Summary
# Key corporate participants and their stakes
This section identifies and analyzes the interests of various key participants in publicly traded companies, examining what each group has at stake from a corporate governance perspective [3](#page=3).
### 3.1 Shareholders
Shareholders are the ultimate beneficiaries of a company's success and are characterized as "residual claimants". Their investment duration is typically open-ended. In publicly traded companies, shareholders are often numerous and have limited involvement in daily operations. Their return is derived from cash distributions (dividends) and capital gains from selling shares. Shareholder risk includes volatility in potential returns, though this can be mitigated through diversification. While shareholders have significant legal rights, including appointing and removing directors, actual participation in day-to-day affairs is often limited due to factors like limited liability, executive expertise, the trivial impact of individual shareholder actions on a diversified portfolio, and collective action problems. However, "blockholders" (individuals or families owning substantial stakes) often exhibit greater engagement to protect their investments. Conflicts of interest can arise between different groups of shareholders or between shareholders and other corporate participants. Bargaining for specific rights is challenging for shareholders in publicly traded companies as they typically buy shares on a "take it or leave it" basis [2](#page=2) [3](#page=3) [4](#page=4) [5](#page=5) [6](#page=6) [7](#page=7).
#### 3.1.1 Duration
The duration of a shareholder's investment is typically open-ended, unlike debt contracts which have specified terms. While companies can exist perpetually, individual shareholders usually do not hold shares for the entire life of a company, benefiting from the stock market's liquidity for exit options. Equity investments are often seen as transitory, leading to concerns about a bias towards short-term results. However, substantial family-owned stakes tend to be long-term propositions. Retail investors trade less frequently than institutional investors, though this trend is changing with commission-free trading and mobile apps. Institutional investors, like pension funds and mutual funds, can engage in frequent trading, leading to concerns about short-termism [3](#page=3) [4](#page=4).
#### 3.1.2 Return
Shareholders are the residual claimants, entitled to what remains after all fixed claims are satisfied. Their return comprises cash distributions (dividends, share repurchases) and the gain or loss upon selling shares. The value of shares is theoretically the present value of future net cash flows. The Efficient Capital Market Hypothesis (ECMH), particularly its semi-strong form, suggests that share prices reflect all publicly available information, making it difficult to consistently "beat the market". Informationally efficient share prices are the market's best estimate of a company's value, though not a perfect predictor of future cash flows. There is mixed evidence regarding "short-termism" in publicly traded companies, as profitable ventures with upfront costs should increase share prices, benefiting both short-term and long-term investors [4](#page=4).
#### 3.1.3 Risk
Shareholders face two primary types of risk: limited liability (their maximum loss is the amount paid for shares) and volatility risk (highly variable potential returns). Diversification across numerous companies significantly reduces unsystematic (company-specific) risk but does not eliminate systematic (market-wide) risk. The Capital Asset Pricing Model (CAPM) suggests risk is correlated with return. Index tracking funds aim to match market performance rather than outperform, and do not protect against systematic risk, but offer lower management costs [5](#page=5).
#### 3.1.4 Control
Corporate law vests boards of directors with ultimate managerial authority, but shareholders retain significant powers, including appointing and removing directors, and having decision rights over fundamental corporate changes like amending the constitution or winding up the firm. Despite these powers, shareholder passivity in publicly traded firms is common due to limited liability, the expertise of executives, the trivial impact of individual actions on a diversified portfolio, and collective action problems. "Blockholders," however, often actively engage to protect their investments. Shareholder activism can be "defensive" (protecting existing investment) or "offensive" (agitating for change in undervalued companies). Hedge funds are prominent practitioners of offensive shareholder activism [5](#page=5) [6](#page=6).
#### 3.1.5 Conflicts of interest
Conflicts of interest can arise between shareholders and other participants (e.g., managers, creditors). Friction can also occur among shareholders, particularly between dominant "blockholders" and minority shareholders, where the dominant faction might secure "private benefits of control" [6](#page=6) [7](#page=7).
#### 3.1.6 Bargaining
Bargaining for specific rights is challenging for shareholders in publicly traded companies, as shares are typically bought on a non-negotiable basis. While some argue this makes the characterization of these arrangements as contractual misleading, the acceptance of standardized, non-negotiable terms is common in many contractual contexts. Evidence suggests private ordering does occur in the public company sector, as smaller firms may have different governance arrangements than larger ones [7](#page=7).
### 3.2 Creditors
Creditors provide funds or credit to companies and can be categorized as trade creditors, institutional lenders (like banks), and bond/debenture holders. Their primary stake is the repayment of principal and interest [7](#page=7) [8](#page=8).
#### 3.2.1 Duration
Debt contracts universally specify a repayment date, defining the maximum legal duration of the debt, which can range from short-term (e.g., 30-60 days for trade creditors) to longer periods for bonds and debentures. However, the relationship with bond and debenture holders can be transitory if these instruments are tradable on the open market. Bank accounts are an exception, where account holders can demand full repayment at any time [7](#page=7) [8](#page=8).
#### 3.2.2 Return
Creditors are entitled to repayment of the principal amount advanced plus interest, commonly referred to as the yield. The yield is fixed by the debt contract. Calculating the precise return can be complex due to the time value of money and inflation. Crucially, debts are fixed claims, meaning the return does not vary with the company's fortunes as shareholder returns do [8](#page=8).
#### 3.2.3 Risk
Creditors face default risk, the possibility that a debtor company may fail to meet its debt obligations. This risk is most significant when a company is in financial distress. In liquidation, creditors have priority over shareholders, but they may not be fully repaid if the company's debts exceed its assets. Strategies to manage default risk include screening (assessing default probability), bargaining for a higher yield, contracting for prompt repayment, and securing collateral. Diversifying debt obligations across many companies also substantially reduces overall default risk [8](#page=8).
#### 3.2.4 Control
In situations of severe financial distress or imminent default, creditors may have contractual rights to take control of a business or ensure its prompt liquidation. If a rescue is attempted, creditors might work with incumbent management or orchestrate a leadership change. However, for solvent companies, creditors typically do not find it worthwhile to become actively involved in decision-making due to their fixed return, limited downside risk (limited liability), and the diversification of their portfolios [9](#page=9).
#### 3.2.5 Conflicts of interest
Conflicts between shareholders and creditors can arise, especially when a company is successful and there's a substantial "equity cushion" protecting creditors. Claim dilution (shareholders favoring new debt for lucrative opportunities) and asset withdrawal (e.g., generous dividend policies eroding the equity cushion) are sources of conflict. Risky managerial strategies also present a conflict, as shareholders can reap significant upside with limited downside (due to limited liability), while creditors bear increased risk of default [10](#page=10) [9](#page=9).
#### 3.2.6 Bargaining
Creditors use debt contracts to protect themselves, employing strategies like bargaining for security, short repayment periods, and acceleration clauses (demanding immediate payment upon breach). Contracts can also enhance monitoring by requiring regular financial information submission. Contractual restrictions can limit a debtor company's actions, such as taking on more debt or distributing dividends. However, bargaining is not a perfect solution due to the impossibility of anticipating all risks, the cost and complexity of drafting detailed agreements, and the difficulty of enforcing extensive contractual rights. Competitive pressures can also lead creditors to forego protective strategies [10](#page=10).
### 3.3 Employees
Employees agree to work for a company and accept a zone of authority, expecting to follow directions. Their employment relationship is primarily governed by the firm's internal administrative system, though market forces and labor norms remain influential [11](#page=11).
#### 3.3.1 Duration
Employment contracts for rank-and-file workers are typically open-ended, continuing until resignation, retirement, company closure, or dismissal. Legal regimes in many jurisdictions protect against immediate dismissal without cause, although the U.S. operates largely on an "at-will" employment basis. The duration of employment can be influenced by the worker's skills and marketability. As workers gain firm-specific knowledge, their mobility may decrease, but their long-term employment may be more secure due to the cost of replacement. The rise of the "on-demand" economy also impacts traditional employment structures [11](#page=11) [12](#page=12).
#### 3.3.2 Return
Employee return primarily consists of wages (hourly or salary) and benefits like pensions and health insurance, which are fixed claims. While thriving companies may pay more, wage and benefit levels are rarely designed to fluctuate directly with company success. Schemes linking remuneration to corporate performance, such as employee share ownership or profit-sharing, aim to align incentives but can dilute the motivation effect due to the minor influence of an individual's contribution. Employees often have reservations about pay being closely tied to performance due to the potential for significant year-to-year pay fluctuations, making financial planning difficult. Thus, such schemes usually supplement rather than replace fixed wages [12](#page=12) [13](#page=13).
