: Compensate managers with equity/stock options.

– Problem: Managers/shareholders may undertake risky decisions to benefit themselves at the expense of bondholders.

Example: Risk Shifting by Stockholders

Interest and Principal=$1,400 Good State with Prob. ½ Bad State with Prob. 1/2

Project A (safe) Good State Bad State

Cash flow ($) 1,800 1,400

Interest and principal ($) 1,400 1,400

Payoff to bondholders ($) 1,400 1,400

Payoff to stockholders ($) 400 0

Expected Outcome ($) 1,800*½+ 1,400*½= 1,600

Project B (risky) Good State Bad State

Cash flow ($) 2,000 1,200

Interest and principal ($) 1,400 1,400

Payoff to bondholders ($) 1,400 1,200

Payoff to stockholders ($) 600 0

Expected Outcome ($) 2,000*½+ 1,200*½= 1,600

Investors

• Small equity holders cannot and have little incentive to monitor managers.

• Large shareholders have enough at stake and are able to absorb the cost of monitoring.

• Who are the large shareholders?– Individuals– Institutions– Other firms (takeovers)

Board of Directors• Legal Definition of the role of a board: “duty of care”

and “duty of loyalty.”• Boards serve as shareholders’ first line of defense.• Compensation decisions, fire CEOs, advise CEOs,

veto bad projects, help the CEO in succession efforts.

• Directors serve on one or more committees.• Since 1997, all publicly traded companies are

required to have an audit committee.• Firms on the NYSE must have a compensation

committee.• Directors’ mandates are unclear: Is our expectation

realistic?

How to create a good board?

• Related issues are board size, board independence, and directors’ expertise and qualifications.

• Nominating Committee

Stakeholders, continued

• Accounting Board: will oversee accounting firms and their auditing activities.

• Securities and Exchange Commission (SEC): publicly traded firms are required to file their financial statement with the agency as well as their proxy statements.– Proxy statements contain information on the firm’s

governance, for example, management compensation and the list of directors.

• Listed exchanges

Regulators• States, supervisors in banking, insurance

and public utilities.• Regulators are active in enforcing proper

governance.– Banks in the state of New York are required to

have eight board meetings per year and a minimum of two-thirds outside directors.

– According to laws passed in 1991, banks with low capital relative to minimum should acquire regulator approval before paying bonuses.

Conclusion

• Governance is an evolving concept. • Proper governance should protect

investors as well as ensure sufficient flexibility for the firm to engage in its day to day activities.