Everything you need to know about corporate governance. Corporate governance defines the way a corporate enterprise should be governed. It describes corporate values, norms and ethics. It explains the direction of development of a corporate enterprise.
“Corporate Governance is the relationship between corporate managers, directors and the providers of equity, people and institutions who save and invest their capital to earn a return.
It ensures that the board of directors is accountable for the pursuit of corporate objectives and that the corporation itself conforms to the law and regulations.”
1. Introduction to Corporate Governance 2. Meaning of Corporate Governance 3. Definitions 4. Objectives 5. Need 6. Features 7. Importance
8. Rationale 9. Elements 10. Principles 11. Theories 12. Mechanisms 13. Models 14. Benefits 15. Problems and Challenges.
Corporate Governance: Meaning, Definitions, Importance, Principles, Benefits, Problems and Challenges
- Introduction to Corporate Governance
- Meaning of Corporate Governance
- Definitions of Corporate Governance
- Objectives of Corporate Governance
- Need of Corporate Governance
- Features of Corporate Governance
- Importance of Corporate Governance
- Rationale of Corporate Governance
- Elements of Corporate Governance
- Principles of Corporate Governance
- Theories of Corporate Governance
- Mechanisms of Corporate Governance
- Models of Corporate Governance
- Benefits of Corporate Governance
- Problems and Challenges of Corporate Governance
Corporate Governance – Introduction
Corporate Governance is a concept and administrative framework to introduce basic directions and viewpoints for managing a business unit with best interest. It shows and determine a new and creative vision of business, where a set of core values, better managerial control, compassing human rights, making better coordination between business and society may be possible.
It is concerned with holding the balance between social and economic goals and between individual and communal goals. It is also a conscious, deliberate and sustained system to make a judicious balance between its own interest and the interest of various constituents in the environment in which it is operating.
It deals with the manner in which companies are directed and controlled by the Board of Directors in order to create and enhance stakeholders’ value by appropriately crafting the corporate strategy that creates tomorrow’s organization. Corporate governance ensures how effectively the Board of Directors and management are discharging their functions in building and satisfying stakeholders’ confidence.
In the words of Catherwool, “Corporate governance means that company manages its business in a manner that is accountable and responsible to the shareholders. In a wider interpretation, corporate governance includes company’s accountability to shareholders and other stakeholders such as employees, suppliers, customers and local community.”
In simple words, corporate governance refers to the accountability of the Board of Directors of a corporation towards its stakeholders. In order to protect and promote the interests of all stakeholders, corporate governance should encompass well defined set of system and processes.
Systems include structural and organizational aspects like Constitution of Board of Directors, their optimum size, composition and qualifications, role and competencies, frequency of change of Board members and nominee Directors. In short, corporate governance refers to the manner in which a corporation is managed and controlled.
Corporate Governance – Meaning
The term ‘Governance’ is derived from the Latin word ‘Gubernare’ which means ‘to steer’. In the context of companies, governance means direction and control of a company. There is no single definition of corporate governance acceptable to all. Different experts have defined the term in their own ways.
Some of the popular definitions of corporate governance are given below:
“Corporate governance is the system by which companies are directed and controlled.”
“Corporate governance is the system of laws, rules and factors that control operations of a company.”
“Corporate Governance is the relationship between corporate managers, directors and the providers of equity, people and institutions who save and invest their capital to earn a return. It ensures that the board of directors is accountable for the pursuit of corporate objectives and that the corporation itself conforms to the law and regulations.”
“Corporate governance is an umbrella term that covers many aspects related to concepts, theories and practices of board of directors and their executive and nonexecutive directors. It is a field that concentrates on the relationship between boards, stockholders, top management, regulators, auditors, and other stakeholders.”
“Corporate governance is concerned with holding the balance between economic and social goals and between individual and community goals. The corporate governance framework is there to encourage the efficient use of resources and equally to require accountability for the stewardship of those resources. The aim is to align as nearly as possible the interests of individuals, corporations, and society.”
Corporate Governance – Definitions According to OECD, The Cadbury Committee Report, The Institute of Company Secretaries of India and a Few Others
“In a narrow sense Corporate Governance involves a set of relationships amongst the company’s management, its board of directors, shareholders and other stakeholders.”
The shareholders are always eager to know whether the management is doing its best towards performance and profitability of the company and whether business is being conducted to promote their economic interests. This syndrome may be considered as one of the main contributions to the philosophy of corporate governance being witnessed today.
Besides this, good corporate governance is committed to protect the interests of all segments of the society. So the essence of corporate governance lies in extending fairness to all the entities, i.e., shareholders, creditors, customers, employees and others associated with the working of the corporate in any capacity whether directly or indirectly; it covers all the entities being affected by its activities in some form or other.
In a broader sense, however, good corporate governance – the extent to which companies are run in an open and honest manner – creates overall market confidence, enhances efficiency of international capital and its allocation. It contributes ultimately to the nation’s overall wealth and welfare. “Corporate Governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment”.
Organization for Economic Co-operation and Development (OECD) has defined Corporate Governance to mean a system by which business corporations are directed and controlled. “Corporate Governance structure specifies the distribution of rights and responsibilities among different participants in the company such as board, management, shareholders and other stakeholders; and spells out the rules and procedures for corporate decision-making. By doing this, it provides the structure through which the company’s objectives are set along with the means of attaining these objectives as well as for monitoring performance.”