#### 3.3.3 Risk
The primary risk for employees is job loss, which can be significant as employees typically lack the diversification protection afforded to shareholders and creditors. Losing a job can negatively impact lifetime earnings, require considerable effort to find new employment, and necessitate lifestyle adjustments. Linking remuneration closely to corporate performance, especially through employee share ownership, compounds this risk, as company stock is most likely to fall when job security is already jeopardized [13](#page=13).
#### 3.3.4 Control
Employees can influence managerial decisions through equity stakes, granting them voting power, or via worker representatives on boards (common in Europe). While proponents highlight increased employee participation and commitment, full-scale employee ownership is rare, and employees typically do not participate in strategic management decisions, often being viewed as "doers, not thinkers" [13](#page=13) [14](#page=14).
#### 3.3.5 Conflicts of interest
Conflicts of interest are common between employees and other participants. Employees, as agents, might be tempted to work at a leisurely pace or over-consume perks, imposing "agency costs" on principals (shareholders and creditors). Conversely, corporate employers may engage in downsizing to enhance profitability, which can be detrimental to employees. However, there can also be alignment: successful firms benefit employees through increased hiring and better pay. Treating employees well can also improve corporate performance, fostering flexibility and loyalty. This alignment can break down during hard times, as seen with companies facing financial challenges [14](#page=14).
#### 3.3.6 Bargaining
Bargaining, through employment contracts, can address conflicts of interest. "Tin parachute" clauses, for example, provide severance pay in case of job loss due to takeovers. However, employment contracts are often brief, focusing on core matters and leaving many workplace issues unaddressed. Mechanisms like unions, with their more intricate collective agreements, and statutory regulations (e.g., written statements of employment particulars, health and safety laws) help fill these gaps [15](#page=15).
### 3.4 Directors
Directors, particularly non-executive directors (NEDs), are formally vested with managerial authority and are responsible for establishing company strategy, advising executives, and monitoring their decisions [15](#page=15) [16](#page=16).
#### 3.4.1 Duration
A director's term begins upon selection, typically by shareholders, though company constitutions or legislation govern this. The term length varies significantly by jurisdiction, from one year (Sweden, Delaware) to several years (Italy, Netherlands, France, Belgium). In the UK, while the constitution dictates the process, listed companies often provide for annual re-election. Directors can be removed before their term ends, usually by the same body that appointed them. Resignation can occur for personal reasons, shifts in voting control, fundamental disagreements, or to limit reputational harm. Recent trends suggest shorter service durations for NEDs, with a nine-year tenure often considered a limit to independence in the UK [16](#page=16) [17](#page=17).
#### 3.4.2 Return
Directors receive fees for their service, distinct from executive pay. These fees are typically modest compared to executive remuneration. Directors' fees are usually fixed periodically and based on the practices of comparable companies, rather than being directly tied to corporate performance [17](#page=17) [18](#page=18).
#### 3.4.3 Risk
Outside directors face relatively low financial risks. While shareholder acceptance of board recommendations is high, directors are unlikely to be sued personally for ordinary course decisions, and even in cases of nominal liability, actual out-of-pocket costs are typically covered by company indemnification or D&O insurance. A significant risk is reputational loss, as directors strive to maintain their good judgment and track record for future opportunities [18](#page=18).
#### 3.4.4 Control
The role of the board in controlling companies is debated. Some view directors as the core decision-making body ("director primacy"), while a more prevalent view sees the board as monitoring management, acting as a check on executives, and providing advice. Critics argue that boards, especially outside directors, often fall short as "watchdogs," with collegiality sometimes overriding independence. While boards have become more diverse and demanding, challenges remain in ensuring effective oversight. Two-tier boards, with a separate supervisory board, theoretically offer better conditions for monitoring due to a more detached perspective, but their effectiveness is also debated [18](#page=18) [19](#page=19).
#### 3.4.5 Conflicts of interest
Outside directors' interests do not fully align with shareholders'. NEDs may be more cautious than shareholders prefer, especially regarding risky ventures, as they have less direct financial benefit from such projects and face reputational and legal risks if they fail. Conflicts can also arise if directors are appointed to represent specific constituencies (e.g., employees, influential shareholders, or creditors), potentially creating divided loyalties despite their overarching duty to the company [19](#page=19) [20](#page=20).
#### 3.4.6 Bargaining
Directors' and Officers' (D&O) insurance is a contractual mechanism that provides coverage for legal liability and expenses arising from a director's service. This insurance is more common in the U.S. due to higher litigation risks but is increasingly prevalent globally. However, D&O insurance has coverage limits and excludes certain types of misconduct, and does not eliminate the inconvenience or adverse publicity of being sued. Reconfiguring director remuneration to link it more closely with firm performance is problematic as it could compromise objectivity. Formulating contractual terms to accommodate all stakeholders' needs regarding director duties is also challenging [20](#page=20) [21](#page=21).
### 3.5 Executives
Top executives are responsible for strategic and administrative decisions, setting the company's direction, determining markets, products, services, and organizational structure. The Chief Executive Officer (CEO) typically leads this function [21](#page=21) [22](#page=22).
#### 3.5.1 Duration
Executive employment contracts often specify a duration, typically between one and five years for CEOs in the U.S., with three years being common. Early termination without cause usually triggers damages based on the remaining contract term, often leading to negotiated severance payments. Some executives work "at will" without an explicit contract, having no legal entitlement to severance. Average CEO tenure in publicly traded companies has been declining, generally ranging from five to six years globally. Many senior executives have long tenure within their companies, though overall career length at a single firm has decreased [21](#page=21) [22](#page=22).
#### 3.5.2 Return
Executives are usually very well paid, with remuneration comprising a base salary, performance-based pay (bonuses, share options), and various "perks" or benefits in kind, such as company cars, lavish offices, and pension plans. Base salaries are fixed between reviews, while performance-based pay is variable, linked to meeting designated targets. Share options offer profit potential if the company's share price increases [22](#page=22) [23](#page=23).
#### 3.5.3 Risk
Senior corporate executives are generally not personally responsible for corporate debts, but they face risks related to their substantial human capital (reputation, specialized knowledge) tied to their job. They may be hesitant to have their remuneration heavily linked to corporate performance due to the risk of job loss and potential damage to future employment prospects, especially if departing with a hint of failure. Forced departures can occur due to board decisions, takeovers, or liquidation [23](#page=23).
#### 3.5.4 Control
Management typically controls publicly traded companies due to boards delegating substantial managerial powers to executives. This control is influenced by internal checks (board, shareholders) and external constraints, including state regulation, the executive labor market, product and service markets, and the market for corporate control. The market for corporate control, through takeover bids, can incentivize executives to run companies effectively to deter potential acquirers. However, these external constraints have limitations; for example, product market competition's impact can be delayed, takeovers are expensive and cyclical, and top executive job mobility is limited [23](#page=23) [24](#page=24) [25](#page=25).
#### 3.5.5 Conflicts of interest
Managerial conduct can negatively impact other corporate participants. "Shirking" (management's choice of effort level) and "looting" (e.g., lavish offices, personal use of funds, nepotism) can reduce shareholder returns and increase debt risk. Executives may also prefer less risky ventures than diversified shareholders, as their human capital is tied to the company's continued existence. However, during business failure, executives may be tempted to pursue high-risk ventures favored by shareholders and employees, hoping for a successful outcome that saves their jobs and reputation [25](#page=25) [26](#page=26).
#### 3.5.6 Bargaining
Contractual mechanisms, such as debt covenants restricting managerial conduct and managerial service contracts with variable pay linked to shareholder returns (stock options, bonuses), can help align executive interests with other participants. However, bargaining cannot fully resolve executive conflicts of interest, as executives may still be discouraged from pursuing lucrative but risky ventures due to their "overinvestment" in the firm. This limitation on bargaining provides a rationale for corporate governance regulation [26](#page=26).
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# Shareholders' role and considerations
This section delves into the multifaceted role and considerations pertinent to shareholders within a corporate structure, focusing on their investment duration, return types, inherent risks, control mechanisms, and potential conflicts of interest.
