Agency costs and corporate governance mechanisms

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Agency costs and corporate governance mechanisms

US Securities and Exchange Commission The modern public corporation and the separation of ownership from control The evolution of the modern public corporation is one of the great developments of the twentieth century.

That the evolution of these organisations has gone comparatively unnoticed is perhaps unsurprising: These developments have changed the lives of everyone. By contrast, the modern corporation — a form of social organisation designed to achieve economic objectives — evolved gradually from its eighteenth and nineteenth century roots.

Its advent did not coincide with any singular event, unlike new forms of political organisation which generally announce themselves with a revolution, a coup or a constitutional convention.

By the time of the stock market crash, the modern corporation was already well established in the United States and Western Europe. Despite its somewhat unheralded debut, the modern public corporation has had a profound impact on the lives of countless individuals.

Like other forms of business organisation, the modern public corporation is an entity designed to achieve certain economic objectives. But, unlike proprietorships and partnerships which pool the capital and resources of a relatively small number of individuals, modern public corporations can tap the investment capital of many people.

These people may be spread out over large distances, and may or may not be particularly wealthy. In a large, generally middle-class country, corporations are able to raise far more investment capital by accessing the savings of thousands or even millions of small investors, than even the wealthiest individual industrialists would have been able to provide in the past.

However, as Adolf Berle and Gardiner Means pointed out 72 years ago, the modern public corporation is characterised by a separation of ownership and control.

This fact means that modern public corporations are also subject to a type of agency problem not usually found in other forms of economic organisation. Corporate and securities laws have approached this problem from one direction: Management experts and economists have approached the issue from a different perspective: The corporate scandals of the past few years — Enron, Worldcom, Vivendi, Parmalat and others — have shown that the tension has yet to be resolved.

While recent corporate scandals have shown that regulators, auditors, lawyers and shareholders must remain vigilant, they have also highlighted the important role corporate governance plays in mitigating the risks posed by the divergent interests of shareholders and managers.

Without robust corporate governance mechanisms, such as an independent board of directors faithfully representing their interests, investors cannot be assured that their property rights are secure.

Governance Committee Terms of Reference – Model Template

Rather than acquiesce to such a situation, investors will demand a premium for their investments, or else seek investment opportunities elsewhere. In either case the cost of capital for issuers increases. Such measures reassure investors, lower the costs otherwise associated with investor due diligence and, consequently, lower the cost of capital for issuers.

Implementation of corporate governance measures has a cost. Extensive financial disclosures require a great deal of time and money to prepare, and thorough independent audits are expensive. Internal compliance and monitoring mechanisms may also entail high start-up costs, including costly legal and consulting fees.

Even those issuers with independent boards of directors and strong internal controls may baulk at the costs associated with demonstrating in detail the strength of those controls and measures. And in truth, these concerns are not illusory. Similarly, a recent poll of chief financial officers by CFO Magazine found that 25 per cent of senior financial executives surveyed believe that the Sarbanes-Oxley requirements are costly and unnecessary.

The costs associated with this act have even led some foreign issuers to threaten to delist from US stock exchanges. While respondents to these surveys are not unbiased and first-year implementation costs are likely to be significantly higher than the cost of ongoing compliance, the price of quality corporate governance standards should not be dismissed out of hand.

Agency costs and corporate governance mechanisms

However, economics teaches us that no cost exists in a vacuum. Many issuers might prefer to avoid the costs associated with even minimal corporate governance measures, particularly if they can give the appearance of maintaining high corporate governance standards without actually having to do so.

Pyramid schemes inevitably collapse. Holes in corporate accounts are uncovered, if only because bills eventually go unpaid. Furthermore, recent empirical research — not to mention common sense — suggests a correlation between poor corporate governance and poor corporate performance, as well as a link between strong corporate governance standards and superior corporate performance.

If nothing else, investors will notice these performance differences, and punish or reward issuers accordingly. Potentially more problematic, however, is that where corporate governance standards are perceived to be weak, even those issuers with high corporate governance measures in place may have to spend a great deal of time and money overcoming investor suspicions.

Under such circumstances, issuers may find private offerings, institutional loans or even commercial paper comparatively less costly. The result is a capital market that is less deep and less liquid than optimal, where issuers pay more for capital than do issuers in markets characterised by higher corporate governance standards.

The costs such a situation imposes on an economy should not be underestimated. Corporations are deprived of capital, with the potential loss of jobs and economic vitality that this entails. Furthermore, the savings and pensions of an entire country may be subject to unnecessary risks or lower-than-optimal rates of return.

Small investors — the millions of individuals who invest in the capital markets through their savings and employee-sponsored retirement accounts — have neither the resources nor the expertise to monitor the management of issuers in which they invest. They make their investments based on their faith in corporate governance standards.

Sarbanes-Oxley, passed by the US Congress inis to date perhaps the most far-reaching of these reforms, insofar as it establishes a new oversight body for the audit profession and requires extensive new disclosures and internal controls for public issuers.Litigation Strategy & eDiscovery.

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Governance Committee Terms of Reference – Model Template [This as a collaborative initiative to design a model template for a Governance Terms of Reference Document.


Agency costs and corporate governance mechanisms

John Armour, Henry Hansmann, Reinier Kraakman. Ethiopis Tafara and Robert J Peterson US Securities and Exchange Commission. The modern public corporation and the separation of ownership from control.

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