07 Apr Behind Closed Doors: How Corporate Governance Structures in Affect Shareholder Wealth
By Omar Hakim, Esq. and Roy G. Brooks III
Corporate governance is one of the most important and least emphasized elements of effective investing. Additionally, understanding how the regulatory framework in each nation alters incentives for managers is key to reducing exposure to unnecessary agency costs and maximizing returns.
When examining firm efficiency, one must understand that the owners, as principals or shareholders, hire managers or executives as agents, who are supposed to act in the principal’s best interests. However, even with managers as complete owners, pursuits of divergent interest prevent firm value and shareholder wealth from being maximized.
Whereabouts of Wealth
Despite analysis predicated on public companies, the following agency costs are also applicable to private markets. These four primary actions of agents, as discussed by Dennis Mueller of the University of Vienna, hinder the growth of shareholder wealth:
- Consumption of Perks
Issuing options instead of shares reduces the value that shareholders can accurately observe, for estimating the value at the time granted and the exercise cost is difficult. Additionally, tangible perks, like company cars or private jets, taken from the corporate accounts will not be salient to investors, adding to the ‘miscellaneous expenses’ line item on income statements. 
- Theft of Company Assets
The most obvious vacuum of shareholder wealth involves pilfering of company resources. Presently, this takes the form of low interest loans to senior managers and accounting fraud in disclosures. Most nations with developed capital markets have protections and remedies for investors, such as civil liability and criminal prosecutions.
- Manipulation of Earnings
The emphasis on earnings throughout the recent history, especially in the United States and United Kingdom, has benefitted shareholders, when showing real changes in company growth. As stock options have become a larger part of managerial compensation, the incentive has shifted to improve earnings reports when possible. Still, nefarious tactics have risen from this incentive through the direct and fraudulent manipulation of earnings. Illegal in most nations and unethical otherwise, this represents both managerial avarice, and a lack of value creating decisions.
- Excessive Managerial Consumption
Comparable to theft, excessive managerial consumption is legal and harder to address. Assuming the efficient market hypothesis for executive wages, managerial productivity should be higher in the US due to the premium in excess of their foreign counterparts. The ratio of executive compensation compared to the average employee dwarfs other nations at 531:1. Yet this ratio is disproportionate to the perceived benefits in productivity. Personal interests can gain priority when managers, especially CEOs, can appoint boards of directors with little conflict of ideas, allowing decisions to pass effortlessly, including salary increases.
The main ownership models are the Anglo-Saxon model, used primarily in the United States and the United Kingdom, the Continental European model, and the Japanese model. The Anglo-Saxon model, an outsider system, prioritizes creating shareholder value and has incredibly strong protections for equity holders. Consequently, high legal costs are incurred at the expense of shareholders. Yet, this same model has the greatest checks on management, pushing them to invest capital effectively, return wealth to shareholders, or to be replaced.
In contrast, the Continental-European model, an insider system, focuses on total stakeholder welfare. This includes the company’s labor force, stemming from the region’s dominant leftist, social-democratic political ideology. Job preservation results in a twofold destruction of shareholder wealth. One is the expenditure of resources in maintaining the workforce, which can be measured easily, but the more difficult measure to properly quantify is the failure to spur growth or formation of other companies from overinvestment in failing industries. Hence, European managers mostly extract value through expansion and company growth.
The Japanese system, known as keiretsu, is characterized by corporate cross equity holdings and circular ownership structures. This insider system allows companies to largely ignore shareholder interests. Managers in Japan like those in Europe are growth-oriented, and reported at near unanimity that they prioritized total stakeholder welfare. For this fact, coupled with Japan’s insular nature, politics favor both large and declining industries.
Of these systems, only in the Anglo-Saxon model with the common-law remedies, individualized focus, and strong investor protections, did the value of assets returned on the investment capital exceed the amount invested, which was on average two cents in this study. Therefore, this strong corporate governance model provides the greatest returns for equity investors. Investors in US companies can expect much greater transparency in disclosures and more confidence in projects. Conversely, managers of businesses both large and small should be cognizant of the importance in the US of the shareholder when evaluating the key players as investment is culturally predicated on the individual investor. This gives the most adequate solution to the principal-agent paradigm, as the agents are less likely to deviate from the scope of the principal’s interests.
We hope this discussion has provided insight that can be used in equity market formation in developing nations. Similarly, investors, as potential shareholders and principals, will be better prepared to know their locus of control in corporate activities.
Individual investors must engage in thorough due diligence to uncover the differences in laws and structures when seeking investment opportunities across securities and nations. Such differences affect the culture of management and reporting relationships. This reduces the information asymmetry inherent in security investment, a higher priority when investing outside one’s home country. Even when there is limited investor power (such as in immigrant investor programs like EB-5) knowing the likely sources of hindrances on growth can empower the investor to seek proper recourse.
Damodaran, Aswath. “Definition of Market Efficiency.” Definition of Market Efficiency. Accessed January 17, 2017. http://pages.stern.nyu.edu/~adamodar/New_Home_Page/invemgmt/effdefn.htm.
Maher, Maria E., and Thomas Andersson. “Corporate Governance: Effects on Firm Performance and Economic Growth.” Organization of Economic Co-operation and Development. doi:10.2139/ssrn.218490.
Mueller, Dennis C. “Corporate Governance and Economic Performance.” International Review of Applied Economics 20, no. 5 (December 2006): 623-43. doi:10.1080/02692170601005598.
 Maria E. Maher and Thomas Andersson, “Corporate Governance: Effects on Firm Performance and Economic Growth,” Organization of Economic Co-operation and Development: doi:10.2139/ssrn.218490.
 Dennis C. Mueller, “Corporate Governance and Economic Performance,” International Review of Applied Economics 20, no. 5 (December 2006): doi:10.1080/02692170601005598.
 Aswath Damodaran, “Definition of Market Efficiency,” Definition of Market Efficiency, , accessed January 17, 2017, http://pages.stern.nyu.edu/~adamodar/New_Home_Page/invemgmt/effdefn.htm.
 Mueller, “Corporate Governance and Economic,” page 625.