### 2.1 Nature of shareholder investment
A fundamental aspect distinguishing shareholders from other corporate participants is the generally open-ended duration of their investment. Unlike creditors, whose debt contracts typically have specified expiration dates, shareholder relationships with a company do not automatically undergo periodic renewal. While the corporate form itself is considered to have perpetual existence, individual shareholdings in publicly traded companies are rarely held for the entire duration of the company's life. Most investors acquire shares after incorporation and dispose of them at some point before the company is dissolved [3](#page=3).
#### 2.1.1 Duration of investment
The duration of a shareholder's investment can vary significantly based on several factors:
* **Publicly Traded Companies vs. Privately Held Companies:** In privately held firms, there are typically fewer shareholders who are often involved in the company's operations, suggesting a potentially longer-term investment horizon for those involved. In contrast, publicly traded companies usually have numerous shareholders, with very few having direct involvement in daily operations [2](#page=2).
* **Transitory vs. Long-Term Holdings:** Equity investments in publicly traded companies are often assumed to be highly transitory, with shares being traded frequently. This can lead to concerns that firms might be biased towards producing short-term results to satisfy impatient investors [3](#page=3).
* **Founder/Family Ownership:** A notable exception to the transitory nature of shareholding occurs when an individual or family owns a substantial block of shares. In such cases, the investment is more likely to be viewed as a long-term proposition. Founders or their families retaining significant equity may be possessive of their investment, reluctant to sell, and disinclined to issue new equity that could dilute their holdings and voting power [3](#page=3).
* **Retail vs. Institutional Investors:** Retail investors (non-professionals) generally trade shares less frequently than institutional intermediaries like pension funds, insurance companies, and collective investment vehicles [3](#page=3).
> **Tip:** The advent of commission-free trading and "gamified" mobile trading apps has increased share "churn" among retail investors, making their investment patterns more dynamic [3](#page=3).
* **Institutional Investor Strategies:** While some institutional investors engage in high-frequency trading, others, like "passive" index tracking funds, trade individual stocks rarely as they aim to mirror a specific stock market index. Some "active" fund managers may also hold stakes for several years [3](#page=3).
> **Tip:** The perception that many institutional investors are preoccupied with current performance and near-term prospects, potentially leading to "short-termism" in corporate behavior, is a subject of ongoing debate with mixed supporting evidence [3](#page=3) [4](#page=4).
#### 2.1.2 Return on investment
Shareholders are considered the ultimate beneficiaries of a company's success, entitled to what remains after all fixed claims are met. They are characterized as the company's "residual claimants". While the total return of shares over time is a function of the net cash flow distributed as dividends, share repurchases, and final liquidation payments, individual investors often focus on [4](#page=4):
* **Cash Distributions:** Payments made by the company while they own their equity.
* **Capital Gains/Losses:** The profit or loss realized upon selling their shares [4](#page=4).
The total return on equity is ultimately determined by the net cash flow generated by the business throughout its existence and distributed to shareholders [4](#page=4).
##### 2.1.2.1 Efficient Capital Market Hypothesis (ECMH)
The valuation of shares at any given time requires estimating the company's future net cash flows. Financial professionals use information on a company's track record and economic prospects to impound this into the share price. This leads to the concept of the Efficient Capital Market Hypothesis (ECMH) [4](#page=4):
* **Weak Form ECMH:** Posits that current share prices fully reflect all information contained in past share prices, making the study of past fluctuations unhelpful for predicting future movements [4](#page=4).
* **Semi-Strong Form ECMH:** Suggests that share prices reflect all publicly available information [4](#page=4).
* **Strong Form ECMH:** The least plausible form, suggesting share prices reflect all knowable information [4](#page=4).
An "informationally efficient" share price is the market's collective estimate of the present value of future net cash flows. However, it is not a perfect indicator of future performance due to unknowable factors and market sentiment swings [4](#page=4).
##### 2.1.2.2 Short-termism revisited
The ECMH suggests that there may be no inherent conflict of interest between short-term and long-term investors. If a company incurs upfront costs that are perceived to lead to increased future profits, the current share price should rise, benefiting all investors regardless of their holding period. This reasoning offers some explanation for the lack of conclusive evidence of "short-termism" in publicly traded companies [4](#page=4).
### 2.2 Risk considerations for shareholders
Shareholders face various risks, notably mitigated by the principle of limited liability, which caps their loss to the amount paid for their shares [5](#page=5).
#### 2.2.1 Volatility risk
A primary risk for equity investors is "volatility" risk, characterized by highly variable potential returns. Unlike the typically fixed returns for creditors, a company's net profit flow can fluctuate significantly, leading to considerable variation in potential share returns [5](#page=5).
#### 2.2.2 Diversification and risk reduction
Diversification is a key strategy to mitigate equity investment risk [5](#page=5).
* **Unsystematic Risk:** This is company-specific risk arising from unique perils affecting an individual company. By owning shares in a substantial number of companies, an investor can reduce this risk, as different companies may prosper or falter independently. Collective investment vehicles, like mutual funds, facilitate diversification by allowing investors to hold shares in numerous firms [5](#page=5).
* **Systematic Risk (Market Risk):** This risk arises from share price fluctuations caused by general conditions affecting the entire stock market. Diversification across many companies does not eliminate this risk, as all holdings are exposed to market-wide factors [5](#page=5).
#### 2.2.3 Capital Asset Pricing Model (CAPM)
The CAPM suggests that investment risk is directly correlated with return. Beating the market, according to this model, requires selecting a portfolio riskier than the overall stock market [5](#page=5).
* **Index Tracking Funds:** These "passive" funds aim to match a designated stock market index rather than outperforming it. They do not protect investors from systematic risk but offer significantly lower management costs. The popularity of index funds has grown due to their cost-effectiveness and a lack of consistent evidence that "active" fund managers can outperform the market long-term [5](#page=5).
### 2.3 Shareholder control mechanisms
While corporate law generally vests ultimate managerial authority in boards of directors, shareholders possess significant powers [5](#page=5).
#### 2.3.1 Shareholder powers
Shareholders collectively hold powers that can influence company direction:
* **Appointment and Removal of Directors:** Shareholders often have substantial rights regarding the appointment and early removal of directors [5](#page=5).
* **Decision Rights:** Shareholders may have "decision rights" that can impinge on the board's and management's authority. Shareholder approval is frequently required for fundamental corporate changes, such as amending the company's constitution or winding up the firm. They also play a role in regularizing arrangements where directors have potential conflicts of interest [5](#page=5).
#### 2.3.2 Shareholder passivity and collective action problems
Despite legal powers, actual shareholder involvement in publicly traded firms often lags behind their legal roles, a phenomenon famously discussed by Berle and Means concerning the separation of ownership and control. Several factors contribute to shareholder passivity [6](#page=6):
* **Limited Liability:** Capping downside risk reduces shareholders' incentive to intervene in managerial affairs [6](#page=6).
* **Managerial Expertise:** Corporate executives are generally better qualified to make managerial decisions than shareholders [6](#page=6).
* **Trivial Impact of Individual Action:** For investors with diversified portfolios, participating in the affairs of a single company may have a negligible impact on their overall equity portfolio value [6](#page=6).
* **Liquidity of the Stock Market:** If mismanagement becomes a significant concern, selling shares can be a quicker and less costly solution than direct intervention [6](#page=6).
* **Collective Action Problem:** This is a critical factor where rational, self-interested individuals fail to act to increase collective welfare. Disciplining management is a classic collective good; all shareholders benefit if management is disciplined, regardless of their individual contribution. This leads individuals to "free ride" on the efforts of others, often resulting in inaction even when intervention would be collectively beneficial [6](#page=6).
#### 2.3.3 Blockholders and shareholder activism
Shareholders are not always "rationally apathetic" and can engage in corporate affairs:
* **Blockholders:** Individuals or families owning a substantial block of shares are an exception. Their disproportionate wealth tied to the company and potential difficulty in liquidating large stakes incentivize them to take a considerable interest in company management. Their voting power positions them to influence shareholder resolutions [6](#page=6).
* **Defensive Activism:** Blockholders often intervene to protect the value of their existing investment [6](#page=6).