The Cadbury Committee Report suggests, “Corporate Governance is the social, legal and economic process through which companies function and are held accountable.”
Actually it is a system of structuring, operating and controlling a company with the following specific aims:
(i) Fulfilling long-term strategic goals of owners;
(ii) Taking care of the interests of employees;
(iii) A consideration for the environment and local community;
(iv) Maintaining excellent relations with customers and suppliers;
(v) Proper compliance with all the applicable legal and regulatory requirements.
Thus, Corporate Governance denotes the process, structure and relationship through which the Board of Directors oversees what the management does. It is also about being answerable to different stakeholders. In other words, Corporate Governance is a system by which the companies are run. It relates to the set of incentives, safeguards and disputes resolution processes that are used to control and coordinate the actions of the agents on behalf of the shareholders by the Board of Directors.
CII – Desirable Corporate Governance Code defined Corporate Governance as “Corporate Governance deals with laws, procedures, practices and implicit rules that determine the ability of a company to take informed managerial decisions vis-a-vis its claimants – in particular, its shareholders, creditors, customers, the state and employees. There is a global consensus about the objective of ‘good’ Corporate Governance: maximizing long-term shareholder value”. Thus, the way a company is organized and managed to ensure that all financial stakeholders (shareholders and creditors) receive their fair share of a company’s earnings and assets.
The Institute of Company Secretaries of India has also defined the term Corporate Governance, as “corporate governance is the application of best management practices, compliance of law in true letter and spirit and adherence to ethical standards for effective management and distribution of wealth and discharge of social responsibility for sustainable development of all stakeholders”. It is an area of economics that emphasizes evolving institutional structures to regulate the contract, organizational designs and legislations. It motivates the shareholders and encourages the managers to deliver better returns on investments.
However Corporate Governance has wider implications and is critical to economic and social well-being, firstly in providing the incentives and performance measures to achieve business success, and secondly in providing the accountability and transparency to ensure the equitable distribution of the resulting wealth.
According to World Bank- Corporate Governance is concerned with holding the balance between economic and social goals and between individual and communal goals. The governance framework is there to encourage efficient use of resources and equally to require accountability for the stewardship of those resources. The aim is to align as nearly as possible the interests of individuals, corporations and society.
In globalization era, Corporate Governance has become an increasingly important in determining the perception of international investor, managerial structures and credibility of business. There is a need for corporates in India to heed this tide of change.
They must proactively design their culture-specific codes and effectively implement, instead of sit and wait for rules to be imposed from the government and regulatory agencies. There is ample evidence to establish that a single wrong doing is enough to ruin the reputation of a company, it took ages to build, while the culture of strict adherence to good governance practices keeps them ahead on sustainable basis.
The Cadbury committees report on Corporate Governance emphasized on the process, structure and relationship through which company functions and is held accountable. While the CII gave emphasis on global consensus about the objective of good Corporate Governance and maximizing long-term shareholders value, ICSI emphasized on adherence to ethical standards for effective management. SEBI committee headed by Shri N.R. Narayan Murthy emphasized on making distinction between personal and corporate fraud in the management of a company.
Another issue, which was not covered, was the functioning of independent directors. As per the revised clause 49, for a company with an Executive Chairman, at least 50 per cent of the board should comprise independent directors. In the case of a company with a Non-Executive Chairman, at least one-third of the board should comprise independent directors.
The institution of independent directors to be successful requires that the independent directors are allowed to act independently. Similarly, independent directors should have courage to say no when things are not moving in the interest of the company and its stakeholders. Independence on paper is not enough in itself. The problem is not ‘the number’ of independents, but the quality of their contribution.
The foremost objectives of corporate governance are to make efficient management as well as inspire and strengthen the trust and confidence of the people by ensuring business’s commitment to higher growth and development.
It seeks to achieve the objectives as stated here:
1. To develop better and most efficient management of business organisation,
2. To develop more applicable criteria towards performing the task,
3. Holding the balance between social and economic goals,
4. To encourage the efficient use of scarce resources,
5. To ensure perspective work place management,
6. To develop the business transactions to be based on values,
7. To develop the confidence and interest among the business men and society at large towards the social reforms,
8. To develop a better working environment to get some patterns of democratic style,
9. The managerial cadres are required to create wealth legally and ethically,
10. To bring a high level of satisfaction to customers, employees, investors and the society at large,
11. To determine the level and composition of accountabilities,
12. To make balanced representation of adequate number of non-executives and independent executive in the board of directors who will take care of the interest and well-being of all the stakeholders,
13. To adopt transparent procedures and practices and arrive at decisions on the strength of adequate information,
14. To provide disclosures to all the relevant facts and information to stakeholders and other partners of the business,
15. To make effectively and regularly monitor and control the affairs and functioning of the managerial group of the concern.
Corporate Governance – Need
Corporate governance is needed for the following reasons:
1. Separation of Ownership from Management:
A company is run by its managers. Corporate governance ensures that managers work in the best interests of corporate owners (shareholders).
2. Global Capital:
In today’s global world, global capital flows in markets which are well regulated and have high standards of efficiency and transparency. Good corporate governance gains credibility and trust of global market players.
3. Investor Protection:
Investors are educated and enlightened of their rights. They want their rights to be protected by companies in which they have invested money. Corporate governance is an important tool that protects investors’ interests by improving efficiency of corporate enterprises.
