Transcript jhu-lec-1 - Financial Policy Forum

Corporate Governance and
Financial Market Regulation
Randall Dodd
Senior Financial Sector Expert
IMF, MCM Department
May 13, 2008
Why study corporate governance?
Student participation in graduate business programs are generally thought to be
motivated by the desire to make money. That motivation is a private one. It
pertains to the individual and their self interests. Taken beyond moderation, and
the pursuit of money enters the dimension of vice, and the vices include greed,
venality and avarice.
Where does the study of corporate governance and market regulation fit within
that motivation? Let me offer two brief answers. The first is that many people
care and respect the public sphere of live. By public I mean that which is not and
cannot be experienced privately or purely privately. Better put, it is the common
interest amongst us. This pertains especially to issues such as the safety and
soundness of our persons and the world in which we live. It pertains to
prohibiting harm to other people – whether from recklessness or deliberate
actions, and collective efforts to help those who suffer from natural disasters,
illness, disabilities and so on. It is what leads people to have affection for their
country, city, school, neighborhood and community. This is a public spirit motive
and while it is not uniformly strong or well articulated in today’s society it is real
and present. This motive drives them to act in the public interest.
MBA students sometimes seek run public or non-profit organizations or to better
understand business activities for public policy purposes.
The second answer is that it is the law. If you do act within the law, then you will
be subject to private lawsuits by those who have suffered damages from you
actions and to criminal charges by public authorities. You can also be subject to
criminal prosecution. I don’t ever want to see one of you operating a weedwhacker in a bright orange jumpsuit along the freeway. If you intend to break
state or federal financial laws in the pursuit of your private gain, then I don’t want
to see you at all.
What this class will offer is a better understanding, specifically an economic
understanding, of why corporate governance is important and why financial
market regulations are not only necessary but can also make markets more
efficient. Now that does not mean that every regulatory measure is as it should
be. What it will give us is an intellectual framework for better understanding
where, when and how to – and not to –regulate financial markets.
We will start with the issue of corporate governance. This is too often treated
as a ‘black box’ in mainstream economic textbooks. We need to better
understand what is otherwise a ‘black box’ in mainstream economic theory in
which production occurs. That black box decides on the minimum cost of
combing labor, capital, land and other inputs to produces goods and services so
as to maximize profit. Economics provides very little discussion of the institutional
arrangements for how this happens. The study of corporate governance – or
what should better be called business governance – is the study of how these
decisions are made, how the organization is structured so as to best made the
decisions and carry out the decisions, and how the conduct of the firm is subject
to the will of stakeholders and the public interest.
The study of corporate governance will demystify the black box. This
is especially important because of the importance of the private sector in
the economy and the larger society. Not only does the private sector hire
the most employees and produce the major share of GDP, but it also
provides for essential services. Many workers acquire through their
private employers their health care insurance, and retirement income
plans (although increasingly less of income insurance provided by
pension funds). Moreover they provide essential services such as
utilities, water, health care, housing, education and so on.
One more important point, private businesses play a major role in the
democratic process as they exercise their political power through
contributions, lobbying and endorsements.
For these reasons, governance of the private sector is important to the
economic and social realms of our nation. We study the institutions of
business and how they are governed in order to better understand and in
the future to better shape the policies of these organizations.
The issue of timing should be added to the above discussion. Seldom
before has the legitimacy of corporate governance been at the
forefront of public policy and investor concerns.
We study governments as institutions. In fact we have entire university
departments issuing various degrees in the study of governments. Yet
business institutions get short shrift. This cannot be because it is not a
problem. There have been massive corporate failures of one sort or
another that have impacted many people, places and the entire
economy. In recent years, Enron, Worldcom, Tyco and Refco have been
colossal failures. Whereas public institutions have at times failed, such
as in poor African nations like Somalia or here at home in their response
to hurricane Katrina when they failed to adequately protect their citizens.
By comparison though, the governments did not start the hurricanes –
although perhaps the issue of climate change has not been responsibly
addressed – while the corporate failures were of their own making.
Businesses are organized into various institutional structures. These are
listed below. They each have a different legal basis and they are
distinguishable by how they are treated as a legal entity, exposure to civil
liability, and taxation. Note that each also raises, and offers different
solutions to, governance concerns.
Types of Businesses
- Corporation: C and S
- Partnership
- Proprietorship
- LLC
These differ by whether a natural or legal person is recognized, how liability
is managed (unlimited or limited liability) and how taxation is assessed.
Four criterion to understanding the differences:
1. Lifetime
2. Legal or natural person
3. Liability – total or limited
4. Taxation – only at level of investor/owners or also a level of the firm
governance
Sole Proprietorship
The individual owns the firms, and the individual is the firm. The
owner is often the manager, and in this case there is no potential conflict
between owner and manager. If the owner hires a manager or additional
management then the owner is responsible for monitoring the activities of the
hired managers in order to make sure that their actions are in the best private
interest of the firm. Towards this end the owner retains ultimate control of the
enterprise.
The returns on the business are treated for tax purposes as the
income of the individual.
The individual is liable for the activities of the business. Creditors
can come after the assets of the own. Employees can suit the individual as
well as the firm to recover unpaid wages or damages caused by the firm.
Other stakeholders as well as the public authorities can sue the individual as
well as the firm for damages they cause to the market, the environment or
public safety.