* **Offensive Activism:** This occurs when an investor without a meaningful stake builds a sizeable holding in a perceived undervalued company to agitate for changes if returns are below expectations. Hedge funds have become prominent practitioners of offensive shareholder activism [6](#page=6).
### 2.4 Conflicts of interest and bargaining
Conflicts of interest can arise between different corporate participants and among shareholders themselves [6](#page=6).
#### 2.4.1 Conflicts between shareholders
Friction can occur between shareholders, particularly when a single individual (like a founder) or a cohesive group (like a family) owns a substantial percentage of shares. Outside investors are at risk of dominant factions securing disproportionate returns, known as "private benefits of control" [6](#page=6) [7](#page=7).
#### 2.4.2 Bargaining over rights
Shareholders anticipating potential conflicts may attempt to bargain for specified rights and remedies [7](#page=7).
* **Privately Held Companies:** Negotiations are typically easier due to face-to-face interactions [7](#page=7).
* **Publicly Traded Companies:** Investors in these companies usually purchase equity on a "take it or leave it" basis, as negotiating corporate constitution terms beforehand is often impracticable [7](#page=7).
> **Tip:** While this non-negotiability is often highlighted, high-volume acceptance of standardized, non-negotiable terms is common in many contracts (e.g., leases, mortgages, click-through agreements). Furthermore, differences in governance arrangements between smaller and larger publicly traded firms suggest that private ordering is still at play in the public company sector [7](#page=7).
---
# Creditors' interests and governance impact
This section details the nature of creditors, the terms of their contracts, the risks they face, and their influence on corporate governance.
### 3.1 Types of creditors
A variety of entities can become creditors of companies. Key examples include [7](#page=7):
* **Trade creditors:** These entities supply goods and services on credit, not requiring immediate payment [7](#page=7).
* **Institutional lenders:** Primarily banks, which also act as creditors to their depositors [7](#page=7).
* **Bond or debenture holders:** Investors whose right to payment is evidenced by certificates issued by the company, often facilitated through a trustee for multiple investors [7](#page=7).
### 3.2 Duration of debt contracts
Debt contracts universally specify a repayment date, defining the maximum legal duration of the debt [7](#page=7).
* **Short-term:** Trade creditors often grant credit for 30 or 60 days [7](#page=7).
* **Long-term:** Corporate bonds and debentures can have repayment periods spanning years. However, the relationship with individual debenture holders or bond investors can be transient due to the tradability of these instruments on the open market [7](#page=7).
**Tip:** While some debt contracts, like bank accounts, allow immediate repayment demands, banks typically lack sufficient funds to satisfy all depositors simultaneously, creating a risk of bank runs [8](#page=8).
### 3.3 Return on debt contracts
The standard debt contract requires the debtor to repay the principal amount advanced, along with interest [8](#page=8).
* **Yield:** The agreed-upon rate of return for the lender if principal and interest are paid on time [8](#page=8).
* **Fixed claims:** A crucial aspect for creditors is that debts represent fixed claims. Their return does not fluctuate with the company's fortunes, unlike shareholder returns [8](#page=8).
**Complications in calculating return:**
* **Time value of money:** Money received in the future is worth less than money available now due to foregone investment opportunities [8](#page=8).
* **Inflation:** Can erode the purchasing power of the repaid amount [8](#page=8).
### 3.4 Risk for creditors
The yield on debt is a promised rate, not guaranteed, as debtors may default [8](#page=8).
* **Default risk:** The likelihood that a corporate debtor will fail to meet its debt obligations partially or in full. This risk is heightened when a company is in financial distress, as creditors have priority over shareholders in liquidation, but may not be fully repaid if assets are insufficient [8](#page=8).
**Strategies to manage default risk:**
* **Screening:** Assessing the probability of default by analyzing market conditions, industry trends, and management quality of the prospective debtor before lending [8](#page=8).
* **Walking away:** Declining to lend if the default risk is non-trivial [8](#page=8).
* **Bargaining for a higher yield:** Compensating for increased risk with a higher promised return [8](#page=8).
* **Contracting for prompt repayment:** Shorter-term debts reduce the likelihood of the debtor facing ruin while the money is still owed [8](#page=8).
* **Bargaining for security:** Securing the right to claim specific corporate assets in case of default [8](#page=8).
* **Diversification:** Holding a portfolio of diverse debt obligations significantly reduces overall default risk, as individual corporate failures are less impactful. Banks and trade creditors typically hold many loans/customers, naturally diversifying their risk [8](#page=8).
> **Example:** Pan American, a large airline in the 1960s, eventually filed for bankruptcy in 1991, illustrating that even seemingly stable companies can default [8](#page=8).
### 3.5 Control by creditors
Creditors can exert control over a debtor company's affairs to mitigate risks, especially when default is imminent or has occurred [9](#page=9).
* **In distress:** Creditors may take charge of the business, arrange for its shutdown and asset sales, or orchestrate corporate rescues by working with existing management or replacing them. Success means the company can repay debts, or it can be sold as a going concern [9](#page=9).
* **In solvent companies:** Creditors typically find it uneconomical to become actively involved in the decision-making of solvent companies. The fixed nature of their return means they do not directly profit from increased corporate prosperity. Their downside risk is limited to the amount loaned, further reducing the incentive to intervene [9](#page=9).
**Factors deterring active creditor involvement in solvent companies:**
* **Diversification:** Lending to numerous companies mutes the incentive to intervene in any single one [9](#page=9).
* **Resource constraints:** Involvement in each company's affairs would be extremely time-consuming and costly for creditors dealing with many corporate debtors [9](#page=9).
### 3.6 Conflicts of interest between creditors and shareholders
While a prosperous company generally sees harmony, tensions between creditors and shareholders can arise [9](#page=9).
* **Equity cushion:** In a prospering company, a substantial "equity cushion" (residual value of assets after liabilities) protects creditors [9](#page=9).
* **Shared monitoring benefits:** Monitoring by both groups can curb mismanagement, benefiting both [9](#page=9).
**Sources of conflict:**
* **Claim dilution:** Shareholders may favor accumulating new debt, even if it increases default risk for existing creditors, to pursue lucrative opportunities [9](#page=9).
* **Asset withdrawal:** Generous dividend policies can please shareholders but erode the equity cushion, increasing creditor risk [10](#page=10).
* **Risky managerial strategies:** Shareholders, as residual claimants with limited liability, may pursue high-risk, high-return projects that offer significant upside for them but disproportionately increase default risk for creditors. This can be seen as a "heads we win, tails creditors lose" scenario for shareholders [10](#page=10).
> **Tip:** Diversification can help equity investors mitigate the impact of failed corporate ventures, further incentivizing them to pursue riskier projects than creditors might prefer [10](#page=10).
### 3.7 Bargaining by creditors
Creditors use debt contracts to negotiate precautions against risks [10](#page=10).
* **Contractual provisions:**
* **Security against assets:** [10](#page=10).
* **Short repayment periods:** [10](#page=10).
* **Acceleration clauses:** Allowing immediate demand for repayment if contract terms are breached [10](#page=10).
* **Monitoring enhancements:** Requiring regular submission of financial information [10](#page=10).
* **Restrictions on conduct:** Requiring permission before creating additional debt, distributing dividends, or engaging in certain business strategies (e.g., stipulating how funds are used) [10](#page=10).
**Limitations of bargaining:**
* **Impossibility of anticipating all risks:** It's impossible to foresee every conduct that could harm creditor interests [10](#page=10).
* **Cost and time:** Negotiating and drafting effective provisions can be expensive and time-consuming [10](#page=10).
* **Enforcement challenges:** Monitoring compliance and collecting on unpaid debts can be costly, diminishing the practical utility of extensive contractual rights [10](#page=10).
* **Competitive pressures:** In a competitive debt finance market, creditors may forego stringent protective strategies to avoid losing business to lenders offering more lenient terms [10](#page=10).
> **Tip:** While creditors can negotiate for rights like debt acceleration, they often hesitate to exercise them when debtors lack the immediate financial means to comply, rendering these rights less effective in practice [10](#page=10).
---
# Employees' position in corporate governance
Employees' position in corporate governance involves understanding their role, the terms of their employment, the risks they face, their influence, potential conflicts, and how bargaining shapes their standing within a company [11](#page=11).