4. Foreign Investments:
Significant foreign institutional investment is taking place in India. These investors expect companies to adopt globally acceptable practices of corporate governance and well-developed capital markets. Demanding International Standards of corporate governance and greater professionalism in management of Indian corporates substantiates the need for good corporate governance.
5. Financial Reporting and Accountability:
Good corporate governance ensures sound, transparent and credible financial reporting and accountability to investors and lenders so that funds can be raised from capital markets.
6. Banks and Financial Institutions:
Banks and financial institutions give financial assistance to companies. They are interested in financial soundness of companies financed by them. This can be done through good corporate governance.
7. Globalization of Economy:
The economy today is globalized. Integration of India with the world economy demands that Indian industries should conform to the standards of international rules. Corporate governance helps in doing this.
Corporate Governance – 6 Important Features: Transparency, Accountability, Trusteeship, Employees’ Welfare, Environment Protection and a Few Others
Important features of corporate governance are as follows:
Feature # 1. Transparency:
A key element of good corporate governance is transparency, projected through a code of good governance, which incorporates a system of checks and balances between key players – boards, management, auditors and shareholders. Transparency in company’s action may be ensured through making non-partisan disclosures and timely dissemination of information complete in all respect equally to all shareholders about results; Annual General Meetings (AGMs); quarterly updates on company’s performance, risks, outlook, opportunities and threats etc.
Feature # 2. Accountability:
“Corporate Governance is a way of life and not a set of rules. It is a way of life that necessitates taking into account the shareholders interests in every business decision. This has brought into focus the accountability of the Board of Directors of a company and their constituent responsibilities.”
(a) Towards Shareholders:
It occurs when the company adopts an equitable and fair approach towards its shareholders, resorts to timely resolution of shareholder’s complaints and grievances, rewards the shareholders on regular basis and constitutes dedicated cells in the organization to address shareholders grievances.
(b) Towards Society:
Following are some of the ways by which a company can discharge its obligations towards the society:
(i) Providing assistance to victims during times of natural calamities;
(ii) Enlistment and education of the underprivileged and deprived;
(iii) Promotion of education and training in general;
(iv) Contributions, charity, donations for socially relevant causes;
(v) Steps for promoting welfare of mentally, physically or visually disabled;
(vi) Establishment of schools, hospitals, parks etc.
Feature # 3. Trusteeship:
“The doctrine of trusteeship is based on the Bhagavad Gita. The twin principles of ‘aparigraha’ (non-possession) and ‘Sambhawa’ (equalism) are the main principles of Bhagavad Gita. Corporates are the trustee of the shareholders and their money; they should use their wealth for the welfare of the society and the community at large.” Trusteeship involves a strong code of discipline and ethical behaviour as well as equally strong principle of accountability.
Feature # 4. Employees’ Welfare:
Good corporate governance is essentially concerned with company’s human resource.
The Annual Report could set out the initiatives taken by the company for employees’ welfare in the following areas in particular:
(i) Training programmes organized for upgrading employees’ skills;
(ii) Identification and rewarding of performance;
(iii) Focus on multi-skill programme where key executives are rotated to various functions to develop skills across different functions;
(iv) Housing schemes launched for employees;
(v) Launching of benevolent fund for employees;
(vi) Scholarships and/or educational facilities for children of the company’s staff.
Feature # 5. Environment Protection:
Irrespective of whether a company is polluting or non-polluting, protection of environment should be concern of every socially responsible organization. Each company must take steps to make sustainable use of resources, establish a healthy and safe working environment, maintain ecological balance, take proactive steps to minimize waste generation and preserve the environment. The securing of ISO Certification for environmental protection could be highlighted in the Annual Report.
Feature # 6. Meeting Social Obligations:
There is a growing expectations that the business enterprise to be much more than a mere economic unit and be a good corporate citizen vigorously contributing to social issues and charity.
It seeks to achieve the following objectives:
(a) A properly structured board capable of taking independent and objective decisions is in place at the helm of affairs;
(b) The board is balanced as regards the representation of adequate number of nonexecutive and independent directors who will take care of the interests and well- being of all the stakeholders;
(c) The board adopts transparent procedures and practices and arrives at decisions on the strength of adequate information;
(d) The board has an effective machinery to sub-serve the concerns of stakeholders;
(e) The board keeps the shareholders informed of relevant developments impacting the company;
(f) The board effectively and regularly monitors the functioning of the management team; and
(g) The board remains in effective control of the affairs of the company at all times.
The overall endeavour of the board should be to take the organization forward, to maximize long-term value and shareholders’ wealth.
Corporate Governance – Importance
Corporate governance is important for the following reasons:
1. It shapes growth and future of capital markets of the economy.
2. It helps in raising adequate funds from capital markets.
3. It links company’s management system with its financial reporting system.
4. It enables management to take innovative decisions for effective functioning of an enterprise within the legal framework of accountability.
5. It supports investors by making corporate accounting practices transparent. Corporate enterprises have to disclose financial reporting structures.
6. It provides adequate and timely disclosure, reporting requirements, code of conduct etc. Companies present material price sensitive information to outsiders and ensure that till the time this information is made public, insiders abstain from dealing in corporate securities. It, thus, avoids insider trading.
