Intro and Chapter 1 Corporate Governance.pdf

# The historical evolution of corporate governance This topic traces the emergence and development of corporate governance from its initial conceptualization in the United States in the 1970s to its global expansion and the evolving priorities between shareholder and stakeholder interests [6](#page=6). ### 1.1 Corporate governance comes on the agenda While the potential for conflicts between investors and managers has existed since the advent of chartered companies in the 16th and 17th centuries, as noted by Adam Smith, the term "corporate governance" gained prominence in the United States in the 1970s. The post-World War II economic boom in the U.S. meant corporate governance was not a high priority, with shareholders largely indifferent to company operations beyond dividends and stock prices, and boards generally supportive of management [6](#page=6) [7](#page=7). However, the 1970s brought challenges. Sprawling corporate empires became difficult to manage, highlighted by the 1970 collapse of Penn Central. Revelations of widespread corporate bribery and misconduct also emerged, prompting the Securities and Exchange Commission (SEC) to place corporate governance on the official agenda. The SEC initiated proceedings against directors and required companies involved in bribery scandals to establish board-level audit committees and appoint independent directors. The New York Stock Exchange (NYSE) was also pushed to mandate independent audit committees [7](#page=7). The legal community also engaged with corporate governance. In 1976, Ralph Nader, Mark Green, and Joel Seligman published "Taming the Giant Corporation," offering an early theorization of corporate governance and advocating for broad director oversight responsibilities and community voting rights on health-hazardous corporate activities. The American Law Institute (ALI) also committed to addressing corporate governance in 1978, organizing a conference in 1980 that garnered support from the business community, who saw the ALI as a means to manage corporate challenges in a desirable way [7](#page=7). ### 1.2 Corporate governance reform: a 1980s counter-reaction The political climate of the 1970s, marked by economic instability and scandals, paved the way for a political shift to the right in the 1980s, exemplified by Ronald Reagan's presidency. This shift influenced the debate surrounding corporate governance reform [8](#page=8). Even before Reagan's election, momentum for 1970s-style reforms began to wane. A 1980 SEC staff report did not recommend legal reform for board structure. Proposed bills in Congress in 1980 aimed at increasing the role of independent directors for more democratic and accountable corporations failed to pass [8](#page=8). The 1980 election further curtailed these reform efforts. A more conservative Congress was unlikely to legislate changes to corporate governance arrangements. The SEC, under new leadership prioritizing capital formation over corporate governance, also became less vigorous in its pursuit of reforms. Debates in the early 1980s largely focused on the ALI's corporate governance project, with a de-regulatory impulse evident [8](#page=8). The business community heavily criticized the ALI's 1982 draft principles, a stark contrast to their earlier conciliatory stance. Groups like the NYSE and the Business Roundtable lobbied against the ALI's proposals, fearing expanded director liability and the imposition of rigid structures on diverse corporate practices [8](#page=8). Academics using a market-oriented "law and economics" perspective provided intellectual support for these criticisms. They rejected the pro-regulation orthodoxy stemming from Adolf Berle and Gardiner Means' 1932 work, which posited a separation of ownership and control requiring regulation to protect shareholders from powerful executives. Instead, "contractarian" theorists like Michael Jensen and William Meckling, using agency cost theory, argued that market forces and contractual relationships naturally limited managerial discretion and aligned interests, suggesting minimal state intervention was necessary. Critics like Frank Easterbrook and Daniel Fischel argued against regulating board structure, emphasizing market dynamics [8](#page=8) [9](#page=9). The ALI eventually made concessions, recasting many mandatory board structure stipulations as recommendations. The final "Principles of Corporate Governance: Analysis and Recommendations" (approved 1992, published 1994) closely resembled existing law, mollifying critics. However, by this time, the ALI's debates had largely faded from public view [9](#page=9). ### 1.3 Institutional shareholders "find" corporate governance The assumption that shareholders would remain passive and unlikely to exercise their rights, a key tenet for pro-regulatory arguments derived from Berle and Means, began to be challenged. While shareholder passivity was widely assumed, the growing ownership stakes of institutional investors (entities investing on behalf of clients) in U.S. public companies during the 1980s created a new dynamic. Institutional holdings increased