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CHAPTER 2CHAPTER 2
THE THEORY THE THEORY AND PRACTICE AND PRACTICE OF CORPORATE OF CORPORATE GOVERNANCEGOVERNANCE
OBJECTIVESOBJECTIVES
Over the past three decades, the concept of Over the past three decades, the concept of
corporate governance has gone through a corporate governance has gone through a
metamorphosis. Theoretically, from one that metamorphosis. Theoretically, from one that
was related to agency cost, it is now was related to agency cost, it is now
perceived to encompass everyone’s interests. perceived to encompass everyone’s interests.
This chapter discusses the theoretical basis, This chapter discusses the theoretical basis,
mechanisms and the divergent models of mechanisms and the divergent models of
corporate governance and culminates in the corporate governance and culminates in the
identification of an ideal corporation.identification of an ideal corporation.
CHAPTER OUTLINECHAPTER OUTLINE The Concept of CorporationThe Concept of Corporation Theoretical Basis of Corporate GovernanceTheoretical Basis of Corporate Governance Agency TheoryAgency Theory Stewardship TheoryStewardship Theory Stakeholder TheoryStakeholder Theory Corporate Governance MechanismsCorporate Governance Mechanisms Corporate Governance SystemsCorporate Governance Systems What Is Good Corporate GovernanceWhat Is Good Corporate Governance Obligation to Society at LargeObligation to Society at Large Obligation to InvestorsObligation to Investors Obligation to EmployeesObligation to Employees Obligation to CustomersObligation to Customers Managerial ObligationManagerial Obligation
What is a Corporate?What is a Corporate?
The term “corporate” refers to an association of The term “corporate” refers to an association of
many persons, who contribute money or many persons, who contribute money or
money’s worth to a common stock and employ it money’s worth to a common stock and employ it
in some trade or business, and who share the in some trade or business, and who share the
profit and loss arising therefrom. The common profit and loss arising therefrom. The common
stocks so contributed is denoted in money and is stocks so contributed is denoted in money and is
the capital of the company. The persons who the capital of the company. The persons who
contribute it, or to whom it belongs, are its contribute it, or to whom it belongs, are its
members. The proportion of the capital to which members. The proportion of the capital to which
each member is entitled is his share. Shares are each member is entitled is his share. Shares are
always transferable, although the right to always transferable, although the right to
transfer them is often more or less restricted.transfer them is often more or less restricted.
What is Governance?What is Governance?
Governance is the process of decision Governance is the process of decision
making and the process by which decisions making and the process by which decisions
are implemented or not implemented.are implemented or not implemented.
Characteristics of a CorporationCharacteristics of a Corporation
o Incorporated AssociationIncorporated Association
o Artificial Legal ExistenceArtificial Legal Existence
o Perpetual ExistencePerpetual Existence
o Common SealCommon Seal
o Extensive MembershipExtensive Membership
o Separation of Management and OwnershipSeparation of Management and Ownership
o Limited LiabilityLimited Liability
o Transferability of sharesTransferability of shares
Theoretical Basis of Corporate Theoretical Basis of Corporate
GovernanceGovernance
o Agency TheoryAgency Theory
o Problems with the Agency TheoryProblems with the Agency Theory
o Stewardship TheoryStewardship Theory
o Shareholder Vs Stakeholder ApproachesShareholder Vs Stakeholder Approaches
o Stakeholder TheoryStakeholder Theory
o Criticisms of the Stakeholder TheoryCriticisms of the Stakeholder Theory
o Sociological TheorySociological Theory
Agency TheoryAgency Theory
Management as agents of Management as agents of stockholdersstockholders
Agency Cost raise issues (Trade-off)Agency Cost raise issues (Trade-off) Mechanisms reducing agency costMechanisms reducing agency cost
Fair and Accurate Financial DisclosuresFair and Accurate Financial Disclosures Financial and Non-Financial DisclosuresFinancial and Non-Financial Disclosures
Efficient and Independent BoDsEfficient and Independent BoDs
Stewardship TheoryStewardship Theory
Managers are trustworthyManagers are trustworthy Managers attach significant value to Managers attach significant value to
their own personal reputationstheir own personal reputations Manager is steward of principalManager is steward of principal Steward will do good for organizationSteward will do good for organization Controls will demotivate stewardsControls will demotivate stewards