### 4.1 The employment relationship dynamics
The employment relationship is characterized by the authority vested in the employer, requiring employees to accept a "zone of acceptance" and follow directions. While day-to-day operations are governed by internal administrative systems rather than formal contract negotiations or market forces, economic principles remain relevant, influencing labor market norms and employment terms. The authority of management can be justified by efficiency considerations, offering predictability and order, although employees may resent this authority and monitoring. Conversely, employment provides employees with predictable hours and wages, aiding in personal and financial planning. Dismissals can sometimes appear arbitrary, but the bargaining elements of duration, risk, return, control, conflicts of interest, and bargaining are key to understanding workers' roles [11](#page=11).
### 4.2 Duration of employment
Employment contracts for rank-and-file workers are typically not fixed-term, continuing until resignation, retirement, company cessation, or dismissal. While employers may seem to have the option to terminate contracts without a specified duration, courts have implied terms requiring notice periods for dismissal. Many jurisdictions provide statutory protection against immediate dismissal without just cause, though the United States largely operates under an "at will" employment doctrine allowing discharge with immediate effect and without cause [11](#page=11).
The duration of employment is influenced by various factors. New entrants to the job market, with transferable skills and fewer firm-specific needs, may find it easier to secure equivalent work, making them less tied to their current employer. The rise of the "on-demand" economy via online platforms has also led to speculation about a decline in full-time employment. However, for many corporate employees, mobility can decrease over time, especially when companies invest in specialized training and unique firm-specific skills, making replacement costly and time-consuming [12](#page=12).
### 4.3 Return on employment
The primary return for employees comes in the form of wages, paid as an hourly rate or a fixed salary, and benefits such as pensions and health insurance. These are considered fixed claims, obligating the corporation to pay agreed wages and provide benefits regardless of its financial performance, provided it remains in business [12](#page=12).
Thriving firms often pay higher wages than less successful ones, but wage and benefit levels rarely fluctuate directly with business success. Linking employee return to corporate performance through schemes like employee share ownership or profit-sharing could incentivize harder work and cost-saving. Nearly two-fifths of American employees participate in some form of profit-sharing [12](#page=12).
However, such schemes have downsides, including incentive misalignment, as an individual's contribution is often a minor factor in overall corporate performance, diluting the incentive effect. Employees also have reservations about pay being closely tied to corporate performance due to significant fluctuations in net earnings and share prices, which complicate personal financial planning. Consequently, profit-sharing and share ownership schemes typically supplement, rather than replace, fixed wages, creating a trade-off between insulating employees from financial impacts and diluting incentives [12](#page=12) [13](#page=13).
### 4.4 Risk faced by employees
The primary risk for employees is job loss, whether through dismissal or company closure, which can result in significant costs. Unlike diversified shareholders and creditors, employees typically have only one job and can experience a hit to lifetime earnings, requiring considerable effort to find new employment and make lifestyle adjustments [13](#page=13).
Linking remuneration closely to corporate performance can exacerbate these risks. Holding an equity stake in their employer becomes particularly risky, as company stock is most likely to decline when job security is threatened, as evidenced by the collapses of Enron and Lehman Brothers [13](#page=13).
### 4.5 Employee control and influence
Employees can influence managerial decisions through two main avenues: direct equity ownership, which grants voting power and distributions based on net earnings, or through worker representatives who confer with company management. Many European countries, for instance, mandate worker representation on boards of directors [13](#page=13).
While worker control is praised for allowing participation in decisions affecting economic welfare and fostering commitment, full-scale employee ownership of large companies is rare. Employees, or their representatives, typically do not participate in strategic management, acting more as "doers" than "thinkers," even in countries with boardroom representation [13](#page=13).
> **Tip:** Understand that while worker control is an appealing concept, its practical implementation in major corporations is limited, with decision-making power often remaining with directors and shareholders.
### 4.6 Conflicts of interest
Conflicts of interest are inherent between employees and other corporate participants. Shareholders and creditors rely on employees to work diligently, skillfully, and honestly, placing employees in an agent-like position. Given fixed pay, employees may be tempted to work at a leisurely pace or over-consume perks, imposing agency costs on principals [14](#page=14).
Conversely, companies may prioritize cost-saving and profitability, leading to downsizing regardless of individual worker capabilities, a practice criticized for being "unsafe and unfair to company workers" in the context of "shareholder-first" capitalism [14](#page=14).
Despite potential conflicts, substantial alignment of interests can exist. In successful firms, stakeholders benefit from growth, leading to potential job creation and better pay. Treating employees well, through consultation, training, and job security assurances, can foster flexibility, adaptability, and loyalty, potentially improving corporate performance and benefiting investors and lenders who see value in employees working "smarter". Empirical evidence links employee satisfaction to customer satisfaction and business value. However, in challenging times, this alignment can be difficult to sustain, as exemplified by a CEO's shift from family rhetoric to acknowledging necessary "head count adjustments" [14](#page=14).
### 4.7 Bargaining in employment
Bargaining can help resolve conflicts between employees and other corporate participants. For instance, "tin parachute" clauses in employment contracts provide severance pay in case of job loss due to hostile takeovers. Employment contracts are often brief, focusing on core terms like wages and hours, and may not explicitly detail responsibilities or performance expectations. Some argue that "at will" employment arrangements lack the commitment to an ongoing relationship to be considered truly contractual [15](#page=15).
Contractual brevity allows flexibility in responding to changing circumstances in a long-term relationship. Gaps in contracts are addressed by mechanisms like unions, whose collective agreements are more detailed than individual contracts, covering working conditions, redeployment, and dismissal procedures. The legal system also addresses employment contract gaps through statutes, such as the U.K.'s Employment Rights Act 1996, which mandates written statements of employment particulars, and regulations governing health and safety, and discrimination [15](#page=15).
---
# Directors' responsibilities and governance functions
This section details the roles, tenure, remuneration, risks, oversight, conflicts of interest, and contractual aspects related to company directors, distinguishing between executive and non-executive roles.
### 5.1 Role and structure of the board
According to the U.K. Corporate Governance Code, a company's board is responsible for establishing the company's strategy. Corporate law generally vests the power to manage a company in the board of directors. In situations of disputes among corporate participants regarding company management, the board of directors, acting collectively, must ultimately make the decision. However, boards typically possess broad discretion to delegate managerial authority, subject to a duty of care to monitor the exercise of these delegated powers. In practice, boards of publicly traded companies often delegate significant managerial responsibilities to individuals holding executive positions within the company. Consequently, decisions concerning hiring, firing, work assignments, product launches, and pricing are usually made outside the boardroom [15](#page=15) [16](#page=16).
#### 5.1.1 Executive and non-executive directors
In publicly traded companies, the highest-ranking full-time executives are typically members of the board. They are often joined by individuals who are not involved in the company's day-to-day operations. These individuals are commonly referred to as "outside" or "non-executive" directors (NEDs). The term "outside director" is prevalent in the U.S., while "non-executive director" is more common in the U.K. [16](#page=16).
NEDs are involved in two primary board functions:
1. Providing advice, guidance, and support to full-time executives in their managerial tasks [16](#page=16).
2. Monitoring executive decision-making [16](#page=16).
The extent to which boards perform these roles depends on their structure [16](#page=16).
#### 5.1.2 Board structures: unitary vs. two-tier
The most common global arrangement is a **unitary, one-tier board structure**, where all directors form a single body and act collectively. In this model, NEDs can theoretically fulfill both advisory and monitoring roles [16](#page=16).
In contrast, **two-tier boards** consist of two separate bodies:
* A **management board**: Composed of senior full-time executives responsible for setting corporate policy [16](#page=16).
* A **supervisory board**: Staffed by outside directors [16](#page=16).
With this structure, NEDs on the supervisory board focus almost exclusively on monitoring [16](#page=16).
### 5.2 Duration of service
#### 5.2.1 Appointment
A director's term of service commences upon their selection. Shareholders typically have significant formal influence over director selection, as equity investment is generally accompanied by governance rights. In countries with unitary boards, company legislation usually grants shareholders the authority to elect directors. The U.K. is an exception, where the company's corporate constitution governs director appointments. In two-tier systems, shareholders' election rights are usually limited to supervisory board members, who then select management board members. In jurisdictions mandating two-tier boards, employees often have the right to elect a proportion (commonly one-third) of supervisory board members [16](#page=16).
