AN OVERVIEW OF CORPORATE GOVERNANCE

E. IRVINGCavehill School of Business

September, 10th, 2013

ContentIntroductionDefinitions of Corporate GovernanceTheoretical Framework

• Agency Theory• Shareholder Theory• New Institutional Theory• Stewardship Theory• Stakeholder Theory

Measuring Corporate GovernanceCorporate Governance: A Caribbean OverviewSummary

INTRODUCTION• The Caribbean region is currently challenged by lingering

negative economic effects of the “great recession”

• “Lehman Brothers is considered to be an example of a company that failed during the financial crisis of 2008 in large part due to ineffective oversight by the board of directors.” Larcker and Tayan (2010)

• They ascertained that board quality and poor oversight played a greater role in the company’s failure than structure and composition.

• The collapse of CL Financial continue to pose challenges for governments, shareholders, and taxpayers across the region.

• “…financial difficulties faced by the CL Financial Group resulted from excessive related-party transactions, an aggressive high interest rate mobilization strategy with corresponding high risk investments, high leveraging of the Group’s assets and weak corporate governance.” Extracted from Caribbean Centre for Money and Finance Newsletter, January 2013, Vol.6 No.1

• The relationship between the governance structure of corporations within the region and mechanisms to ensure compliance and sustainability should be examined and strengthened.

Definitions of Corporate Governance• ‘Rules and regulation that govern the relationship between

the managers and shareholders of companies as well as stakeholders like employees and creditors.’ OECD (2004)

• “procedures and processes according to which an organisation is directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among the different participants in the organisation – such as the board, managers, shareholders and other stakeholders – and lays down the rules and procedures for decision-making.” OECD (2010)

• Cadbury (1992) states that “Corporate Governance is the system by which companies are directed and controlled.”

• According to Aoki (2001), corporate governance is defined as “structure of rights and responsibilities among the parties with a stake in the firm.”

• Becht, Bolton and Roell (2002) define corporate governance as being ‘concerned with the resolution of collective action problems among dispersed investors and reconciliation of conflicts of interest between various corporate claimholders.’

• Cornelius (2005) proposes that “corporate governance can be defined as the stewardship responsibility of corporate directors to provide oversight for the goals and strategies of a company and foster their implementation.”

• Fahy et al (2006) states that “corporate governance is the systems and processes put in place to direct and control an organisation in order to increase performance and achieve sustainable shareholder value.”

• The firm has a particular governance structure to enable it to balance the rights and responsibilities of varying stakeholders.

THEORETICAL FRAMEWORK

Agency Theory

• Principal – Agent Problem

– Self interest / Conflict of interest– Information Asymmetry – Moral hazard– Agency costs

Model of Principal – Agent ProblemFigure 1. P- Principal A-Agent

• Berle and Means (1932), recognized need to separate the issue of control and ownership and called for more transparency, voting rights and accountability.

• This became the basis of the Principal-Agent Theory which tries to explain the conflict arising from the varying interest of the principal (owners) and the agent (managers). Jensen and Meckling (1976)

• Fama and Jensen (1983) explained this relationship in terms of legal contracts and the mechanisms that are needed to maintain this relationship.

• Eisenhardt (1989) examined two streams of Agency Theory: positivist agency theory and principal-agent relationship approach.

• The former generally focuses on the owner/CEO relationship in large corporations while the latter is more general and can be applied to family ran companies.

Shareholder Theory• "There is one and only one social responsibility of business –

to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.” Friedman (1970)

• Shareholder theory is aligned with the agency theory, both view the relationship between the principal and agent as paramount and that the responsibility of management is to maximize profits.

New Institutional Economics• Coast (1937) proposed that in reality firms

focus on minimizing transaction costs.

• These costs include contractual hazards, information asymmetries, self interested opportunism, Williamson (1984)

• Like agency theory, this model focuses on the principal – agent relationship although the approach to the problem differs slightly

Stewardship Theory• Left alone management will act in best interest of firms and

shareholders

• Don’t believe in the pessimistic view of human nature (e.g. self-interest), they hold that this view re-enforces and influences such negative behavior, Ghoshal and Moran (1996)

• Donaldson and Davis (1991, 1997) argues that no principal- agent problem exists.

