Lecture 7

Theoretical FrameworkTheoretical Framework

Learning Outcome

At the end of the lecture, students would be able to: Explain the various approaches/models

to good Corporate Governance; Discuss the issues and solutions to the

separation of ownership and control; Understand the pillars of CG; and Describe the core concepts to sound CG

Theoretical Frameworks

1. Principal-Agent (Finance)Model2. Shareholders / Anglo-American Model3. Stakeholder/Pluralistic Model4. Enlightened Shareholder Model5. Myopic Market Model6. Abuse of Executive Power Model

Principal-Agent Model (cont’d)

Definition of Agency Relationship: A contract under which one or more

persons (principals) engage another person (agent) to perform some service on their behalf, which involves delegating some decision-making authority to the agent” (Jensen & Meckling, 1976)

Sometimes called “Contract for Service”

Assumptions: All individuals will act in their own self

interest, which leads to potential conflicts of interest;

Agents are in a unique position to further their own interests at the expense of the principals;

Shareholders’ wealth maximisation = share value maximisation.


Theoretically managers work for shareholders (owners).

In reality – shareholders are usually inactive, firm actually seems to belong to management.


Separation of Ownership & Control

Most shareholders do not wish to take part in firm’s business activities. They act like investors not owners.

Investors tend to be inactive shareholders of many firms.

These absentee owners provide funding to public companies and delegate all aspects of management of the companies from strategic positioning to the daily business operations to the executive management team.

Owners focus on business performance of firm and investors focus on risk and return of stock portfolios.

Why Would Managers Care About Owners?

Managers/directors may act in their own personal interest, if possible, even at the expense of owners.

This situation is known as the principal-agent problem or agency problem.

Solution to Principal-Agent Issue

1. Incentives & monitoring Incentive solution to tie wealth of executive

to wealth of shareholders so that executives and shareholders have the same objectives.

This is called aligning executive incentives with shareholder desires.

Managers will then act and behave in a way that is also best for the other shareholders.

E.g. stock options or stocks or both as a significant component of their compensation.

Solution to Principal-Agent Issue

(Source: Kim, K. & Nofsinger, (2004). Corporate Governance. P6)

Stockholders

Creditors

Employees

Society

Stakeholders Monitors

Within CompanyBoard of Directors

Outside CompanyAuditorsAnalystsBankers

Credit AgenciesAttorneys

GovernmentSC/CCM/IRD

Bursa Malaysia

Managers

Controllers

2. Set up mechanisms for monitoring behaviour of managers.

Stakeholders Model

Key Features Top management also serves as an

agent to stakeholders; Companies are accountable to a broad

range of stakeholders; Promote ethical behaviour in

organisational practices; Criticises shareholder wealth

maximisation.

Stakeholders Model (cont’d)

Key Features (cont’d) Ethical principle gives competitive

advantage; Build reputation; Ethic behaviour minimises agency and

monitoring costs; Employees interest should be protected; Promote good relationship with suppliers.

Myopic Market Model

Key features: Criticises Anglo-Saxon (American) model for

over emphasising on short term perspectives Accounting practice is too concerned with

short term returns – executive rewards Share market misprices – does not take

fundamentals into account Fund managers dominate share market –

performance evaluated on short term basis/ short term forecast.

Shareholders wealth ≠ Share price maximisation

Myopic Model (cont’d)

Reforms proposed: Increase shareholder loyalty and ‘voice’ Reduce ease of shareholder ‘exit’

Restrict voting rights for short term investors

Restrictions on takeover process

Abuse of Executive Power Model

Key Features: Governance problems arose due to abuse of

power by top management; Current CG mechanisms are not adequate to

curb power abuse; BOD is too powerful and serves to promote

members’ interest only; Criticises free market – weakens ethical

constraints (governance problems) Disagrees with pay performance model.

Abuse of Executive Power Model (cont’d)

Reforms proposed: Limit CEO’s term (legislative/statutory

changes) Independent nomination of non-executive

directors (NEDs) Greater power for NEDs

Purpose : to weaken top management entrenched position.

Conditions For Corporate Governance

Source : Siebens, H.(Aug 2002). Concepts and Working Instruments for CG.Journal for Business Ethics (Electronic Journal)

Transparency & Accountability: tell me, show me & involve me

Pluralistic Model = Stakeholders’ Model

Shareholders Value Stakeholders Value

Anglo American Model

Enlightened Shareholders Model

Regulation of power and

competence

Duality Care

Responsible business

Risk Management

Shareholder Value Approach

BOD should govern their company in the best interest of the owners and shareholders

Objectives of the company to maximise the wealth of owners and equity shareholders in the form of share price growth and dividend payments.