significantly, making it harder for them to simply sell their shares when a company performed poorly [10](#page=10) [9](#page=9). This led institutional investors to develop a corporate governance agenda, initially driven by the threat of hostile takeovers. Executives sought to counter takeover threats with measures like "greenmail" and "poison pills". Institutional investors, concerned about losing the option to sell at a premium, pushed back against these anti-takeover tactics [10](#page=10). Despite initial setbacks, the takeover wave profoundly impacted shareholder influence. A shareholder-oriented infrastructure emerged, with the Council of Institutional Investors founded in 1985. More significantly, managerial priorities shifted towards shareholder interests. The "corporate responsibility" ethos of the 1970s, which considered multiple constituencies, began to be replaced by a focus on shareholder value. Companies emphasized share prices to ward off unwelcome bids [10](#page=10). By the 1990s, institutional investors expanded their agenda beyond takeovers. They advocated for removing underperforming CEOs and successfully lobbied the SEC to reduce disclosure requirements for proxy solicitations. They also pushed for executive pay reform, moving from "pay-for-size" to "pay-for-performance" through equity-based compensation like stock options. While this activism did not fundamentally reshape U.S. corporate governance, the shift in executive compensation solidified the prioritization of shareholder interests [11](#page=11). > **Tip:** The shift from "pay-for-size" to "pay-for-performance" in executive compensation during the 1990s was a crucial mechanism for reinforcing the shareholder value mentality in U.S. boardrooms [11](#page=11). ### 1.4 And economists too Economists were relatively latecomers to the systematic analysis of corporate governance, despite foundational work like Jensen and Meckling's 1976 "Theory of the Firm" which discussed agency costs and Fama's 1980 article on agency problems. These early works, while influential, did not explicitly use the term "corporate governance" and implicitly suggested that market forces adequately addressed governance issues, thereby critiquing the pro-regulatory stance of the ALI project [12](#page=12). A significant shift occurred in the early 1990s, signaled by Michael Jensen's 1993 presidential address to the American Finance Association. Jensen lamented the decline of hostile takeovers as a mechanism for corporate change and highlighted the importance of governance arrangements in driving organizational efficiency. He argued that product and factor markets were too slow to control corporate behavior, necessitating effective internal control systems, which he found lacking in publicly traded companies due to "ineffective governance". He identified improving internal control systems as a major challenge for economists and management scholars in the 1990s [12](#page=12). The term "governance" began appearing in economists' lexicon in the late 1980s. This coincided with the increasing shareholder orientation of corporate governance discussions, linking the phrase "corporate governance" to the creation and preservation of shareholder value. This resonated with economists who often equated corporate governance with mechanisms ensuring satisfactory risk-adjusted returns for investors [13](#page=13). ### 1.5 Corporate governance goes international Initially, corporate governance analysis was almost exclusively focused on American corporations, with the U.S. "managerial" corporation seen as the apex of organizational evolution. However, a U.S. recession in the early 1990s and the perceived competitive threat from German and Japanese companies led to a broader examination of governance systems. This sparked a growing sense of competition between different governance models, with the U.S. often appearing less effective. A key theme was that U.S. executives' short-term focus on quarterly earnings, driven by takeover threats, contrasted with the long-term investment approach of their German and Japanese counterparts [13](#page=13). Britain took a leading role in developing corporate governance codes. The 1991 Committee on the Financial Aspects of Corporate Governance, chaired by Sir Adrian Cadbury, released its report in 1992. Amidst corporate collapses and concerns about Britain's competitiveness, the Cadbury Code of Best Practice recommended disclosures for non-compliance, leading listed companies to avoid deviating from the code. The Cadbury Code is considered the first "serious" corporate governance code [14](#page=14). The momentum continued in the UK with reports on executive pay by Sir Richard Greenbury and a review by Sir Ronald Hampel which led to the Combined Code. The 1992 Cadbury Report also gained international recognition, influencing the OECD's principles in 1999 and sparking a global movement of corporate governance codes [14](#page=14) . The internationalization of corporate governance extended beyond the UK, fueled by a U.S. economic resurgence in the mid-1990s, which positioned the U.S. model as one to emulate. Continental Europe and Japan also