#### 5.2.2 Term lengths
Many jurisdictions stipulate the duration of a director's term before they must step down and potentially seek re-election. There is considerable variation [16](#page=16):
* In Sweden and Delaware (U.S.), the term is typically one year, unless the corporate constitution states otherwise. A one-year term is also the norm for large U.S. public companies [16](#page=16) [17](#page=17).
* Other countries have longer terms, such as three years in Italy, four years in the Netherlands, and six years in France and Belgium [17](#page=17).
* In the U.K., the corporate constitution dictates director tenure, but guidance from the U.K. Corporate Governance Code suggests most companies listed on the London Stock Exchange provide for annual re-election of directors [17](#page=17).
#### 5.2.3 Departure from office
Directors may leave office before their terms expire through:
* **Removal**: The power to remove a director is usually vested in the same body responsible for appointment. In the U.K., while the constitution governs board selection, the Companies Act 2006 allows shareholders to dismiss a director via an ordinary resolution (simple majority vote) [17](#page=17).
* **Resignation**: This can occur for personal reasons, or due to circumstances like a shift in voting control after a takeover, leading existing directors to resign for the new regime. Directors may also resign if they fundamentally disagree with the rest of the board, or to limit reputational harm from possible corporate malfeasance, though they may have an ethical or legal obligation to serve their term if it helps minimize harm to the company [17](#page=17).
Recent trends suggest that the actual time of service for NEDs has become shorter. Guidance in the U.K. Corporate Governance Code indicates that boardroom service exceeding nine years for a listed company can impair a director's independence. Conversely, in the U.S., average board tenure in large public firms increased from under eight years in 2001 to nearly nine years by 2013, and director term limits are rare [17](#page=17).
### 5.3 Remuneration (Return)
Directors are typically entitled to fees for attending board meetings and related duties. It is crucial to distinguish between director-related returns and executive pay. This summary focuses on what outside directors receive for their service [17](#page=17).
* **Director fees**: These are generally modest compared to executive pay. For example, in 2023, the average annual NED remuneration in large U.K. public companies was approximately GBP 77,000, while CEO pay averaged nearly GBP 4 million. Unlike executive pay, which is often performance-linked (e.g., share price or profits), directors' fees are typically fixed periodically. They are usually set by referencing the practices of comparable companies [17](#page=17) [18](#page=18).
* **Executive pay**: While not the focus of this section, it is mentioned that executive pay often varies with share price fluctuations or accounting profits [18](#page=18).
> **Tip:** Always differentiate between the remuneration of non-executive directors and the compensation of executive management when analyzing board compensation, as they serve different roles and face different incentives.
### 5.4 Risk
While directors' fees are modest, the risks faced by outside directors are also generally not substantial [18](#page=18).
* **Retention risk**: Directors typically do not need to worry about retaining directorships, as shareholders almost always accept board recommendations for elections [18](#page=18).
* **Legal liability risk**: If an outside director of a publicly traded company avoids dishonest or self-serving behavior, personal liability from litigation is highly unlikely. While the prospect of being sued might incentivize vigilance, "nominal liability" (where liability is found or settled) rarely results in "out-of-pocket liability" where NEDs personally pay damages or legal fees. Such costs are almost always covered by the company, directors' and officers' (D&O) insurance, or both [18](#page=18).
* **Reputational risk**: This is a significant risk for non-executive directors. Individuals appointed as NEDs usually have established reputations for good judgment and prudent handling of complex matters. Maintaining this track record is important for pride and future business opportunities, including further board appointments. This provides a non-pecuniary incentive for directors to take their responsibilities seriously [18](#page=18).
### 5.5 Control and oversight
#### 5.5.1 The board's role in control
Some academics view corporations through a "director primacy" lens, positioning the board as the central decision-making body that balances competing interests. The more prevalent view is that boards play a modest role in company operations, despite formal managerial authority. Under this view, the board's primary responsibilities are selecting and setting pay for the CEO and top executives, and then monitoring management as a check. Boards may also act in an advisory capacity [18](#page=18).
#### 5.5.2 Criticisms of board oversight
Many critics argue that outside directors fall short as managerial "watchdogs," failing to sufficiently restrain corporate executives. Historical criticism, punctuated by major governance scandals (e.g., Enron, WorldCom) and the 2008 financial crisis, highlights ongoing concerns about board effectiveness. Even when directors work harder, many acknowledge that board performance may not be satisfactory [18](#page=18) [19](#page=19).
#### 5.5.3 Two-tier boards and monitoring
Theoretically, two-tier boards appear better positioned for effective corporate oversight than unitary boards. Supervisory board directors, separate from policy formulation and continuous management interaction, should be able to maintain a detached perspective and focus solely on monitoring, theoretically making them better guardians of managerial accountability. However, the extent to which this potential is realized is subject to considerable doubt [19](#page=19).
> **Example:** Critics like Walter Buffett have noted that the "boardroom atmosphere almost invariably sedates (directors') fiduciary genes" and that "collegiality trumps independence," suggesting a reluctance to challenge management effectively [18](#page=18).
#### 5.5.4 Evolving board dynamics
Recent observations suggest that outside directors may be exerting more influence. Boards are described as having evolved from informal gatherings to more diverse and demanding constituencies, working harder and longer. Despite these claims, criticism persists, with some commentators noting that directors too often "opt for the path of least resistance" and that many boards are not performing adequately [19](#page=19).
### 5.6 Conflicts of interest
#### 5.6.1 Divergence from shareholder interests
While shareholders typically select most directors in publicly traded firms, the interests of outside directors do not always fully align with those of shareholders. A key divergence is that NEDs tend to be more cautious than shareholders might prefer. Diversified equity investors typically favor projects with high risk-adjusted returns, even if success is not guaranteed [19](#page=19).
Outside directors view matters differently because:
* Their return as directors is not usually linked to corporate profitability, providing little direct financial benefit from successful risky ventures [19](#page=19).
* They may face reputational losses and legal liabilities if ambitious projects fail [19](#page=19).
* Their lack of day-to-day involvement limits their ability to closely monitor risky ventures [19](#page=19).
Consequently, outside directors often have incentives to act as a brake on changes that diversified equity investors might support [19](#page=19).
#### 5.6.2 Representation of special constituencies
NEDs can also face conflicts of interest when appointed to represent a particular constituency on the board. This can occur if [19](#page=19):
* The law grants employees the right to elect a proportion of directors [19](#page=19).
* A director is a de facto nominee of an influential shareholder (e.g., a large stake holder or activist) [19](#page=19).
* An influential creditor is given the opportunity to nominate a director, particularly in financially troubled companies [20](#page=20).
#### 5.6.3 "Nominee" directors and conflicting duties
While company law imposes uniform duties on all directors, "nominee" directors are often understood to support the views of their appointers. This can place them at odds with other corporate constituencies. For example, a director appointed by a bank might face a dilemma if the company plans to raise capital and the director's bank is competing to finance it. In situations of underperforming management, a bank-appointed director might be reluctant to cross executives, while still needing to consider shareholder and other creditor interests [20](#page=20).
> **Tip:** Directors appointed to represent specific constituencies (like employees or creditors) must navigate complex loyalties, balancing their duty to the company with the interests of their nominators.
### 5.7 Bargaining and contractual mechanisms
#### 5.7.1 Directors' and Officers' (D&O) insurance
A significant contractual mechanism for directors is Directors' and Officers' (D&O) insurance. This is a policy purchased by the company to cover legal liabilities and expenses incurred by directors due to their service. The policy can reimburse the company for indemnifying a director or reimburse a director directly if the company does not [20](#page=20).
* **Prevalence**: D&O insurance has traditionally been more popular in the U.S. due to higher litigation risks, but it has become commonplace globally, with many larger public companies purchasing such coverage [20](#page=20).
* **Limitations**: D&O insurance has coverage limits and excludes certain misconduct (e.g., dishonest or fraudulent behavior). It also does not shield directors from the inconvenience or adverse publicity of being sued [20](#page=20).
#### 5.7.2 Reconfiguring remuneration
Addressing conflicts of interest for NEDs through contractual responses is challenging. Linking director remuneration more closely to firm performance, as some might suggest, could compromise objectivity, which is highly valued in corporate governance. For directors representing special constituencies, questions exist about whether their duties to the company are truly voluntary undertakings [20](#page=20).
---
# Executives and their influence on corporate strategy
This topic examines the roles, remuneration, risks, control, conflicts of interest, and bargaining limitations of top corporate executives in shaping corporate strategy.
