🏛️ Corporate Governance
Definition: The system of rules, practices, and processes by which a company is directed and controlled. It balances the interests of a company’s many stakeholders — shareholders, management, customers, suppliers, financiers, government, and the community.
Key courses: Wharton LGST 611, HBS FRC, Columbia CBS
🔑 The Agency Problem
At the heart of corporate governance is the principal-agent problem:
- Principals (shareholders) own the company
- Agents (managers) run it on their behalf
- Their interests don’t always align
Problems that arise:
- Managers pursue empire-building vs. shareholder returns
- Excessive executive compensation
- Short-termism (hit quarterly EPS, not build long-term value)
- Insider trading and self-dealing
- Entrenchment (resisting value-creating M&A)
Jensen & Meckling (1976): Agency costs = monitoring costs + bonding costs + residual loss
🏢 The Board of Directors
The board is the primary governance mechanism — elected by shareholders to oversee management.
Board Structure
| Element | Description |
|---|---|
| Chairman vs. CEO | Should they be split? (Yes — better independence) |
| Independent directors | Not employed by company; provide objective oversight |
| Inside directors | Executives who sit on board |
| Board size | 7–15 members is typical; too large = ineffective |
| Key committees | Audit, Compensation, Nominating/Governance |
What Good Boards Do
- Hire, evaluate, and fire the CEO
- Set executive compensation
- Oversee financial reporting (audit committee)
- Approve major strategic decisions (M&A, capex)
- Ensure legal and regulatory compliance
💰 Executive Compensation
One of the most contentious governance issues:
Pay Components
| Component | Purpose | Risk |
|---|---|---|
| Base salary | Attract and retain | No performance link |
| Annual bonus (cash) | Short-term performance | Myopic decision-making |
| Long-term incentives (LTI) | Align with shareholders | Complex, gaming risk |
| Stock options | Reward stock appreciation | Incentivize risk-taking |
| Restricted stock units (RSU) | Retention and ownership | May vest even with poor performance |
CEO Pay Ratio (US public companies, required disclosure since 2018):
- Median CEO pay: 300–400× median worker pay
- Has grown from ~20× in 1965 → ~300-400× today (Economic Policy Institute)
Say-on-Pay
- Shareholders vote (non-binding in US) on executive pay packages
- Growing norm: >70% approval needed to avoid controversy
📊 Governance Mechanisms
| Mechanism | How It Works |
|---|---|
| Board oversight | Independent directors monitor management |
| Shareholder voting | Annual meeting votes on directors, major decisions |
| Activist investors | Hedge funds pressure boards for change |
| Proxy advisors | ISS, Glass Lewis advise shareholders on votes |
| Executive compensation | Align manager pay with shareholder outcomes |
| Auditors | External verification of financial statements |
| Regulators | SEC, NYSE/NASDAQ listing standards |
| Market for corporate control | Takeover threat disciplines management |
⚠️ Famous Governance Failures
| Company | Failure | Consequence |
|---|---|---|
| Enron (2001) | Board approved fraudulent SPVs; auditor (Arthur Andersen) complicit | Bankruptcy; Sarbanes-Oxley Act passed |
| WorldCom (2002) | $11B accounting fraud; board asleep | Bankruptcy |
| Lehman Brothers (2008) | Board didn’t understand risk; excessive leverage | Bankruptcy; financial crisis |
| Boeing 737 MAX (2019) | Board prioritized profitability over safety culture | 346 deaths; $20B+ in costs |
| Theranos (2015–2018) | Board of luminaries but no medical/tech expertise | Criminal fraud; Elizabeth Holmes convicted |
Post-Enron Reform: Sarbanes-Oxley Act (2002) — CEOs/CFOs must certify financial statements; audit committee must be fully independent.
🔗 Connected Concepts
- Stakeholder Theory — Who governance must serve
- ESG Ratings — Governance is the “G”
- Agency Theory — Theoretical foundation
- Executive Compensation — Central governance mechanism
- LBO Model — PE buyouts often used to reform governance
← ⚖️ Ethics & ESG MOC | Related: Stakeholder Theory · ESG Ratings · LBO Model