7. It improves efficiency and effectiveness of an enterprise and adds to material wealth of the economy.
8. It improves international image of the corporate sector and enables home companies to raise global capital.
Corporate Governance – Rationale: Need for Norms and Codes, Agency Costs, Distribution of Rights & Responsibilities, Common Purpose and a Few Others
Rationales of corporate governances are as follows:
1. Need for Norms and Codes:
Inadequacies and failures of an existing system often bring to the fore the need for norms and codes to remedy them. In the UK, deficiencies in the Accounting Standards became more evident after many companies, in their eagerness to increase earnings and accelerate growth, exploited the weaknesses in the accounting standards to show inflated profits and understate liabilities. Corporate Governance develops norms and codes for board management regarding management of companies in the interest of stakeholders.
2. Agency Costs:
The basic need for corporate governance arose due to agency costs. In the case of a public limited company, the shareholders are the owners or principals. But due to inherent nature of a public limited company, its large body of shareholders are scattered throughout the country and hence they themselves are unable to manage or run the company.
Their interest mainly lies in getting reasonable return, based on the risk- profile of the company, year after year without any hindrance, whatsoever. To run their company they have to appoint competent manager on market-related compensation package. These managers, thus, run the company on day-to-day basis as agents of their principals, i.e., the shareholders.
While principals may feel that agents would be running the show in their interest, in actual practice things may not be often so. For example, the chief executive and other senior managers may even indulge in window-dressing of operational results of the company by fudging the firm’s accounts.
3. Distribution of Rights & Responsibilities:
Corporate Governance is a system, which directs and controls business corporations. The Corporate Governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as the board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs. By doing this, it also provides the structure through which the company objectives are set and the means of attaining those objectives and monitoring performance.
4. Mechanism of Transformation into Action:
Corporate Governance is the mechanism by which the values, principles, management practices and procedures of corporation are made manifest in the real world. Good Corporate Governance implies not only a mechanical compliance of legislations but also adding value to various stakeholders.
Amidst the fierce competition in the wake of globalization and advent of knowledge economy, excellence is the only way of survival and growth. The essence of corporate governance involves the development of constructive relationship between different constituents of a corporate enterprise based on the principles of justice, lucidity, effectiveness and responsibility.
Intensive competition, emerging new multilateral trading order and the need for sustainable development have generated extensive debate on the process and style of Corporate Governance. “The need of the hour for the corporates is to follow corporate governance norms in their true spirit and practice the parameters of fairness, accountability, disclosure and transparency.”
5. Common Purpose:
Governance has proved an issue since people began to organize them for a common purpose. How to ensure the power of organization is harnessed for the agreed purpose, rather than diverted to some other purpose, is a constant theme. The institutions of governance provide a framework within which the social and economic life of countries is conducted. Corporate Governance concerns the exercise of power in corporate entities.
Corporate Governance – 16 Main Elements: Role and Powers of Board, Legislation, Management Environment, Board Skills, Board Appointments and a Few Others
Elements of good corporate governance are as follows:
Element # 1. Role and Powers of Board:
Good governance is decisively the manifestation of personal beliefs and values, which configure the organizational values, beliefs and actions of its Board. “The Board as a main functionary is primarily responsible to ensure value creation for its stakeholders. The absence of clearly designated role and powers of Board weakens accountability mechanism and threatens the achievement of organizational goals. Therefore, the foremost requirement of good governance is the clear identification of powers, roles, responsibilities and accountability of the Board, CEO, and the Chairman of the Board. The role of the Board should be clearly documented in a Board Charter.”
Element # 2. Legislation:
Clear and unambiguous legislation and regulations are fundamental to effective corporate governance. Legislation that requires continuing legal interpretation or is difficult to interpret on a day-to-day basis can be subject to deliberate manipulation or inadvertent misinterpretation.
Element # 3. Management Environment:
Management environment includes setting-up of clear objectives and appropriate ethical framework, establishing due processes, providing for transparency and clear enunciation of responsibility and accountability, implementing sound business planning, encouraging business risk assessment, having right people and right skill for the jobs, establishing clear boundaries for acceptable behaviour, establishing performance evaluation measures and evaluating performance and sufficiently recognizing individual and group contribution.
Element # 4. Board Skills:
To be able to undertake its functions efficiently and effectively, the Board must possess the necessary blend of qualities, skills, knowledge and experience. Each of the directors should make quality contribution. A Board should have a mix of the following skills, knowledge and experience: Operational or technical expertise, commitment to establish leadership; financial skills; Legal skills; and Knowledge of government and regulatory requirements.
Element # 5. Board Appointments:
To ensure that the most competent people are appointed on the Board, the board positions should be filled through the process of extensive search. A well- defined and open procedure must be in place for reappointments as well as for appointment of new directors. Appointment mechanism should satisfy all statutory and administrative requirements.
Priority should be given to an understanding of skill requirements of the Board particularly at the time of making a choice for appointing a new director. All new directors should be provided with a letter of appointment setting out in detail their duties and responsibilities.
Element # 6. Board Induction and Training:
Directors must have a broad understanding of the area of operation of the company’s business, corporate strategy and challenges being faced by the Board. Attendance at continuing education and professional development programmes is essential to ensure that directors remain abreast of all developments, which may impact their corporate governance and other related duties.
Element # 7. Board Independence:
Independent board is essential for sound corporate governance. The goal may be achieved by associating sufficient number of independent directors with the board. Independence of directors would ensure that there are no actual or perceived conflicts of interest. It also ensures that the board is effective in supervising and where necessary, challenging the activities of management.
Element # 8. Board Meetings:
Directors must devote sufficient time and give due attention to meet their obligations. Attending board meetings regularly and preparing thoroughly before entering the boardroom increases the quality of interaction in board meetings. Board meetings are the forums for decision-making.