The theory definesThe theory defines Managers are not motivaed by individual Managers are not motivaed by individual
goals but with the objectives of principlesgoals but with the objectives of principles A steward will choose the interessts of A steward will choose the interessts of
his/her organization, and will not his/her organization, and will not entertain self-serving behaviorentertain self-serving behavior
Control can be potentially Control can be potentially counterproductivecounterproductive
Behavioural DifferencesBehavioural Differences
THEORY AGENCY STEWARDSHIP
Managers act as Agents Stewards
Governance Approach Materialistic Sociological and Psychological
Behaviour Pattern o Individualistico Opportunistic o Self-serving
o Collectivistic o Pro-organisational o Trustworthy
Managers motivated by Their own objectives
Principal’s objectives
Manager’s and Principal’s Interests
Differ Converge
Management Structures Monitor and control
Facilitate and empower
Owners’ Attitude Risk Avoidance Risk taken
Principal – Manager Relationship based on
Control Trust
Psychological MechanismsPsychological Mechanisms
PSYCHOLOGICALRESPONSES
AGENCY THEORYSTEWARDSHP
THEORY
Motivation o Lower order needs o Extrinsic needs
o Higher order needs o Intrinsic needs
Social comparison Compatriots Principal
Attachment Little attachment to company
Great attachment to company
Power Institutional Personal
Situational MechanismsSituational MechanismsSITUATIONALRESPONSES
AGENCY THEORYSTEWAREDSHIP
THEORY
Management Philosophy
Control oriented Involvement oriented
While dealing with increasingUncertainty and risk
Greater controls More supervisions
Training and empowering people Making jobs to be more challenging and motivating
Risk orientation Through a system of control
Through trust
Time frame Short term based Long term based
Objective Cost control Improving performance
Cultural differences Individualism Large power
distance
Collectivism Small power
distance
Shareholder Vs. Stakeholder Shareholder Vs. Stakeholder TheoryTheory
• Shareholders are investors of the firmShareholders are investors of the firm• Stakeholders are all-interest groupsStakeholders are all-interest groups
• Employees, customers, dealers, Employees, customers, dealers, government and the society at largegovernment and the society at large
• Ethics of care, theory of property rights Ethics of care, theory of property rights and so onand so on
• Not applicable in practiceNot applicable in practice• CriticismCriticism
• Difficulty in defining the conceptDifficulty in defining the concept• Who is genuine stakeholder?Who is genuine stakeholder?• Practical?Practical?
Sociological TheorySociological Theory
• Focuses on:Focuses on:• Board CompositionBoard Composition• Power and Wealth Distribution in SocietyPower and Wealth Distribution in Society• Power in few hands (privilege class)Power in few hands (privilege class)
• Challenge to equity and social Challenge to equity and social progressprogress
• To promote equity and fairnessTo promote equity and fairness• Board composition, financial reporting, Board composition, financial reporting,
disclosure and auditingdisclosure and auditing
Corporate Governance MechanismsCorporate Governance Mechanisms
o The Importance of Corporate GovernanceThe Importance of Corporate Governance
o Contemporary Corporate Governance SituationContemporary Corporate Governance Situation
o Growing Awareness and Societal Responses Growing Awareness and Societal Responses
Corporate Governance SystemsCorporate Governance Systems
o Anglo-American ModelAnglo-American Model
o The German ModelThe German Model
o The Japanese ModelThe Japanese Model
o Indian Model of Corporate Indian Model of Corporate
GovernanceGovernance
Fig.1 : The Anglo-American Model
Company
Officers(Managers)
Board of Directors(Supervisors)
Legal/Regulatory System
Stakeholders
Creditors
ShareholdersElect
Monitors & Regulates
Lien on
Own
Stake in
Appoints & Supervises
Manage
Fig.2 : The German ModelFig.2 : The German Model
Company
Management Board(Including Labour Relations Officer)
Supervisory Board
Employees and Labour
Unions
Shareholders
Appoints and Supervises
Appoint – 50%
Appoint – 50%
Manage
Fig.3 : The Japanese ModelFig.3 : The Japanese Model
Company
Executive Management(Primarily Board of Directors)
President
Supervisory Board(Including President)
Main Bank
Shareholders
Provides Loans
elect
Ratifies the President’sDecisions
Consults
Manages
Provides Loans
Owns
Own
Provides ManagersMonitors & Acts in
Emergencies
What Is Good Corporate What Is Good Corporate Governance?Governance?