began adopting corporate governance principles, driven by capital market liberalization and pressure from institutional investors seeking diversification. American pension funds actively campaigned for better governance in Europe, seeking allies among local funds [14](#page=14) [15](#page=15). Empirical research highlighting the link between strong legal protection for minority shareholders and economic development reinforced this trend. International organizations like the IMF, World Bank, and OECD also promoted stronger regulations protecting outside investors [15](#page=15). ### 1.6 Corporate priorities A central debate in corporate governance revolves around whether companies prioritize shareholders ("shareholder primacy" or "shareholder centrality") or balance the interests of all key corporate participants. The takeover activity of the 1980s strongly reoriented U.S. managerial priorities towards shareholders. The internationalization of corporate governance in the 1990s also carried a strong shareholder orientation, aiming to enhance managerial accountability and investor returns. Henry Hansmann and Reinier Kraakman predicted in 2001 that the shareholder-centered ideology would prevail globally [16](#page=16). However, this prediction was challenged by early 2000s U.S. stock market downturns and corporate scandals (Enron, WorldCom), which discredited the shareholder-oriented model internationally. The 2008 financial crisis further damaged confidence in shareholder-centric governance, leading to a broader definition of corporate governance encompassing relationships between management, the board, shareholders, and other stakeholders, such as employees [16](#page=16). Stakeholder-oriented analysis continued to gain momentum. In the UK, the Financial Reporting Council revised the Corporate Governance Code in 2018 to include provisions for employee representation. In the U.S., the Business Roundtable's 2019 statement emphasized a commitment to all stakeholders, shifting focus away from sole shareholder primacy. The COVID-19 pandemic further accelerated pro-stakeholder trends, highlighting issues like climate change and racism. While a fundamental reorientation of corporate purpose remains debatable, stakeholders have become an integral part of the governance discussion globally and in the U.S. [16](#page=16). --- # Corporate governance reform and resistance Corporate governance reform efforts in the 1970s faced a significant backlash from the business community in the 1980s, fueled by a shift in political ideology and the rise of contractarian legal theories. ## 2. Corporate governance reform and resistance The 1970s marked a period when corporate governance moved onto the official agenda in the United States, largely in response to corporate failures and misconduct. However, the subsequent decade saw a strong counter-reaction from the business community, bolstered by new economic and legal theories that challenged the need for regulatory reform. ### 2.1 The emergence of corporate governance as an issue Following the post-World War II economic boom, corporate governance was not a prominent concern as American corporations prospered and individual investors were largely passive. The 1970s brought challenges, including the collapse of conglomerates like Penn Central, highlighting the issue of passive boards. Revelations of widespread bribery and misconduct by public corporations further raised concerns about corporate accountability [7](#page=7). The Securities and Exchange Commission (SEC) took an active role, initiating proceedings against directors and requiring companies to establish board-level audit committees with independent directors. The SEC also held hearings on corporate governance and shareholder democracy [7](#page=7). Interest in corporate governance extended beyond regulatory bodies. Publications like Ralph Nader, Mark Green, and Joel Seligman's *Taming the Giant Corporation* offered early theorizations of corporate governance and advocated for increased director oversight responsibilities. The American Law Institute (ALI) also committed to addressing corporate governance, organizing a conference in 1980 that was co-sponsored by the American Bar Association and the NYSE. Initially, the business community saw the ALI project as a potential avenue for a measured response to the corporate challenges of the 1970s [7](#page=7). ### 2.2 The 1980s counter-reaction to reform The political landscape shifted significantly in the 1980s with the election of Ronald Reagan in 1980, ushering in a more conservative era that impacted the debate on corporate governance. Efforts towards corporate governance reform began to wane even before Reagan's victory. A 1980 SEC staff report did not recommend legal reforms regarding board structure. Proposed congressional bills in 1980 aimed at mandating a greater role for independent directors failed to be enacted [8](#page=8). The 1980 election further diminished the prospects for major federal governance reform, as a more conservative Congress was unlikely to pass such legislation. The SEC also appeared less focused on governance reform, with its new chair, John