These meetings enable directors to discharge their responsibilities. The effectiveness of board meetings is dependent on carefully planned agendas and providing relevant papers and materials to directors sufficiently prior to board meetings. Also, in the present scenario, board meetings through modern means of communication like tele-conferencing, video conferencing may be expressly allowed under law.
Element # 9. Board Resources:
Board members should have sufficient resources to enable them to discharge their duties effectively. It includes and access for director to independent legal and professional advice at the company’s expense. The costs of supporting the board should be transparent and reported.
Element # 10. Code of Conduct:
It is essential that the organization’s explicitly prescribed norms of ethical practices and code of conduct are communicated to all stakeholders and are clearly understood and followed by each member of the organization. Systems should be in place to periodically measure, evaluate and if possible recognize the adherence to code of conduct.
Element # 11. Strategy Setting:
The objectives of the company must be clearly documented in a long- term corporate strategy including an annual business plan together with achievable and measurable performance targets and milestones.
Element # 12. Business and Community Obligations:
Basic activity of a business entity is inherently commercial but it should also take care of community’s obligations. Commercial objectives and community service obligations should be clearly documented after approval by the board. The stakeholders must be informed about the proposed and on-going initiatives taken to meet the community obligations.
Element # 13. Financial and Operational Reporting:
The board requires comprehensive, regular, reliable, timely, correct and relevant information in a form and of a quality that is appropriate to discharge its function of monitoring corporate performance.
For this purpose, clearly defined performance measures – financial and non-financial should be prescribed which would add to the efficiency and effectiveness of the organization. Reports and information provided by the management must be comprehensive but not so extensive and detailed as to hamper comprehension of the key issues.
Element # 14. Monitoring the Board Performance:
The board must monitor and evaluate its combined performance and also that of individual directors at periodic intervals, using key performance indicators besides peer review. The board should establish an appropriate mechanism for reporting the results of board’s performance.
Element # 15. Audit Committees:
The Audit Committee is inter alia responsible for liaison with the management; internal and statutory auditors, reviewing the adequacy of internal control and compliance with significant policies and procedures, reporting to the board on key issues. The excellence of Audit Committee significantly contributes to the governance of the company.
Element # 16. Risk Management:
Risk is an element of corporate functioning and governance that should not be neglected. There should be a clearly established process of identifying, analyzing and tackling risks, which could prevent the company from achieving its objectives effectively. It also involves establishing a link between risk-return and resourcing priorities.
Appropriate control procedures in the form of a risk management plan must be put in place to manage risk throughout the organization. The plan should cover activities viz. review of operating performance, effective use of information technology, contracting out and outsourcing.
Corporate Governance – Principles
Issues involving corporate governance principles include:
1. Oversight of preparation of the entity’s financial statements.
2. Internal controls and independence of the entity’s auditors.
3. Review of the compensation arrangements for the chief executive officer and other senior executives.
4. The way in which individuals are nominated for positions on the board.
5. The resources made available to directors in carrying out their duties.
6. Oversight and management of risk.
7. Dividend policy.
The aim of corporate governance principles is to align the interest of individuals and community goals, corporations and society in the following ways:
Companies have to be transparent. Transparency means accurate, adequate and timely disclosure of relevant information to stakeholders. Transparency and disclosure provide information to the stakeholders that their interests are being taken care of.
Chairman, board of directors and chief executive of the company should fulfil accountability to the shareholders, customers, workers, society and the Government. Since they have considerable authority over company’s resources, they should accept accountability for all their decisions and actions.
For ethical reasons, corporate governance seems to be independent, strong and non-participatory body where all decision-making is based on business and not personal biases.
Good corporate governance involves adequate reporting to shareholders and other stakeholders, for example, a company should publish quarterly, half yearly and yearly performance and operating results in newspapers. It should also report functioning of various committees set by the board of directors for efficient administration. It is important on ethical grounds of the society.
Corporate Governance – Top 3 Theories: The Agency Theory, The Stewardship Theory and The Stakeholder Theory
Various theories of corporate governance are described below:
1. The Agency Theory:
According to this theory there exists agency relationship between the shareholders and management of a company. Under a contract of agency, one party (the principal) appoints another party (the agent) to perform some functions on its behalf. Shareholders of a corporation delegate the decision making authority to the board of directors. As an agent, the board of directors is expected to exercise its authority on behalf of and in the best interests of the shareholders (the principal).
In reality, however, board of directors and chief executives may promote their own interests rather than the interests of shareholders. In other words, there can be a divergence of interests between shareholders and managers. Effective governance system is needed, therefore, to safeguard the interests of shareholders.
Agency theory presents a narrow view of corporate governance as it suggests that a company is responsible only to its shareholders. It does not consider the interests and rights of other stakeholders like employees, customers, suppliers, creditors, distributors, government, media, and the community.
2. The Stewardship Theory:
This theory is based on the assumption that the top managers of a company will act on their own as responsible stewards of the assets under their control. They work diligently to achieve high levels of profits which yield good returns to shareholders.
The interests of the company and its owners are aligned with those of managers when they work towards collective goals. The interests of shareholders are automatically served when the company’s performance is maximised. Therefore, board of directors, and chief executives should be given adequate authority, and discretion to act as good stewards. A proper governance structure is required for this purpose.
Stewardship theory is based on the assumption that board of directors will always work for corporate performance and will use such performance in the interests of shareholders. This may not always hold true. Moreover, the theory overlooks the interests of stakeholders other than shareholders.
