Well, we have completed the analysis of anti takeover defenses as important contributors to the potential value creation. And now, as has been mentioned before, we are moving to another idea or concept that oftentimes seems to be overlooked, because sometimes it's taken for granted. And sometimes it's just not given enough emphasis. And this is the idea of corporate governance. Well, strictly speaking, corporate governance has little to do with governing or managing. Sometimes it's used in a narrow sense as honoring the rights of small investors. Namely, minority shareholders and others. And in this first part, we will analyze how the system is organized in the United States and why is it organized so and how it contributes to the potential of value creation in many, many transactions. So this is corporate Governance (1). Now, the key story here is that it is United States where we observe a have huge demand for corporate governance, why is that so? Because the United States market is characterized by diffuse stock ownership. We've talked about that before. There are very few companies in which we observe majority stakeholders. And if someone owns 1% of the stock outstanding, this person or institution is treated to be a major, a large shareholder. And as a result, what we see is the huge field where there are hundreds of millions of investors. And all of them are small investors. So unless these people are protected and their rights are observed and defendant. Then, unfortunately, these people will not be willing to participate in this market. And it is the direct or indirect contribution of the money provided by these people that feeds the huge US stock market and US financial market in general. So here we see that it is the diffuse stock ownership that results in the huge demand for corporate governance. And again, the corporate governance system in the US is developed, and in general, it works well, with some exceptions, but in general, it does work well. And that is why, often times, people sort of overlook the contribution of good corporate governments or, as we will see in the next episodes, poor corporate governments, into the bottom line value of the project or a company. So here, we have to realize that why is that corporate governance is required, the good corporate governance is required to contribute to creation, but why is that the problem? And how it is solved? Well, the story is that in all transactions in this market, we see stakeholders. And before we proceed, I will have to point out the contractual Theory of Firm. That basically says that the firm is an organization in which people get into a lot of explicitant asset contracts. And it is the ability to save on costs of these otherwise explicit contracts that pushes the people to get organised in forms of companies. But that, in itself, poses some challenges. And again, if we recall that there are stakeholders And if we recall that there is an agency situation which is costs, control, Incentives and so on. So we can see the overall result is such that shareholders in stakeholders interest. They should be recognized. And also, there is some external influence. So that leads to the overall idea that corporate governance is approximately equal to the protection Of the weakest. Well, it's sort of, we are not talking about survival of the fittest, we're talking about the protection of the weakest. Because like I said, given this, these called the weakest, they contribute most overall to the volume, liquidity, and importance of this market. Let's proceed here. We have to study first of all internal control mechanisms at a company and then external control mechanisms that sort of show how this honoring of the rights of these weakest and not only them is achieved. So first here we have internal Control mechanisms. And these are, first of all, the Board of Directors. The Board of Directors is elected by the shareholders. Again, the shareholders, they are the ultimate principals in the company. But because there are so many, they cannot effectively contribute to the measurement processes. So these people let the board of directors as their representatives, and it is the board of directors that hires, fires, and controls the actions of the managers. And again, the top manager to the company, this is the group of people who actually control all resources, make most decisions and that final in charge of what's going on at a company. So here we can see that clearly the people who exert control and the people who actually use the resources, they are not the people who are the ultimate owners of the company, that's the classic case of agency. And although in theory, board of directors are positive, but in reality, they have been oftentimes inefficient. And here, the key story is the composition of this Board of Directors. Well, again, in theory, if there are some groups of shareholders, they can vote for their representative, but if there are few large groups, that's an easier process. However, if you have lots of small people, then you cannot have so many representatives in the board. Because if you have, for example, 1,000 people on the Board of Directors, that would be a completely, these people would not be able to make any decisions efficiently. And therefore, there are normally few people, maybe a dozen or oftentimes even fewer. And the key story here is the outside directors. So these are the people who are not insiders to the company, not the managers. So they do not have the invested interest. They are not shareholders. But these people have a more objective view, and it has been shown that the existence and activity outside the vectors has a positive correlation with the bottom line performance. These people have more influence on the changes of CEOs at companies. So that is sort of a good thing, and therefore, we can say that if the Board of Directors is structured properly and can act effectively then it contributes positively, if not, then we have to expect some, let's say M&A activity because people may not be really happy with what's going on in the company. But before we talk about that in greater detail, let's talk about an interesting observation, the ownership structure. And also the agency theory sends us signals that the efficiency of decisions and the efficiency of actions of the management depends upon their stock ownership. And some interesting results have been observed in the empirical studies. If the ownership structure of a management is less than 5%, but it still exists so it's not zero, then you see it's all good things. So these are improvement of performance. These are realignment of interests. So everything's great. However, when it's somewhere between 5 and 25%, we see the opposite trend. So this is entrenchment and deteriorated performance. When it goes over 25%, we can see some recovery, and this recovery, although is slow, but can be attributed to that. Now, we are major shareholders in this company so this is our company. So we can see that this is really a dangerous area. And also the percentage of the stock owned by the management, it has significant effect on its financial policy. And for example, that deals with leverage buyout or management buyout. That is share repurchases. And this is financed with that. And also, if this company engages in the activity itself, the likely way of payment is cash. So they take more aggressive stances, because if they borrow a lot, and then buy the stock of the other shareholders, the ones that are outstanding. So you can seriously infringe yourselves. So another issue here is executive compensation. Some years ago, it was quite a long time ago, but it was noticed that the actual level of executive compensation depends not upon performance, not upon even size of the company but it depends upon the number of layers of the management. Maybe this was observed 30 years ago. But clearly this does not disappear automatically. So sometimes the management at large companies, they are compensated in such huge amounts and with such huge bonuses that they have little or no relatedness to the bottom line performance and this is really bad. And although, recently, there have been trends in giving out bonuses, let's say, in the form of stock options, but it does depend upon how long you have to avoid exercising these options by agreement. So basically the idea is that if indeed there is a link to performance, that's great. If this link can be hardly seen, that's not always bad but also sends a poor signal to the management, and the management may take a path of further entrenchment. Now, finally, in this episode, I would like to say if you were to buy outside mechanisms of control, outside control mechanisms. And these include, first of all, the stock market itself. So if the stock is rising, then that's great. If the stock is falling, that's a big signal that something had got rotten in the state of Denmark. And therefore, the stock market performance of the public company is a great outside control mechanism. Then another thing is a proxy contest, so this is the activity when the dissident group of shareholders wants to get representation on the board of directors and they try to reach that. And it has been shown that, regardless of whether they are successful or not, in some of the more global influences on a company. But this very activity is seen as a very good signal by the market. And then, finally, we have the M&A market. And that is by far the most widely recognized and strong, powerful mechanism for basically correcting someone's mistakes. So why is that? So the M&A market, it does influence the company's performance. It has been unequivocally shown by various empirical studies. This market is actually important in, basically say who is right and who is wrong. And what is even more recognizable here is that if there is an M&A transaction or even an attempt thereof, that is a clear signal that the internal mechanisms of control, they fail. So, now we see that. And we could have stopped here, but then we can summarize that sort of the corporate governments that deals with the conflict of interest between various shareholders. And the next thing is how it is resolve. And here, it's time for us to recall that there exists sort of huge shareholders like the market, well, first of all, big governments in various countries. And then the markets, the societies, the global market, and all these big shareholders that are sort of, they are encompassing many specific participants. And that is important to keep in mind because the assistance of corporate governance is not the same across countries. And what is normal or taken for granted for the US is not very widely observed anywhere else. In the next episode, we'll say a few words why. And that, we will deal specifically with these big stakeholders.