### 6.1 Executive roles and decision-making
Top executives hold managerial authority delegated by the board of directors and are responsible for making key strategic and administrative decisions. These decisions establish the company's future direction, including market exploitation, product/service offerings, and organizational structure. The Chief Executive Officer (CEO) typically leads in setting and implementing corporate policy, while other top managers handle specialized duties or oversee specific operational areas [21](#page=21).
### 6.2 Contractual duration
Executive employment is typically governed by explicit service contracts [21](#page=21).
#### 6.2.1 Fixed-period contracts
These contracts specify an expiration date. In the U.S., CEO contracts for publicly traded companies often have durations of one to five years, with three years being most common. If a contract is not renewed, employment formally ends upon its expiry [21](#page=21).
#### 6.2.2 Breach of contract and severance
Executives dismissed before their contract expires may sue for breach of contract, with damages often dependent on the remaining contract duration. Substantial remaining time can facilitate negotiation of generous severance payments. The U.K. Corporate Governance Code suggests notice or contract periods of one year or less for executives, unless longer periods are necessary for external hires [21](#page=21).
#### 6.2.3 Notice periods
Contracts can specify a notice period required for termination. The length of this notice period influences severance pay for dismissals without legal cause [21](#page=21).
#### 6.2.4 Employment "at will"
A minority of CEOs of large American public companies may not have explicit employment contracts, effectively working "at will" with no legal entitlement to severance [22](#page=22).
#### 6.2.5 Executive tenure
Research from the U.S. indicates a trend of decreasing CEO tenure, falling from nearly eight years in the 1990s to around five years by the late 2010s. Average CEO tenure in other countries also falls between five and six years. Executives often have a longer overall tenure with their company, though the proportion of those spending their entire careers with one firm has declined. However, a substantial proportion of new CEOs are internal hires or come from within the board or executive ranks of the hiring firm [22](#page=22).
### 6.3 Executive remuneration
Top executives are typically well compensated, with remuneration comprising several components [22](#page=22).
#### 6.3.1 Base salary
Managerial service contracts invariably include a salary, which is adjusted periodically but remains fixed between reviews and is not tied to corporate performance [22](#page=22).
#### 6.3.2 Performance-oriented pay
Various remuneration forms are variable and linked to performance targets:
* **Bonus schemes:** Executives receive cash, shares, or a combination, based on meeting or exceeding performance targets. These can be annual or long-term [22](#page=22).
* **Share options:** Granting executives the right to buy company equity at a predetermined price can be profitable if the company's share price increases [22](#page=22).
#### 6.3.3 Perks and benefits in kind
Companies often provide executives with additional benefits, such as company cars, lavish office accommodations, tickets to events, and pension plans. Pension plans are frequently the most lucrative perk [22](#page=22).
### 6.4 Executive risk
While executives are generally not personally liable for corporate debts (absent specific legislation) they face significant risks due to their substantial human capital (reputation, training, knowledge) being tied to their roles [22](#page=22) [23](#page=23).
#### 6.4.1 Overinvestment and remuneration
Executives may have legitimate reservations about variable pay strongly linked to corporate performance because they are already functionally "overinvested" in their firms. Diversification is a prudent investment strategy, and executives may prefer not to further concentrate risk by tying their pay directly to company fortunes [23](#page=23).
#### 6.4.2 Job loss and reputation
Losing their job is a highly unwelcome prospect for executives, leading to loss of remuneration and potential long-term damage to future employment prospects. Departures involving failure or controversy can make it difficult to regain trust from boards and investors. Association with scandal can also negatively impact job prospects, particularly in countries with strong governance systems [23](#page=23).
#### 6.4.3 Circumstances of departure
Forced departures can occur when boards seek new leadership, after poor firm performance, during takeovers, or upon company liquidation. It is often difficult to distinguish between voluntary and forced departures due to companies' reticence to discuss dismissals publicly. Academics often classify CEO "retirement" before age 60 as forced turnover. Forced turnover rates vary geographically, being higher in Northern Europe and North America than in Southern Europe, South America, India, and Japan [23](#page=23).
### 6.5 Executive control
Boards typically delegate significant managerial powers to executives, giving management considerable control over publicly traded firms. However, control extends beyond formal authority to the discretion to act without substantial constraints [23](#page=23).
#### 6.5.1 Internal constraints
Corporate governance focuses on "internal" checks and balances, primarily scrutiny by the board of directors and shareholders [24](#page=24).
#### 6.5.2 External constraints
Market-driven external constraints also limit managerial discretion:
* **Labor market for executives:** Ambitious executives seeking better opportunities elsewhere are incentivized to perform well in their current roles to impress potential employers [24](#page=24).
* **Markets for products and services:** Competition disciplines management. Poorly performing companies lose market share and may face insolvency [24](#page=24).
* **Capital markets:** The need to raise funds for operations and expansion leads to scrutiny by investors and financial intermediaries, incentivizing effective and profitable management [24](#page=24).
* **Market for corporate control:** Incompetent or complacent management can lead to a disparity between actual and potential performance, potentially resulting in a takeover bid. Executives aim to run companies effectively to deter such bids and protect their jobs [24](#page=24).
#### 6.5.3 Limitations of external constraints
* **Product market:** The impact can be delayed, especially for companies with significant market power [24](#page=24).
* **Market for corporate control:** Takeovers are expensive and may only address extreme cases of poor management; activity is also cyclical [25](#page=25).
* **Managerial talent market:** This is only a significant constraint if job mobility is high. Movement at the very top remains rare, with few CEOs being hired directly from similar roles at other companies [25](#page=25).
### 6.6 Conflicts of interest
Executives may engage in conduct detrimental to other corporate participants.
#### 6.6.1 Shirking and competence costs
"Shirking" refers to management's choice of effort level. While executives benefit from diligence, they are not personally liable for corporate debts. However, honest mistakes ("agent competence costs") are considered more likely to adversely affect others than managerial laziness, given the ambition of top managers [25](#page=25).
#### 6.6.2 Looting
This involves less egregious conduct than outright theft, such as authorizing lavish offices, exploiting expense accounts for personal gain, or hiring family and friends in high-paying roles. Such actions can reduce shareholder returns, increase debt risk, and threaten the company's viability [25](#page=25).
#### 6.6.3 Risk preferences
Executives, with their human capital tied entirely to their company, may have different risk preferences than diversified shareholders [25](#page=25).
* **Established companies:** Shareholders may favor risky projects with high potential returns, while executives, concerned about jeopardizing the company's stability and their jobs, might prefer a more cautious approach [25](#page=25).
* **Impending failure:** In times of crisis, shareholders and employees may favor high-risk gambles for a chance at recovery, while creditors would oppose them due to the increased debt risk. Management may be tempted to align with shareholders and employees if success could save the company and their positions [26](#page=26).
### 6.7 Bargaining and its limitations
Contractual mechanisms can address some conflicts of interest.
#### 6.7.1 Contractual solutions
* **Debt contracts:** Can restrict certain corporate actions to alleviate creditor concerns [26](#page=26).
* **Managerial service contracts:** Provisions for substantial variable pay linked to shareholder returns (e.g., stock options, performance-based bonuses) aim to motivate executives to think like shareholders and align their interests with those of equity investors [26](#page=26).
#### 6.7.2 Inherent limitations
Despite contractual measures, conflicts of interest cannot be fully resolved. As Lynn Stout notes, "This quest is a bit like the quest for the Holy Grail. No perfect contract is possible, and gaps inevitably remain" [26](#page=26).
* **"Overinvestment" dilemma:** Even with equity-linked pay, senior executives who are "overinvested" in a successful company might still shy away from lucrative but risky ventures that diversified shareholders might favor, as these ventures could jeopardize their jobs and the value of their remuneration [26](#page=26).
#### 6.7.3 Implications for regulation
The limitations of bargaining, monitoring, market forces, and contractual clauses mean that executives retain scope for conduct that can detrimentally affect stakeholders. This justifies the consideration of corporate governance-related regulation [26](#page=26).