Shad, prioritizing capital formation over corporate governance [8](#page=8). The focus of corporate governance debates in the early 1980s largely centered on the ALI's corporate governance project, with a prevailing de-regulatory impulse. When the ALI reporters issued a draft of principles in 1982, the business community launched a strong criticism, a stark contrast to their more conciliatory stance at the 1980 conference. Groups like the NYSE and the Business Roundtable lobbied against the ALI proceeding with the draft principles [8](#page=8). Several factors contributed to this strong counter-reaction: * **Diminished threat of federal reform:** With the perceived threat of federal governance reform receding, business leaders felt empowered to oppose regulatory reform outright [8](#page=8). * **Fear of legal doctrine:** Executives worried that policy missteps in the draft could become formal legal doctrine, potentially increasing director liability risks [8](#page=8). * **Opposition to prescriptive governance:** Critics argued it was misguided to dictate board composition and structure, as beneficial governance innovations were occurring voluntarily, and diverse corporate structures were appropriate [8](#page=8). ### 2.3 The rise of contractarian legal theories Academics employing a "law and economics" perspective provided significant intellectual support for the business community's criticism of the ALI draft. These scholars rejected the prevailing pro-regulation orthodoxy, which was influenced by Adolf Berle and Gardiner Means' 1932 work, *The Modern Corporation and Private Property*. Berle and Means had argued that the separation of ownership from control in large public companies necessitated regulation to protect shareholders from managerial self-interest [8](#page=8). In contrast, corporate law academics embracing economic analysis advocated for a "contractarian" theory of the corporation. This perspective used economic analysis as its starting point and contested the idea that executives systematically short-changed shareholders. Michael Jensen and William Meckling's influential 1976 article on agency cost theory characterized the corporation as "a nexus for contracting relationships" and provided an account of market-oriented limitations on managerial discretion [9](#page=9). Contractarian scholars, such as Frank Easterbrook and Daniel Fischel from the University of Chicago, argued that market dynamics fundamentally and beneficially defined relationships between managers, shareholders, and other stakeholders, thus counseling against substantial state intervention. They criticized the ALI's proposals for regulating board structure [9](#page=9). The ALI project eventually made concessions to its critics, with most mandatory stipulations on board structure being recast as recommendations. The final published principles closely resembled existing law, which mollified many critics. However, by 1989, some academics felt the debate had bogged down in trivialities [9](#page=9). ### 2.4 Shareholder passivity and the "Deal Decade" The notion that regulation was necessary stemmed from the assumption that shareholders were unlikely to take corrective action and deploy their legal rights. This assumption of shareholder passivity was widely held, even by proponents of shareholder democracy. Law and economics scholars agreed on shareholder passivity but argued that market mechanisms sufficiently aligned managerial and shareholder interests, mitigating the risks of such passivity [9](#page=9). This perspective was particularly relevant during the 1980s, known as "the Deal Decade" due to a substantial merger wave. Bidders for corporate control often employed aggressive strategies that, while potentially benefiting shareholders, also generated significant wealth for certain intermediaries [9](#page=9). --- # The role of institutional shareholders Institutional shareholders became increasingly prominent in corporate governance during the 1980s, significantly influencing takeovers, executive compensation, and the overall shift towards shareholder value prioritization. ### 3.1 The rise of institutional shareholders and their growing influence The initial assumption, stemming from Berle and Means' work, was that shareholders were passive and unlikely to actively protect their interests, necessitating regulatory intervention. While law and economics scholars critiqued this pro-regulatory stance, they largely agreed with shareholder passivity, believing that market mechanisms adequately aligned managerial and shareholder interests. The "Deal Decade" of the 1980s, characterized by a significant merger wave, further supported this view, as takeovers offered shareholders generous premiums, incentivizing executives to deliver strong returns to avoid unwanted bids [10](#page=10) [9](#page=9). However, institutional investors—entities investing on behalf of clients or beneficiaries—began to emerge as key players in corporate governance. Their influence grew due to increasing voting power, with their ownership of U.S. public company shares rising from 16 percent in 1965 to 47 percent in 1987 and 57 percent by 1994. Crucially, the