3. The Stakeholder Theory:
This theory suggest that a company must be run in the interests of all the stakeholders. The interests of stakeholders are numerous and may often be contradictory. Therefore, a harmony or compromise is required between them. A board of directors consisting of the representatives of various Stakeholder groups could be entrusted with this task.
The stewardship theory recognises the rights of shareholders as well as other stakeholders. But in practice, board of directors may not always be able to maintain equity. It is likely to overstress the interests of some stakeholders and underemphasize those of other stakeholders. It is a very difficult tight rope walk and a very effective system of governance is needed for this challenge.
Corporate Governance – Two Important Types of Mechanisms: Internal Mechanism and External Mechanism
There are two types of mechanism generally used in corporate governance- Internal mechanism and external mechanism.
These mechanisms are as follows:
(i) Ownership Structure:
Agency theory says that separation of ownership and control incur some costs. Hence, owners need to find out various mechanisms to minimize these costs. That means owners can align the interests of managers and owners by adopting different mechanism. Based on this, it can be assumed that if owners are the managers then there will be no cost. But in the days of widespread ownership it is not that easy.
As majority of owners are with smaller holdings with which they cannot discipline managers. Hence, the structure of ownership is important in disciplining the managers. Owners, by virtue of the size of their equity positions, effectively have some control over the firms they own. Thus, ownership structure is a potentially important element of corporate governance.
(ii) Board of Directors:
The board of directors is a mechanism through which shareholders can exert considerable influence on the behaviour of managers in order to ensure that the company is running in their interest. Corporation in most countries of the world have board of directors. The board exists primarily to hire, fire, monitor, and compensate management, all with an eye towards maximizing shareholders value.
Major responsibilities of board of directors include determine the organizations mission and purpose, select the executives, support the executives and review the performance, ensure effective organizational planning, ensure adequate resources, manage resources effectively, determine and monitor the organisations programmes and services, enhance the organisations public, image, etc.
(iii) Executive Compensation:
The third mechanism that ensures that managers pursue the interest of shareholders is executive compensation. If structured appropriately, it discourages the managers, who have control over the firm without investing in it, from acting against the interest of shareholders. The measures used to evaluate managers include both stock valuation and accounting based performance measures. However, Studies suggest that there is a positive relationship between executive pay and performance.
In the absence of day-to-day control of operations of shareholder, disclosures by the management about company information has become very crucial for good governance. Honest managers will attempt to provide sufficient, accurate and timely information regarding the firms, operations, financial status, and external environment.
Information about operational efficiency risks involved compliance to legal and regulatory matters, adherence to codes of conduct, environmental laws etc. are mostly internal information to the company. The management needs to disclose the information to the concerned parties.
These mechanisms help in improving the governance of a corporation.
External mechanisms are as follows:
(i) The Market for Corporate Control:
The existence of an active market for corporate control is essential for efficient allocation of resources. When internal control mechanism fail to bridge the gap between the actual value of a firm and its potential value, will create incentive for outside parties to seek control of the firm. Changes in the control of firms virtually always occur at a premium, thereby creating value for the target firm’s shareholders.
Furthermore, the mere threat of a change in control can provide management with incentives to keep firm value high, so that the value gap is not large enough to warrant an attack from the outside. Thus, the takeover market has been an important governance mechanism.
(ii) Legal/Regulatory Framework:
Legal environment play very crucial role in the standard of corporate governance of a country. Country’s laws protect investors rights. Legal framework prevalent in a country helps disciplining managers and controlling shareholders’ opportunistic behaviours. Extensive studies done suggest that in countries with common law tradition, governance standards are generally higher and minority shareholders are relatively better protected.
In contrast, countries pursuing continental law systems normally have poor minority shareholders protection and practice lower governance standards. Interestingly, they that cross-country differences in equity valuation, cost of capital and magnitude of external financing. It could be explained by a complained by a country’s legal origin. Obviously, legal framework is an effective external mechanism that assures investors to get a fair return on their investment.
It is another powerful mechanism for solving a variety of agency problem is competition in product markets. If the managers of a firm waste resources, the firm will eventually fail in product markets. Hence, increased competition reduces managerial slack and may be helpful in limiting efficiency losses. The same logic implies that product competition helps curtail the “tunnelling” activities of the controlling shareholders.
Thus good corporate governance helps protect investors and ensures that investors get a fair return on their investment. An effective combination of the above internal and external mechanism influences the standards of good corporate governance.
Corporate Governance – 4 Main Models: The Anglo-Saxon Model, The Insider Model, Japanese Model and The Family Based Model
The corporate governance structure has certain basic elements. These elements are the pattern of share ownership, key players in the corporate sector, composition of the board of directors, interaction among the key players, the regulatory framework, and disclosure requirements for listed companies, and corporate decisions that require approval of shareholders. These elements differ between countries. As a result there are different corporate governance models.
These models are explained below:
1. The Anglo-Saxon Model (The Outsider Model):
The corporate governance model of the United States and commonwealth countries such as UK, Australia, Canada, India (to a large extent), etc., is known as the outsider model. This model is characterised by-
(i) A Well-developed Stock Market with, Considerable Depth and Liquidity – In the USA and the UK a vast majority of public companies are listed at stock exchanges. The capital market in these countries serves as a disciplinary mechanism. There is convergence between the interests of shareholders and managers due to the threat of takeover.