---
## Common mistakes to avoid
- Review all topics thoroughly before exams
- Pay attention to formulas and key definitions
- Practice with examples provided in each section
- Don't memorize without understanding the underlying concepts
Glossary
| Term | Definition |
|------|------------|
| Agency analysis | An analytical framework used to understand conflicts of interest between parties, often characterized as principals and agents, where one party acts on behalf of another. |
| Agency costs | Costs incurred by principals due to conflicts of interest with their agents, arising from imperfect monitoring, bonding by the agent, and residual loss. |
| Asset withdrawal | A practice where a company's shareholders may favor policies that lead to the extraction of company assets, such as through generous dividend payments, which can reduce the equity cushion protecting creditors and increase their risk. |
| Bargaining | The process of negotiation between parties to reach an agreement on terms and conditions, crucial for resolving potential conflicts of interest and defining relationships within a corporate context. |
| Blockholders | Shareholders who own a substantial percentage of a company's shares, often giving them significant influence over corporate decisions and potentially leading to unique governance considerations compared to smaller, dispersed shareholders. |
| Board of directors | The governing body of a company, formally vested with the authority to manage the company's affairs, responsible for setting strategy, monitoring executive performance, and acting in the best interests of the corporation. |
| Capital markets | The markets where financial assets like stocks and bonds are traded, playing a crucial role in corporate finance by providing mechanisms for companies to raise capital and for investors to buy and sell ownership stakes. |
| Collective action problem | A situation where individuals acting in their rational self-interest fail to contribute to a group's welfare, even though collective action would benefit everyone; this is often seen in shareholder passivity. |
| Company constitution | The set of rules and regulations that govern the internal affairs of a company, often including articles of association or bylaws, which dictate how the company is managed and how decisions are made. |
| Contract of adhesion | A standardized contract drafted by one party and offered on a "take-it-or-leave-it" basis to another party, who has little or no opportunity to negotiate its terms. |
| Corporate governance | The system of rules, practices, and processes by which a company is directed and controlled, involving the balancing of interests of a company's many stakeholders, such as shareholders, management, customers, suppliers, financiers, government, and the community. |
| Creditors | Individuals or entities to whom a company owes money or financial obligations, such as lenders or suppliers who have extended credit. |
| Default risk | The risk that a borrower will fail to meet its debt obligations, either partially or in full, leading to financial losses for the creditor. |
| Directors and Officers (D&O) insurance | Insurance purchased by a company to protect its directors and officers from personal liability and legal expenses arising from their actions while serving the company. |
| Diversification | An investment strategy that involves spreading investments across various assets or companies to reduce overall risk, particularly by mitigating company-specific or "unsystematic" risk. |
| Dividend policy | The guidelines a company follows regarding the distribution of profits to shareholders in the form of dividends, which can impact the equity cushion protecting creditors. |
| Efficient Capital Market Hypothesis (ECMH) | A theory suggesting that asset prices fully reflect all available information. Its weak form posits that past prices do not predict future prices, while the semi-strong form suggests prices reflect all public information, and the strong form implies prices reflect all information, public or private. |
| Equity | Ownership interest in a company, typically represented by shares, which entitles holders to a share of the company's profits and assets after liabilities are met. |
| Equity cushion | The residual value of a company's enterprise after all liabilities have been accounted for, representing the value of assets available to shareholders. |
| Executives | Senior managers responsible for the day-to-day running of a company and the implementation of corporate strategy, often comprising the CEO and other top management positions. |
| Fiduciary duty | A legal or ethical relationship of trust between two or more parties, where one party owes a duty of care, loyalty, and good faith to act in the best interests of the other(s). |
| Fixed claims | Financial obligations that are predetermined and do not vary with the company's financial performance, such as contractual wages for employees or principal and interest payments for creditors. |
| Founder/family ownership | A situation where the original founder of a company or their family retains a substantial ownership stake, influencing long-term strategy and governance. |
| Fund management costs | The expenses associated with managing investment funds, including fees paid to fund managers and operational costs, which are passed on to investors. |
| Index tracking funds | Investment funds that aim to replicate the performance of a specific stock market index by holding the same securities in the same proportions. |
| Information asymmetry | A situation where one party in a transaction has more or better information than the other, which can lead to market inefficiencies and conflicts of interest. |
| Institutional investors | Large organizations, such as pension funds, insurance companies, and mutual funds, that invest significant sums of money on behalf of their beneficiaries or clients. |
| Limited liability | A legal principle that protects shareholders from personal responsibility for the debts and obligations of the corporation, meaning they can only lose the amount invested in their shares. |
| Managerial authority | The power and discretion vested in company managers to make decisions and direct the operations of the business. |
| Market for corporate control | The market where controlling interests in companies are acquired and disposed of, often through takeover bids, which can act as a constraint on incumbent management. |
| Market for managerial talent | The labor market for executives, where their skills and performance are evaluated by prospective employers, influencing their conduct in their current roles. |
| Market forces | Economic principles, such as supply and demand, that influence corporate behavior and market outcomes without direct intervention from regulators. |
| Monitoring | The process by which stakeholders, such as boards of directors or creditors, oversee and scrutinize the actions and performance of company management to ensure accountability and compliance. |
| Nominee directors | Directors appointed to a board to represent the interests of a particular shareholder or constituency, which can sometimes create conflicts of interest with the company's overall interests. |
| Non-executive directors (NEDs) | Directors who are not full-time employees of the company and typically serve on the board to provide independent oversight and advice, focusing on monitoring executive decision-making. |
| Outside directors | Another term for Non-Executive Directors (NEDs), emphasizing their independence from the company's day-to-day operations. |
| Overinvestment | A situation where senior executives are functionally "overinvested" in the companies they run due to their human capital being tied to the firm, potentially leading to risk-averse decision-making. |
| Private benefits of control | Advantages or profits that dominant shareholders or management can secure for themselves, disproportionate to their ownership stake, often at the expense of other shareholders. |
| Profit-sharing arrangements | Compensation schemes where employees receive a portion of a company's profits, linking their remuneration to corporate performance and potentially aligning interests. |
| Residual claimants | Stakeholders, primarily shareholders, who are entitled to any remaining assets or profits of a company after all other obligations and claims have been satisfied. |
| Retail investors | Individual investors who purchase securities for their own accounts, as opposed to institutional investors. |
| Risk aversion | A preference for certainty and a reluctance to take on risk; risk-averse investors prefer lower returns with lower risk over higher returns with higher risk. |
| Screening | The process by which lenders assess the probability of a borrower defaulting before extending credit, by evaluating market conditions, industry trends, and management quality. |
| Security | In the context of debt, this refers to collateral or assets pledged by a borrower to a lender, which the lender can seize in the event of default. |
| Separation of ownership and control | A phenomenon in large corporations where the ownership of the company (shareholders) is distinct from the control and management of the company (executives and directors). |
| Shareholder activism | The practice of shareholders using their influence and voting power to advocate for changes in a company's management, policies, or strategy. |
| Shareholder primacy | A corporate governance approach that prioritizes the interests of shareholders above those of other stakeholders. |
| Shareholder value | The financial worth of a company to its shareholders, typically measured by the stock price and dividends. |
| Shirking | A type of managerial conduct where executives exert less effort than optimal, potentially due to a lack of personal accountability or a disconnect between effort and reward. |
| Stock market | A public market where shares of publicly listed companies are traded, providing liquidity for investors and a mechanism for price discovery. |
| Takeover bid | An offer made by one company to acquire a controlling interest in another company, often leading to changes in management and strategy. |
| Trade creditors | Suppliers who sell goods or services to a company on credit, expecting payment at a later date. |
| Transaction costs | Expenses incurred during the process of economic exchange, such as the costs of searching for information, bargaining, and enforcing contracts. |
| Trustee | An individual or entity appointed to hold and manage assets or funds on behalf of beneficiaries, often used in the issuance of bonds or debentures. |
| Unitary board | A single-tier board of directors that comprises both executive and non-executive directors, responsible for both management and oversight. |
| Unsystematic risk | Risk that is specific to a particular company or industry and can be reduced through diversification, as opposed to systematic risk that affects the entire market. |
| Volatility risk | The risk associated with a highly variable potential return, characteristic of equity investments, where the value of shares can fluctuate significantly over time. |
| Voluntary association | An arrangement where parties choose to associate with a company based on mutual agreement and perceived benefits, allowing for analysis through bargaining relations. |
| Two-tier board | A board structure divided into two separate bodies: a management board (composed of executives) and a supervisory board (composed of non-executives), with distinct responsibilities. |