substantial stakes they held made it increasingly difficult for them to rely on the traditional "Wall Street Rule" of simply selling shares of poorly performing companies [10](#page=10). > **Tip:** Understand the shift from theoretical shareholder passivity to the practical emergence of institutional investors as active agents in corporate governance. ### 3.2 Institutional shareholders and the market for corporate control During the 1980s, executives sought to mitigate the threat of hostile takeovers through tactics such as "greenmail" payments and the implementation of "poison pills". These anti-takeover measures were met with resistance from institutional investors, who saw them as impediments to selling their shares at a premium in response to takeover bids. Jesse Unruh, overseeing the California Public Employees Retirement System (Calpers), was a notable figure in this shareholder-oriented backlash [10](#page=10). While shareholder efforts to challenge takeover defenses faced judicial setbacks that entrenched the role of outside directors, the takeover wave fundamentally altered the governance landscape for shareholders. This period saw the emergence of a shareholder-oriented corporate governance infrastructure, including the establishment of the Council of Institutional Investors in 1985 by Unruh and Calpers to advocate for shareholder rights. More significantly, the takeover activity drastically reoriented managerial priorities in American public companies, shifting away from the "corporate responsibility" ethos of the 1970s, which considered the interests of customers, employees, and society alongside shareholders [10](#page=10). > **Example:** The Business Roundtable's 1981 statement, emphasizing that managers should serve the public interest and consider constituencies beyond shareholders, represents the prevailing view before the takeover wave began to reorient priorities [10](#page=10). ### 3.3 The shift towards shareholder value capitalism and executive pay reform The threat of unwelcome takeover bids, particularly for companies with lagging stock prices, became a primary driver for the renewed emphasis on share prices in the 1980s. This led to a significant modification of the power balance between management and stockholders in favor of the latter. Business school professor Alfred Rappaport proclaimed the arrival of an era of "shareholder value capitalism," noting that the market for corporate control had profoundly changed managers' attitudes and practices [10](#page=10) [11](#page=11). In the 1990s, institutional investors expanded their governance agenda beyond takeovers to include advocating for the removal of underperforming chief executives and lobbying the Securities and Exchange Commission (SEC) to reduce securities law requirements related to proxy solicitations. A key focus of their activism was the overhaul of executive compensation arrangements, aiming to move away from "pay-for-size" (where larger companies paid higher salaries) towards "pay-for-performance" to align executive incentives with shareholder returns. This led to a substantial increase in equity-based compensation, such as stock options, for CEOs in large U.S. public companies, rising from 20 percent in 1990 to 60 percent by 1999 [11](#page=11). While the activism of the 1990s did not fundamentally reshape U.S. corporate governance—institutional investors allocated a small proportion of assets to governance efforts, rarely acted in concert, and did not seek board representation—it had a lasting legacy in reshaping executive pay. This reconfiguration of executive compensation helped to solidify the prioritization of shareholder interests in American boardrooms, even as hostile takeovers receded. The shift towards equity-based executive pay ensured that the shareholder value mentality fostered in the 1980s persisted, as executives increasingly sought this "Holy Grail" through their compensation structures. Management professor Gerald Davis identified this massive shift in compensation practices as perhaps the most compelling reason for executives' enhanced devotion to shareholder value [11](#page=11). > **Tip:** Recognize that the reform of executive pay was a critical mechanism through which institutional investors cemented the prioritization of shareholder value, even in the absence of sustained takeover threats. --- # International perspectives on corporate governance The analysis of corporate governance broadened significantly from its initial focus on American corporations to encompass international systems, driven by economic shifts, competitive pressures, and the influence of international organizations. ### 4.1 The globalization of corporate governance analysis The study of corporate governance, which was primarily focused on American corporations during the 1970s and 1980s, experienced an "explosion of research on corporate governance around the world" by the early 2000s. Non-U.S. research subsequently became an integral part of the mainstream. This international reorientation began in the U.S. but rapidly gained momentum globally [13](#page=13). #### 4.1.1 Early assumptions and the shift in perspective