Obligation to society at largeObligation to society at largeo National InterestNational Interest
o Political Non-alignmentPolitical Non-alignment
o Legal CompliancesLegal Compliances
o Rule of Law Rule of Law
o Honest and Ethical Conduct Honest and Ethical Conduct
o Corporate CitizenshipCorporate Citizenship
o Ethical Behaviour Ethical Behaviour
o Social Concerns Social Concerns
o Corporate Social Responsibility Corporate Social Responsibility
o Environment-friendlinessEnvironment-friendliness
o Health, Safety and Working EnvironmentHealth, Safety and Working Environment
o Competition Competition
o Trusteeship Trusteeship
o AccountabilityAccountability
o Effectiveness and EfficiencyEffectiveness and Efficiency
o Timely ResponsivenessTimely Responsiveness
o Corporations Should Uphold the Fair Name of the Corporations Should Uphold the Fair Name of the
Country Country Obligation to investorsObligation to investors
o Towards Shareholders Towards Shareholders
o Measures Promoting Transparency and Informed Measures Promoting Transparency and Informed
Shareholder ParticipationShareholder Participation
o TransparencyTransparency
o Financial Reporting and RecordsFinancial Reporting and Records
Obligation to customersObligation to customers o Quality of Products and ServicesQuality of Products and Services
o Products at Affordable PricesProducts at Affordable Prices
o Unwavering Commitment to Unwavering Commitment to
Customer SatisfactionCustomer Satisfaction
Obligation to employeesObligation to employees
o Fair Employment Practices Fair Employment Practices
o Equal-opportunities Employer Equal-opportunities Employer
o Encouraging Whistle BlowingEncouraging Whistle Blowing
o Humane TreatmentHumane Treatment
o ParticipationParticipation
o EmpowermentEmpowerment
o Equity and InclusivenessEquity and Inclusiveness
o Participative and Collaborative EnvironmentParticipative and Collaborative Environment
Managerial obligationManagerial obligation
o Protecting Company’s AssetsProtecting Company’s Assets
o Behaviour Towards Government AgenciesBehaviour Towards Government Agencies
o ControlControl
o Consensus OrientedConsensus Oriented
o Gifts and Donations Gifts and Donations
o Role and Responsibilities of Corporate Board and Role and Responsibilities of Corporate Board and DirectorsDirectors
o Direction and Management must be DistinguishedDirection and Management must be Distinguished
o Managing and Whole-Time Directors Managing and Whole-Time Directors
Johnson & Johnson’s excellent Credo Johnson & Johnson’s excellent Credo exemplarily epitomises what an ideal exemplarily epitomises what an ideal
corporate should aspire to be.corporate should aspire to be.
Our CredoOur Credo
We believe our first responsibility is to the doctors, We believe our first responsibility is to the doctors, nurses and patients,nurses and patients,
to mothers and fathers and all others who use our to mothers and fathers and all others who use our products and services.products and services.
In meeting their needs everything we do must be of In meeting their needs everything we do must be of high quality.high quality.
We must constantly strive to reduce our costsWe must constantly strive to reduce our costsin order to maintain reasonable prices.in order to maintain reasonable prices.
Customers' orders must be serviced promptly and Customers' orders must be serviced promptly and accurately.accurately.
Our suppliers and distributors must have an Our suppliers and distributors must have an opportunity to make a fair profit. opportunity to make a fair profit.
We are responsible to our employees,We are responsible to our employees,the men and women who work with us throughout the world.the men and women who work with us throughout the world.
Everyone must be considered as an individual.Everyone must be considered as an individual.We must respect their dignity and recognize their merit.We must respect their dignity and recognize their merit.
They must have a sense of security in their jobs.They must have a sense of security in their jobs.Compensation must be fair and adequate,Compensation must be fair and adequate,
and working conditions clean, orderly and safe.and working conditions clean, orderly and safe.We must be mindful of ways to help our employees fulfill their family responsibilities.We must be mindful of ways to help our employees fulfill their family responsibilities.
Employees must feel free to make suggestions and complaints.Employees must feel free to make suggestions and complaints.There must be equal opportunity for employment, developmentThere must be equal opportunity for employment, development
and advancement for those qualified.and advancement for those qualified.We must provide competent management,We must provide competent management,and their actions must be just and ethical.and their actions must be just and ethical.
We are responsible to the communities in which we live and workWe are responsible to the communities in which we live and workand to the world community as well.and to the world community as well.
We must be good citizens – support good works and charitiesWe must be good citizens – support good works and charitiesand bear our fair share of taxes.and bear our fair share of taxes.
We must encourage civic improvements and better health and education.We must encourage civic improvements and better health and education.We must maintain in good orderWe must maintain in good order
the property we are privileged to use,the property we are privileged to use,protecting the environment and natural resources. protecting the environment and natural resources.
Our final responsibility is to our stockholders.Our final responsibility is to our stockholders.Business must make a sound profit.Business must make a sound profit.
We must experiment with new ideas.We must experiment with new ideas.Research must be carried on, innovative programs developed and mistakes paid for.Research must be carried on, innovative programs developed and mistakes paid for.
New equipment must be purchased, new facilities provided and new products launched.New equipment must be purchased, new facilities provided and new products launched.
Reserves must be created to provide for adverse times.Reserves must be created to provide for adverse times.When we operate according to these principles,When we operate according to these principles,
the stockholders should realize a fair return.the stockholders should realize a fair return.
Johnson & Johnson & JohnsonJohnson