Aims of sound corporate governance not only to meet objectives of shareholders

Also takes into account the interest of other individual or groups with a stake in the company.

Shareholder Value Approach

Criticisms of Stakeholders Value Approach

1. Firm’s contribution - it is harder to measure the firm’s contribution to the welfare of employees, suppliers or customers than to measure its profitability.

2. Market Value - there is no market value of the impact of past and current managerial decisions on future welfare of stakeholders.

3. Efficiency & Effectiveness - with the enlarged and restricted fiduciary duty concept, it would be questionable whether effective work can be done by management.

Pillars of CG

Legal & Regulatory Framework Compliance and legal protection

Directors & Board of Directors Board independence, Composition and size; & Role of CEO/Chairman

Board Committees Audit, remuneration & nomination

Pillars of CG (cont’d)

Company Secretary & Whistle blower Professional advise & independence

Auditors & Internal Control Independent assurance, risk

management system Shareholders & Stakeholders

Rights & activism Institutional Shareholders

IS activism Capital Structure

Debt vs. equity financing

Core Concepts of CG

Openness Willingness to provide information to

individuals and groups about the company (without giving away commercially sensitive information).

Honesty Not lying, cheating or stealing, fair and

upright; not hiding one’s real nature (oxford dictionary).

In an age of ‘spin’ and manipulation of facts, honest information is by no means prevalent.

A sign of questionable honesty is some measure of scepticism and disbelief.

Core Concepts of CG (cont’d)

Transparency Refers to ease with which an outsider is

able to make a meaningful analysis of a company and its actions.

Refers both to information about financial position of company and

Non financial issues such as direction the company is taking, strategic objectives, etc.

Independence Defined as a person free from influence

from another individual or individuals and free from conflicts of interest.

Refers to the extent which procedures and structures are in place so as to minimise (or avoid completely) potential conflicts of interest that could arise.

Independence can also be undermined by familiarity.


Accountability Requirement for a person in a position of

responsibility to justify, explain or account for/answerable for his/her actions in the course of his duties.

Responsibility Having authority over something and liable

to be held accountable for the exercise of his/her authority.


Fairness Impartial or un-bias and things done with a

sense of justice. All shareholders should receive equal

consideration. Reputation

Reflects the overall way in which the company is perceived by the market and in the wider community.

Influenced by code of ethics, corporate social responsibility, fair treatment of staff, attitudes to customers, community involvement and willingness to obey the spirit as well as the letter of the law.


Corporate Social Responsibility Refers to business decision making

linked to ethical values, compliance with legal requirements and respect for people, communities and the environment (www.bsr.org)

Viewed as a comprehensive set of policies, practices and programmes that are integrated throughout business operations, and decision making processes that are supported and rewarded by top management.


http://www.bsr.org/

Role of ‘Exit’ & ‘Voice’ in CG Relates to shareholders’ power in monitoring

the actions/performance of the BOD. Exit

shareholders not satisfied with company’s affairs have the right to sell shares of the company.

inability to voice due to strong influence by a certain individual on BOD.

Voice Shareholders have the power to approve or

reject corporate transactions either through shareholders’ activism with assistance of the Minority Shareholders’ Group.

Factors Influencing CG System

Insider Countries : Germany,

Japan & Asian countries

Firms owned by insider shareholders

Little separation of ownership & control

Rare hostile takeover activities

Weak investor protection in law

Outsider Countries: UK, USA Firms controlled by

managers but owned by outside shareholders

Prevalent separation of ownership & control

Frequent hostile takeover activities

Strong investor protection in law

Factors Influencing CG System (cont’d)

Insider Potential abuse of

power

Majority shareholder tend to have more voice

Ownership concentrated in a small group of shareholders

Outsider Potential for

shareholder democracy

Shareholding characterised more by ‘exit’ than ‘voice’

Dispersed ownership

Insider Excessive control by

insider shareholder

Wealth transfer from minority to majority shareholders

Outsider Moderate control by

large range of shareholders

No transfer of wealth from minority to majority shareholders

Factors Influencing CG System (cont’d)

Questions

1. What key elements show good governance?2. Explain one of the theoretical models

describing corporate governance.3. What are the essential pillars that forms the

corporate governance framework?4. What should shareholders do when they are

not happy about the governance of a corporation?

Documents

Lecture 7