• Agents are stewards for the company’s assets and not agents of owners. They are a necessary component of this relationship.

Stakeholder Theory

• Firms should recognize the interests of stakeholders that have a vested interest in the corporation. RE Freeman (1984)

• Research indicate that the country environment or political-economic climate affect corporate performance, Shleifer and Vishny (1997), Doidge et al (2007), Aggarwal et al (2009).

Country Environment

Country Environment

Stakeholder Theory ModelFigure 2. Adopted from Letza, Sun, Kirkbride (2004)

Measuring Corporate Governance

• Varying interests, incentives and rights of the stakeholders make it difficult to design and measure a suitable rubric across corporations and countries.

• The fact that the institutional setting varies and the country context are different make comparative analysis a challenge. Judge (2009)

Corporate Governance Index (G-Index)

• Designed by Investor Responsibility Research Center (IRRC).

- Utilizes 24 provisions to measure proper governance e.g. corporate by-laws, charters, annual reports, filings to the S.E.C.

Governance Matrix International (GMIRatings)

• Uses over 600 variables including board accountability, financial disclosure, internal controls, corporate social responsibility, and shareholder rights.

• Gathered mainly through publicly available information including press releases, regulatory filings, news articles, company websites, company policy, company documents as well as board and management interviews.

Corporate Governance Quotient (CGQ)• Developed by the Institutional Shareholder Services (ISS)

• Uses over 50 criteria in seven broad categories to rate corporate governance. The rating is based on related companies (industry specific) in seven categories plus an overall score.

• These variables are two-fold: ‘inside’ content such as board of directors, audit, charter, by laws, laws of the state or territory of incorporation, executive compensation, qualitative factors, ownership and director education, and ‘outside’ or public information, regulatory filings, websites and press releases.

Antidirector Rights Index (ADRI)

• This matrix was developed mainly by La Porta et al (1998) and further refined by Gompers (2003).

• Uses six components, three that impact

shareholder voting – voting by mail, voting without block shares and ability of minority to call extraordinary meeting and three variables looks at minority shareholder protection, preventive rights, potential and judicial remedies.

Caribbean Overview• The Caribbean Corporate Governance Forum Report of

2003 in addressing the challenges to CG in the region stated:“Firstly, corporate governance is most often discussed in the context of promoting investor protection. In the Caribbean less than 1% of the population could be deemed as being an active investor community. CG has not played an important role in regional corporations due to the lack of institutional and retail investor participation. Secondly, the Caribbean has not experienced the types of crisis and loss of investor money/depositor’s funds that has been happening in other regions”

Caribbean Trade and Investment Report 2005, list the following challenges:

• Small pool from which to chose directors;• The concept of the independent director is hard to apply;• Small number of public companies;• Relatively large number of private companies;• Active role of the State in economic activities;• Dominance of large family owned firms;• Preference for commercial bank financing; • Legal, statutory and regulatory framework is under-

resourced

Trinidad and Tobago

• The Chamber of Industry and Commerce, Trinidad and Tobago Stock Exchange and the Caribbean Corporate Governance Institute are working to prepare a draft Corporate Governance Code

• It is hoped that national standard for how companies (both private and state owned) are governed will improve investor confidence and reduce the risk of corporate failures.

Jamaica

• In late 2012 Jamaica produced a corporate governance framework for 191 public bodies.

• These rules cover twenty principles of good

governance - governance composition, roles and responsibilities of boards and top management, risk management, disclosure, ethics and corporate social responsibility.

Barbados

• The Barbados Central Bank published its revised code for corporate governance in the financial sector in early 2013.

• Regional corporations have traditionally used debt verses equity to finance their operations, this enables banks and other financial institutions to ensure firms are governed properly.

• Well governed financial institutions should help to stabilize the finance sector and act as an additional mechanism to monitor corporations

Summary• Corporate Governance is critical as corporate failures

can have negative social and economic effects• CG theory has evolved from focusing solely on the

principal – agent relationship to include other stakeholders

• Measuring what is good CG is challenging particularly for analysis across industries and countries

• The Caribbean has begun to pay some attention to the role of CG

Questions or Comments?