Limitations:
•
limited to the life of the owner/operator
•
limited access to capital
•
unlimited liability to the owner
Partnership
A partnership is not so different than a sole proprietorship in regards
to taxation and liability. The major difference is the importance of a viable
agreement to contribute capital and labor and then share in the proceeds of
the firm.
Unlimited liability as the partners are joint and several liable for
claims on the firm.
Lifetime. The partnership dissolves whenever a partner dies or
leaves, unless there is a partnership agreement on how to reorganize the
company.
Partnership income is taxed only once at the level of the individual
owner (it is not taxed at the firm level).
Governance generally handled by committee, or executive
committee of partners/owners.
Limitations:
•access to capital
•illiquid
•governance/monitoring
Limited Liability Partnership (LLP)
Combines some of the preferred aspects of partnership and
corporation. It is not taxed at the firm level, and owners have limited liability like
corporate shareholders.
There must be one or more general partners who have unlimited
liability. The limited partners have limited liability and may have a completely
passive investment role in the enterprise.
This structure is often used for its tax advantages. A long-term project
can yield significant short-term loses that partners can deduct from other
income.
Limitations:
• access to capital
• illiquid
• governance/monitoring (general and other partners)
Limited Liability Company (LLC)
Combines the single, pass-through taxation of a LLP of partnership and the
limitations on liability of corporations. Unlike a partnership, investors are NOT
personally liable for other partners’ or investors’ malpractice. Like a partnership,
the LLC files a partnership tax return to the IRS.
LLC structure offers infinite (and finite) life like a corporation, but without being
taxed at the firm level like C corporations.
Investors are considered ‘members’ of the company (somewhat like partners or
shareholders). Members are shielded from the debts and judgments against the
company like a corporation.
An LLC is created by filing with a state government and is governed by an
Operating Agreement instead of By-Laws (as with corporations). The OA defines
who contributes capital and how earnings/profits are distributed. It also defines
management structure and how the members will meet to govern management
decisions.
S Corporation
Or ‘subchapter S’ corporation, taxes on at individual level, limited liability,
Limited to 75 or fewer investors (shareholders), the shareholders must be
individuals (or trusts ) and not corporations, can issue only one class of equity,
and cannot be a holding company (cannot hold a controlling amount of stock in
another company).
C Corporation
A corporation, formed by filing articles of incorporation with a state agency and
governed by by-laws, normally provides its shareholders with a shield against
creditors (whether lenders, suppliers, or tort judgment creditors) of the corporation,
unless the shield could be "pierced" or the shareholders give personal guarantees.
Generally, therefore, regardless of the financial strength of the corporation, the
assets of the shareholders not invested in the business (for example, one's
residence) cannot be attached by the corporation's creditors. Yet there is a tax price
to be paid for this protection; a regular, or "C", corporation is subject to tax as if it is
a separate person, and the shareholders receive only the earnings of the
corporation reduced by the taxes paid by the corporation. Also, if the corporation
runs a net loss, the shareholders are not able to claim the loss on their own tax
returns.
• Infinitely lived.
• Limited liability.
• Unlimited access to capital.
• Taxed at the level of the firm and distributed income also taxed at
individual level.
• Governance/monitoring: through board of directors elected by
shareholders and through independent audits of activities of executive
management.
Corporate Structure – Overview
Ownership, Management and Control
Separating ownership from control raises problems with controlling the efforts to
executive management and their best pursuit of shareholder interests. It also
raises issues about how to best govern the pursuit of stakeholder interests and
the public interest. This combines the classic economic ‘principal-agent’
problem with the challenge of defining the shareholder, stakeholder and public
interest.
These features of the corporate structure along with a few additional factors
make up the corporate governance system. The system, man. The governance
systems is designed to manage the principle-agent problem as well as influence
the corporation in the interest of other stakeholders and the public interest. The
goal, as the textbook points out, is not mere profit maximization. That is not
enough. Rather the goal should be the maximum risk-adjusted, present value of
future profits – in a word the stock price of the corporation and hence the wealth
of the shareholders. Other goals concern the firm’s relationship with
stakeholders. This is more complicated in that it might seem, and an analysis of
market incentives is not enough to explain it.
Corporate Structure – Overview
The following are parts of the corporate structure. Some are internal to the
corporation and others are external but form part of normal enterprise activities
and business relationships.
Board of Directors
Outside vs insiders (Independent and non-independent directors)
Committees:
Compensation
Audit
Corporate Governance and Nomination
CEO and other Executive Management
Shareholders
Creditors
Other stakeholders
• Preferred stock holders
• Bond holders
• Other creditors
• Clients, vendors and customers
• Employees
• Community
• Government
Gatekeepers
• Auditors (outside)
• Accountants
• Lawyers
• Labor Unions
• Auditors
– these serve as gatekeepers
– their independence is critical, subject of SarBox
• Accountants
– these too serve as gatekeepers
– accounting rules and integrity of accounting profession are critical in ensure accuracy of
public disclosure
• Criminal and civil liability
– consider the consequences of the Securities Litigation Reform Act of 1996
Current Issues in Corporate Governance
• Sarbanes Oxley Act
• Employee Stock Options
• Securities Litigation Reform
• Proxy Voting
• SPEs