(ii) The Ownership Structure of Companies is Widely Dispersed – For example, the median size of the largest voting block is 5 per cent in the USA and 10 per cent in the UK. The influence of shareholders on management is weak due to widely dispersed share ownership.
(iii) Strict Laws Concerning inside Trading and Disclosure of Information – These help to protect shareholders. A sound stock market provides exit routes to shareholders. The threat of replacing underperforming directors also helps to maximise shareholders value.
(iv) Unitary Board of Directors to Give Primacy to the Interests of Shareholders – Directors are elected by shareholders who have voting rights in proportion to their shareholding.
(v) The Board of Directors Consists Inside and Outside Directors – Inside directors are either employed in the company (called executive directors) or have significant relationship with the promoters. Outside or independent directors are neither employed in the company nor are related to the promoters.
(vi) Little Role of Trade Unions – These do not participate in strategic decisions of the company.
(vii) Key Players – Shareholders, directors and management. The company’s power is distributed between these players. The ultimate authority lies with the shareholders. The residuary executive authority rests with the board of directors and managers.
The Anglo-Saxon model is market-oriented. It is characterised by a large number of listed companies, widespread shareholding, and a well-functioning capital market. The stock market exercises control over the functioning of companies. In addition, the legal framework and regulatory agencies are assumed to ensure protection of shareholders who elect directors.
The board of directors performs the functions of direction, control, and representation. Managers appointed by the board of directors implement policies and manage day-to-day affairs of the company. Institutional investors (pension funds, mutual funds, insurance firms, etc.,) are exercising increasing control over companies.
2. The Insider Model:
This model of corporate governance is prevalent in Germany, Japan, etc.
This model exists in Germany, Switzerland, Australia, and Netherlands. Therefore, this is also known as Continental Europe Model.
The main features of the German Model are as follows:
(i) Weak Stock Market:
Debt is the major source of finance due to restrictions on listing of companies. It is a bank-oriented rather than market-oriented system. Universal banks supply both loans and equity capital. The concentrated bank holdings and cross holding are not traded on the stock market. Therefore, the stock market is less developed and illiquid. The stock market exercises insignificant control over companies.
(ii) Concentrated and Cross Shareholdings:
In most German companies there are large controlling block holders of shares. According to Franks and Mayer, a single owner holds more than 50 per cent of the equity in more than half of the listed companies. The widely used mechanism of cross holding creates ownership pyramids.
A few big shareholders maintain control through substantial voting power. Block holders also form voting pacts such as multiple or capped voting systems. Bank may even exercise veto power.
(iii) Dual Class Shares:
One class of shares has more voting rights than the other class. Therefore, the principle of one share one vote is not applicable.
(iv) Dual Board or Two Tier Board:
All public limited companies (AG) and private limited companies (GmbH) with more than 500 employees have an executive’s board (vorstand) and a supervisory board (Aufsichts-crat). The executive board consists of full time managers who are appointed by the supervisory broad.
Strategic planning, day-to-day management, and performance review are the main functions of the executive board. The supervisory board elected by the shareholders and employees approves the decisions and oversees the activities of the executive board. Banks are offered membership on the supervisory board.
(v) Low Legal Protection:
In the German model reliance is more on large investors and banks than on legal regulations. The insiders who work through banks control the disciplinary mechanism. Therefore, the German model is called the insider model. Disclosure standards are comparatively low.
(vi) Employee Participation:
In German companies, employees elect one third to one half (depending on the total member of employees) directors on the supervisory board. The rest of the directors are non-executives such as representatives of banks and firms having business relationship, and professional advisers.
Thus, concentrated ownership, cross shareholding, bank finance, two tier board structure, weak capital market, little legal protection for investors and weak public disclosures are the key features of the German model.
The German model reduces institutional pressures for short term decisions and allows long range strategic planning. It is relationship-oriented. It provides representation to employees. But this model overlooks the interests of small shareholders. The model is not suitable for global capital market as it is too secretive.
3. Japanese Model:
The Japanese corporate governance model is characterised by the following features:
Industrial groups (e.g., Mitsubishi) are linked by cross- shareholdings and trading relationships. Most of these groups are diversified and vertically integrated by cross holdings.
(ii) Consortium Financing:
Banks and other financial institutions are the main source of funds for Japanese companies. They provide both debt and equity capital. They are led by a major bank known as main bank. Banks hold majority of shares on a long-term basis and build strong relationship with the client companies.
(iii) Government – Industry Linkage:
The industrial groups employ retired civil servants and work together on government sponsored committees. Retired Government officers are appointed as directors to seek preferential treatment from the government. These bureaucrats also ensure effective implementation of government politics.
(iv) Employee Participation:
Long serving and committed employees are offered membership on the board of directors. Senior managers and former employees account for 90 per cent of the company directors.
(v) Unitary Board Structure:
Boards of major corporations represent the company as an integrated social unit. The entire board takes all major decisions of the company. In theory, the ultimate power to oversee the company’s functioning lies with the board of directors.
But in practice the board of directors has by tradition surrendered most of its authority to the president of the company. The presidents along with an operating committee of top executives select new members of the board of directors and evaluate the company’s performance.
(vi) High Degree of Autonomy:
Banks and financial institutions do not exercise direct control over a company so long as the company is run well in terms of market share and growth. But in case of poor performance and doubtful governance, the main bank intervenes by exercising oversight over the management and reviewing the company’s investment plans.
