Theory and Practice of Corporate Governance

The concept: Corporate Governance • The joint stock company known as the

corporation is the nucleus of all business activities in modern economies. All corporations do not however enjoy equal share of power; they also do not have the same size and degree of operations. In India as well as countries like US, UK the major share of the capital is in the hands of few giant corporations that control the production and the market for goods.

Definition

• “The business corporation is an instrument through which capital is assembled for activities of producing and distributing goods and services and making investments. Accordingly, a basic premise of corporation law is that a business corporation should have as its objective the conduct of such activities with a view to enhancing the corporation’s profit and gains of the corporation’s owners, that is the share holders.”

According to Chief Justice John Marshall (1801)

• “A corporation is an artificial being, invisible, intangible, and existing only in the contemplation of the law. Being the mere creature of the law, it possesses only those properties which the charter of its creation confers on it, either expressly or as incidental to its very existence. These acts are supposedly best calculated to effect the object for which it was created.

• Among the most important properties are immortality, and, if the expression be allowed, individually; which a perpetual succession of many persons are considered the same, and may act as a single individual.”

What is Corporate?

• In the capitalist economy, capital accumulation takes place through development and growth of industries, trade and commerce, infrastructure and agriculture. The corporation of today has replaced the sole proprietor of old days and tries to maximize profits and generate wealth. But it differs on two counts:

1. The life of the corporation is much longer2. It is more rational in decision making as it is run by a

board of directors and besides they take decisions based on cost accounting, budget analysis, data collection and processing, and managerial consulting.

Characteristics of a corporation

1. Incorporated or registered under the Companies Act of a country

2. Artificial legal existence- equal to that of a natural person with its own legal entity

3. Perpetual existence – Law creates a company and only law can dissolve it

4. Common seal – an artificial person can not sign documents

5. Extensive membership – no limitation on the number of members

6. Separation of management from ownership7. Limited liability (owners risk is limited unlike in the case

of partnerships, individual ownerships)8. Transferability of shares

Concept of governance

• The concept of governance is as old as human civilization. Governance stands for decision making and implementing it. It is used in several contexts – corporate governance, international governance, national governance, local governance. Government is one of the players; others are companies, associations, NGOs, Cooperatives, political, parties, police and so on. All except government and the armed forces are said to be part of the “civil society”.

Theoretical basis for corporate governance

A. Agency Theory

The fundamental theoretical basis of corporate governance is agency costs. Adam Smith had identified the agency problem (managerial negligence and profusion). Shareholders are the owners and the principals too. The management, the board, chosen by the shareholders are the agents. Principals may want to carry out the objectives of the company but the agents may not quite exactly match the requirements. The cost of the “dissonance” caused by the agency problem is the agency cost. There are many a way through which the management go counter to the objectives of the shareholders such maximizing shareholder returns. Ostentatious life styles of directors, empire building etc. are examples.

• Mechanisms that help reduce agency costs:

1. Fair and accurate financial disclosures

2. Efficient and independent board of directors

B. Stewardship Theory The theory defines situations in which managers

are not motivated by individual goals, but rather they are stewards whose motives are aligned with the objectives of their principals.

It assumes that managers are trustworthy and have high reputations. There fore their behavior will not run counter to the interests of the company. There is a significant emphasis on the responsibility of the board to the shareholders in a corporate governance model that is emboldened by stewardship and trusteeship. These concepts of stewardship and trusteeship are traceable in the scriptures of India and Christendom.

Basic behavioral differences between Agency & Stewardship Theories

Agency Stewardship

Managers act as agents Managers act as stewards

Governance approach is materialistic Governance is sociological and psychological

Behavior pattern is individualistic, opportunistic, and self serving

Behavior pattern is collectivistic, pro-organizational, and trustworthy

Managers are motivated by their own objectives

Managers are motivated by the principals’ objectives

Interests of the managers and principals differ

Interests of the managers and principals converge

The role of the management is to monitor and control

The role of the management is to facilitate and empower

Owners’ attitude is to avoid risks Owners’ attitude is to take risks

Principal-manager relationship is based on control

Principal-manager relationship is based on trust

Issues in Shareholder Versus Stakeholder• Shareholder approaches fundamentally mean that

corporations have limited responsibilities namely that of obeying laws and maximizing shareholder wealth. That is to say, shareholder interests will automatically maximize societal utility. But this argument presupposes that there will be perfect competition which is rather suspect in many situations.

• Stakeholder approaches dwell upon the theme that corporate managements have responsibilities toward other stakeholders. In other words responsibilities of the companies in terms of maximizing profits toward the shareholders should be subject to obligations toward others.

Stakeholder theory

• Dating back to 1930s, this theory represents a synthesis of a fair bit of economics, behavioral science, business ethics, and stakeholder concept. It deals with the common interests of employees, customers, dealers, government, and the society at large and draws all of them into corporate-mix. It is often criticized as “wooly minded liberalism” because it is not applicable in practice by companies. But the defense is that managers can act efficiently only by drawing upon the resources of the stakeholders and as such there is a “contract” between the company and the stakeholders.

• But then who are all genuine stakeholders? Some might make bizarre choices like terrorists, dogs, trees and to the least questionable like employees and customers!

Corporate Governance Mechanisms• The joint-stock, limited liability company is

becoming the most preferred organization for running any business.

• It has been successful in providing employment, generating wealth, and contributing to economic and social development.

• In the limited liability company, the business is incorporated as an independent legal entity separate from its owners.

• Shareholders’ liability for debts is limited to the amount of capital they have agreed to subscribe for.

• The company as a legal person has the rights to sell, buy, to own assets, to incur debts, to employ, to contract, and to sue and be sued upon.

• Company has a long life span different from those of its innumerable shareholders.