Following World War II, it was widely assumed in the U.S. that the prevalent "managerial" corporation, characterized by executive dominance and diffuse share ownership, represented the apex of organizational evolution. The international success of American corporations led to a disregard for differing corporate governance arrangements in other countries, as they were not considered compelling subjects of study [13](#page=13). The situation changed in the early 1990s with a recession in the U.S., which eroded faith in the American economy. The competitive threat posed by German and Japanese companies spurred extensive research into the causes and solutions for America's perceived economic decline, with corporate governance featuring prominently. This period saw a growing recognition of competition between governance systems, with the U.S. often appearing to be at a disadvantage. A key theme was that American executives, pressured by takeover threats and financial markets, focused excessively on short-term earnings, whereas German and Japanese counterparts, operating within systems that valued long-term relational investment, were more visionary [13](#page=13). ### 4.2 The emergence of corporate governance codes and international influence The momentum for corporate governance analysis spread globally, with Britain leading the way in developing formal codes and best practices. #### 4.2.1 The Cadbury Report and its impact In the United Kingdom, corporate governance received little attention before the 1990s. In 1991, the accountancy profession, the London Stock Exchange, and the Financial Reporting Council (FRC) established the Committee on the Financial Aspects of Corporate Governance. The committee's 1992 report, chaired by Sir Adrian Cadbury, recommended a Code of Best Practice. Companies listed on the London Stock Exchange were required to either comply with the Code or disclose their non-compliance and provide explanations. Despite initial criticisms that the code lacked legal enforceability, listed companies generally avoided non-adherence. The response to the code was described as "heartening," indicating real progress in raising governance standards [13](#page=13) [14](#page=14). The 1992 Cadbury Report achieved significant international recognition and provided a benchmark for measuring corporate governance standards in other markets. It influenced the development of impactful corporate governance principles issued by the Organisation for Economic Co-operation and Development (OECD) in 1999. The Cadbury Code of Best Practice is widely regarded as the first "serious" corporate governance code [14](#page=14). #### 4.2.2 Further developments in the UK Following the Cadbury Report, the momentum in the UK continued with a 1995 report on executive pay chaired by Sir Richard Greenbury and a 1998 report by a committee chaired by Sir Ronald Hampel, which reviewed the work of the previous committees. The Hampel Review led to the overhaul of the Cadbury Code of Best Practice, combining it with the Greenbury Committee's guidance on executive pay to form the Combined Code. Compliance with the Combined Code remained on a "comply or explain" basis under the listing rules for companies quoted on the London Stock Exchange [14](#page=14). > **Tip:** The "comply or explain" principle is a key feature of many corporate governance codes, allowing companies flexibility while still encouraging transparency and accountability. ### 4.3 International adoption and convergence of governance models The proliferation of corporate governance codes was intrinsically linked to the internationalization of corporate governance that extended beyond the UK during the 1990s. #### 4.3.1 Shifting economic fortunes and the appeal of the U.S. model Comparative analysis of corporate governance initially gained traction in the U.S. during its early 1990s confidence crisis, prompting American observers to seek inspiration elsewhere. As the decade progressed, the U.S. economy flourished, leading to the perception that the American corporate governance model was highly effective and worthy of emulation by other countries. This was in contrast to Japan's prolonged recession and Germany's post-unification economic adjustments [14](#page=14) [15](#page=15). #### 4.3.2 Corporate governance on the continent and in Asia While the U.S. approach gained favor, the corporate governance movement also took root in continental Europe and Japan. Mid-1990s controversies in prominent European companies, coupled with the liberalization of capital markets, brought corporate governance to the forefront. European firms seeking capital for restructuring increasingly turned to equity markets, necessitating responsiveness to shareholder concerns. U.S. public pension funds, already active proponents of better corporate governance in the U.S., extended their advocacy to Europe, seeking allies among foreign pension funds [15](#page=15). This trend extended to Asia, where corporations faced pressure to adopt more shareholder-friendly "western" business styles as they accessed foreign institutional investment for equity capital. A 1998 OECD advisory group report, which