Thus, long-term company bank relationship, high level of stock ownership by banks cross holdings, board of directors controlled by insiders, employee representation, retired government officers board members, and intervention by the main bank in emergency are the main characteristics of the Japanese model. This model is m any sided and represents trust and relationship-oriented to corporate governance.
The Japanese Model involves participation of employees in corporate governance which ensures their long-term commitment to the company. The model seeks to balance the interests of all stakeholders unlike the Anglo — Saxon model which gives primary to the interest of shareholders.
Difference between Insider and Outsider Models:
1. Share ownership – Concentrated
2. Voting power – High concentration
3. Main shareholder – Families, banks other companies, Govt.
4. Corporate control market – Low level of takeover
5. Information – Private
6. Composition of board of directors – Large number of directors appointed by the main block holder
7. Control on management – High
1. Share ownership – Dispersed
2. Voting power – Low concentration
3. Main shareholder – Institutional investors
4. Corporate control market – High activity in corporate control market
5. Information – Public
6. Composition of board of directors – Presence of outside directors
7. Control on management – Low
4. The Family Based Model:
Family based model of corporate governance exists in several underdeveloped and emerging countries of East Asia India, Korea, Malaysia, Middle East, Brazil, Mexico, Chile, Turkey, Egypt, Kuwait, Saudi Arabia, UAE, etc.
The main characteristics of this model are as follows:
i. Closely Held Companies:
In most of the listed companies, the promoter’s family is a dominant shareholder accounting for more than 50 per cent of the issued share capital. The founder, his relatives and associates dominate. In case of public enterprises, Central or State Government is the major shareholder. Family owns the company for long term and ownership is inherited by succeeding generations.
ii. Family Control:
The family exercises full control due to ownership, cross holding, inter-locking directorships. Business families are held in high esteem, the regulatory framework is weak and outside shareholders have apathy. Banks and financial institutions provide considerable finance to family owned and managed companies. But they do not exercise much control. Their nominees on the board of directors of the borrowing company generally support the family control.
iii. Unitary Board of Directors:
There is a single board of directors. The controlling family appoints most of the directors and the chief executive. The board is staffed with family members, friends, and business associates. Outsiders (independent directors) are appointed to meet the regulatory requirement.
iv. Family Interest:
The Company is run primarily for the benefit of the family. Owners extract private gain by transfer of wealth through sale of assets at lower than market prices. Funds are sometimes diverted for family’s interest. In some cases there have been conflicts of interest between the controlling family and minority shareholders. Managers act primarily for the controlling family.
Family based model fills the monitoring gap of market mechanism because the family exercises an effective control. It is driven by long term interest of creating wealth for the family. But the model expropriates the minority interest. Tensions within the controlling family may hamper the functioning and performance of companies. Corporate governance practices are not very sound and effective.
The family based model of corporate governance is changing due to globalisation and liberalisation. Internationalisation of capital markets, global competition, increasing role of financial institutions, tightening of regulatory framework are the major forces due to which companies in developing countries are improving their corporate governance practices. For example, Indian companies which want to raise capital abroad and get listed on foreign stock exchanges are adopting international standards concerning accounting and public disclosure.
Corporate Governance – Benefits of Good Corporate Governance
Good corporate governance provides the following benefits to a company:
1. Access to Capital Market – Globalisation and increase in the size of firms have enhanced the role of institutional investors and financial intermediaries. Investors now have a wider choice due to the opening up of financial markets.
Companies which continuously create shareholder value and maximise wealth for shareholders are preferred by investors. Such companies have an easy access to capital markets both at home and abroad. Good corporate governance helps to create value and wealth for shareholders. It increases the confidence of investors in a company.
2. Acquisition and Retention of Talent – Well governed companies have an edge in attracting, retaining, and engaging well-qualified employees. Hardworking, ambitious, and competent people want to join and stay in a company which treats them as valuable assets.
3. Risk Cover – Companies are now exposed to greater risks due to price deregulation, growing competition, and structural reforms. Good corporate governance helps to provide a risk cover by creating and maintaining mutual trust with different sections of society. It leads to increase in revenue and profitability.
4. Public Image – Good governance of a company helps to improve its goodwill and build brand image. Infosys, Wipro, TCS and other well governed companies enjoy international prestige. Positive image provides stability and growth to a company.
5. Market Position – Good corporate governance creates customer loyalty which in turn helps to improve market share of the company.
6. Innovations – ITC, Hindustan Unilever, and several other companies have discovered new opportunities for business through their initiatives in the social sector.
Corporate Governance – Problems and Challenges in Corporate Governance at Individual and Group Level
There are certain problems and challenges as arising within the purview of corporate governance. In any organisation, the challenging aspects may be setup into two parts i.e., at individual level and at group.
Showing the Problems and Challenges as Arising in Corporate Governance:
The problem and challenges at individual and group level within corporate governance are briefly stated here:
1. At Individual Level:
i. Individual Interest
ii. Individual Differences
iii. Lack of Accountabilities
iv. Indifferent Attitudes
v. Lack of Initiatives
vi. Communication Barriers
vii. Differences in Motives and Perception
viii. Undesirable Behaviour
2. At Group Level:
i. Lack of the Code of Conduct
ii. Lack of Coordination
iii. Lack of Education and Training
iv. Resistance to Change
v. Lack of Team Spirit
vi. Lack of Adequate Resources
vii. Lack of rationality in Decision Making
viii. Not Formulating the Professional Codes