• Companies need to be governed as well as managed. The board of directors is central and its structure and processes are fundamental; so are the board’s relationships with its shareholders, regulators, auditors, top management, and other legitimate stakeholders.

• These days companies’ shareholders are of diverse nature – private individuals, institutional investors such as banks and pension funds, insurance companies, and other companies who might have business relationship with the company. This make it a very complex situation.

• There has been a growing awareness of corporate governance around the world. A number of studies and official reports have followed as a result of the growing awareness and societal responses. These provided a code of best practices for the governance.

• Many a major company today operate through group structures of wholly-owned subsidiary companies, partly owned subsidiaries in which other external parties have a minority equity interest and associated companies in which the holding company has a significant but not dominant holding. In an era of globalization, major companies are getting engaged in a variety of joint ventures and strategic alliances.

Corporate governance systems

• The role of the management (which mostly appears in the organizational chart and not the board) is to run the business while the board oversees that it is run well and in the right direction. Management operates as a hierarchy. There is an ordering of responsibility, authority, delegation downwards through the firm and accountability upwards to the top brass.

• By contrast, the board members need to work together as equals reaching agreement by consensus or if necessary by voting. Each director bears the same duties and responsibilities.

• Corporate governance systems vary around the world:

1.The Anglo-American Model

2.The German Model

3.The Japanese Models

Elect

Appoints & supervises

Monitors & regulates Lien on

Manage

Own Stake in

Regulatory Legal System

Company Creditors

Shareholders Board of directors (Supervisors) Stakeholders

Officers (Managers)

The Anglo-American Model

Features of Anglo-American Model

1. Ownership equally divided among individual and institutional shareholders

2. Directors are rarely independent of management3. Companies run by professional managers with

negligible ownership stakes – clear separation of ownership and management

4. Institutional investors are reluctant activists – if not satisfied with the company, they just sell shares and pack off

5. Disclosure norms are comprehensive – rules against insider trading, penalties for price manipulation, protection for small investors, discourage large investors from taking active role in corporate governance

Appoints & Supervises

Manage

Own

Appoint 50%Appoint 50%

Employees & Labor Unions

Supervisory Board

Management Board (incl. labor relations officer)

Company

Shareholders

The German Model

Features of German Model

1. Governance is exercised through two-tier board – upper board supervises the executive board on behalf of shareholders

2. The shareholders own the company but do not entirely dictate governance mechanism – shareholders and labor unions on a 50-50 basis appoint the supervisory board

3. Supervisory board appoints and monitors the management board

Ratifies the President’s decisions

President

Supervisory Board (including the President)

Consults

Manages

Company

Executive Management (Primarily Board of Directors)

Shareholders

Provides loans

Owns

Provides managers

Appoint

Own

Provides managers . monitors, acts in emergencies

Main Bank

The Japanese Model

Features of Japanese Model

1. The financial institution has accrual role in governance – shareholders and main bank together appoint the Board of Directors and the President

2. The President who consults the supervisory board and the executive management is included

3. Importance of the lending bank is highlighted

Corporate Governance System

External Environment

Internal Environment

Company vision, mission, policies, norms

Internal stakeholders

Auditors Board of Directors

Government regulations, policies, guidelines , etc

Company Act SEBI, Stock Exchange

Corporate culture, structure, characteristics, Influences

Depositors, borrowers, customers and other external stakeholders

Proper governance

Shareholder value

Corporate governance outcomes/Benefits to society

Transparency

Investor protection Concern for customer

Healthy corporate sector development

Indian Corporate Governance Model

Features of Indian Model

1. Indian companies are governed by the Company’s Act of 1956

2. Follows more or less the UK model3. Private companies are closely held or

dominated by a founder, his family, and associates

4. In the wake of economic liberalization, India has adopted the key tenets of the Anglo-American external and internal control mechanism

What is good Corporate Governance?

• Bad governance is being recognized as the major root cause for corrupt societies

• Investors and institutions provide loans and aid stressing that the reforms that ensure good governance are adopted by the companies

• Good corporates are not born, rather they are the result of the combined efforts and contributions of all stakeholders, board of directors, government, and the society at large

• There are obligations to society at large, investors, employees, and customers

• Managerial obligations too are important

Values, Concerns , Duties, Responsibilities

Society expects from Corporates

• If a corporate has to survive, grow, and wants to be counted, its vision should focus on the ways and means of becoming a responsible and responsive corporate citizen.

Our Credo We believe that our first responsibility is to the doctors ,

nurses, and patients, to mothers and fathers and all others who use our products and services. In meeting

their needs everything we do must be of high quality. We must consistently strive to reduce costs in order to

maintain reasonable prices. Customers’ orders must be serviced promptly and accurately. Our suppliers and

distributors must have an opportunity to make a fair profit.

We are responsible to our employees, the men and women who work with us throughout the world.

Everyone must be considered as an individual. We must respect their dignity and recognize their merit. They must

have a sense of security on their jobs. Compensation must be fair and adequate, and working conditions

clean, orderly, and safe. We must be mindful of ways to help our employees fulfill their family responsibilities. Employees must feel free to make suggestions and

complaints. There must be equal opportunity for employment, development and advancement for those

qualified. We must provide competent management, and their actions must be just and ethical.

We are responsible to the communities in which we live and work and to the world community as well. We must be good citizens – support good works and charities and

bear out fair share of taxes. We must encourage civic improvements and better health and education. We must maintain in good order the property we are privileged to use, protecting the environment and natural resources.

Our final responsibility is to our stockholders. Business must make a sound profit. We must experiment with new ideas. Research must be carried on, innovative program developed and mistakes paid for. New equipment must be purchased, new facilities provided, and new products

launched. Reserves must be created to provide for adverse times. When we operate according to these

principles, the stockholders should realize a fair return.