served as a precursor to the OECD's 1999 principles, supported this logic, positing that strengthened corporate governance arrangements would improve a company's ability to raise capital. Management consultancy McKinsey & Co. reported in 2000 that institutional investors were willing to pay a significant premium for shares in well-governed companies, particularly those in countries perceived to have weak shareholder rights [15](#page=15). #### 4.3.3 The influence of "law matters" research and international organizations Academic research reinforced the momentum for investor-oriented governance changes. Empirical studies indicated a strong correlation between robust legal protection for minority shareholders and positive economic outcomes, such as a larger number of listed companies, more valuable stock markets, and more diffuse share ownership. This "law matters" research suggested that countries would struggle to achieve their full economic potential without laws protecting minority shareholders. The U.S. economic success during the 1990s and early 2000s was often attributed to its rich and deep securities markets and the underlying regulatory environment. Supranational actors like the International Monetary Fund, the World Bank, and the OECD adopted this message, influencing numerous governments worldwide to strengthen regulations protecting outside investors [15](#page=15). > **Example:** The "law matters" research provides a strong empirical basis for understanding why certain jurisdictions attract more investment and experience greater economic development. It highlights the critical role of legal frameworks in fostering investor confidence and market efficiency. --- # Key components of corporate governance Corporate governance encompasses the foundational elements and principal actors involved in directing and controlling a corporation, with a primary focus on balancing the interests of various participants [3](#page=3). ### 5.1 Core participants and their stakes The functioning of corporate governance is determined by the interplay between several key corporate participants, each with distinct interests and influences [3](#page=3). #### 5.1.1 Shareholders Shareholders are central to corporate law, possessing a range of rights that empower them in significant ways. However, they often utilize these powers less than governance commentators might prefer. Corporate law bestows both collective and individual rights upon shareholders [3](#page=3) [4](#page=4). #### 5.1.2 Creditors Creditors hold a meaningful "stake" in the fate of companies and their protection under corporate law is a significant consideration within corporate governance [3](#page=3) [5](#page=5). #### 5.1.3 Employees Employees also represent a key corporate constituency with a stake in a company's well-being. Discussions around corporate governance have increasingly included the concept of employee representation on boards [3](#page=3) [5](#page=5). #### 5.1.4 Directors Directors are crucial to corporate governance, forming the board which is considered the focal point for corporate decision-making from a legal perspective. Their primary corporate governance role is to monitor the executives who manage the company on a daily basis [4](#page=4). #### 5.1.5 Executives Executives are responsible for the day-to-day management of companies and are subject to monitoring by the board of directors. Executive pay is a highly contentious area within corporate governance, even when the amounts involved are relatively small compared to a company's market value [4](#page=4) [5](#page=5). #### 5.1.6 Stakeholders Stakeholders are defined as corporate constituencies with a meaningful "stake" in the fate of companies. The concept of corporate "purpose" is closely linked to the duties directors owe to the company and its stakeholders. The inclusion of stakeholders in the corporate governance agenda has gained momentum, particularly in light of global financial crises and societal concerns like climate change and racism [3](#page=3) [5](#page=5). ### 5.2 The shareholder primacy versus stakeholder balance debate A significant dualism in corporate governance revolves around whether publicly traded companies prioritize shareholders when their interests conflict with those of other key participants (termed "shareholder primacy" or "shareholder centrality") or if they aim to balance the interests of all key corporate participants [5](#page=5). * **Shareholder Primacy:** The 1980s takeover activity in America strongly reoriented managerial priorities towards shareholders. The internationalization of corporate governance in the 1990s also had a strong shareholder orientation, focusing on enhancing managerial accountability to improve investors' risk-adjusted returns. This shareholder-centered ideology was predicted to become globally dominant [5](#page=5). * **Stakeholder Balance:** The shareholder-oriented model faced significant challenges with major corporate scandals in the early 2000s and the 2008 financial crisis, which shook confidence in the shareholder-owner model and led to a broader definition of corporate governance encompassing relations between management, boards, shareholders, and other stakeholders like employees. This has led to a growing momentum for stakeholder-oriented corporate governance analysis, with initiatives like the U.K. Corporate Governance Code in 2018 mandating provisions for employee representation. In the U.S., a 2019 statement by the Business Roundtable emphasized a "fundamental commitment to all of our stakeholders" [5](#page=5). ### 5.3 Regulatory frameworks and codes Corporate governance is subject to regulation, with discussions on its justifications, drawbacks, and various rule types. Corporate governance codes play a role in shaping these arrangements. For example, the U.K. Corporate Governance Code has been revised to include provisions related to employee representation [3](#page=3) [5](#page=5). ### 5.4 International influence and convergence The U.S. corporate governance model, particularly its strong shareholder orientation, gained significant international favor in the 1990s, influencing other countries to adopt similar approaches to attract capital. This movement was reinforced by academic research highlighting the importance of strong legal protection for minority shareholders. International organizations like the IMF, World Bank, and OECD also promoted strengthened regulations for outside investors. However, corporate scandals and financial crises later challenged this purely shareholder-centric view, leading to a more capacious understanding of corporate governance that includes various stakeholders. This has contributed to a global discussion on corporate priorities and governance systems [3](#page=3) [5](#page=5). > **Tip:** Understanding the historical development and the shift in emphasis from shareholder primacy to stakeholder considerations is crucial for grasping the current landscape of corporate governance. Pay attention to how economic events and major scandals have influenced these priorities. > **Example:** The Enron and WorldCom scandals in the early 2000s severely discredited the shareholder-oriented model internationally, leading to a broader consideration of stakeholder interests in corporate governance [5](#page=5). --- ## 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

| Term | Definition | |------|------------| | Corporate governance | The system of rules, practices, and processes by which a company is directed and controlled, encompassing the relationships between management, the board of directors, shareholders, and other stakeholders. | | Shareholder primacy | A corporate governance principle that emphasizes prioritizing the interests of shareholders above all other corporate constituencies. | | Stakeholders | All parties who have an interest in a company's operations and success, including employees, customers, creditors, suppliers, and the wider community, in addition to shareholders. | | Institutional shareholders | Entities that invest in equities on behalf of clients or beneficiaries, such as pension funds, mutual funds, and insurance companies, and often hold significant blocks of shares in public companies. | | Agency cost theory | An economic theory that explains the potential conflicts of interest between principals (e.g., shareholders) and agents (e.g., managers) and proposes mechanisms to mitigate these conflicts, often through monitoring and incentive alignment. | | Contractarian theory of the corporation | A theoretical perspective that views the corporation as a nexus of contracts among various participants, where market dynamics and voluntary agreements, rather than extensive regulation, are seen as the primary means of governance. | | Market for corporate control | The market in which takeovers and mergers occur, which acts as a mechanism to discipline inefficient management and reallocate corporate assets to more productive uses. | | Board of directors | A group of individuals elected by shareholders to oversee the management of a corporation, responsible for strategic decisions, risk management, and ensuring accountability. | | Executive pay | The compensation provided to top-level managers of a company, often including salary, bonuses, stock options, and other incentives, which has been a significant focus of corporate governance debates. | | Corporate governance codes | Sets of guidelines or principles, often voluntary, that aim to promote good corporate governance practices and enhance transparency and accountability, such as the Cadbury Code and the UK Corporate Governance Code. | | Two-tier boards | A corporate board structure common in some European countries, consisting of a management board responsible for daily operations and a supervisory board responsible for oversight of the management board. | | Retail investors | Individual investors who buy and sell securities for their own accounts, as opposed to institutional investors. | | Greenmail | A practice where a company buys back its own stock at a premium from a potential hostile bidder to prevent a takeover. | | Poison pill | A defensive tactic used by a company to prevent or discourage a hostile takeover bid, typically by making the target company's stock less attractive to the acquirer. |