Theory and Practice of Corporate Governance

7/29/2019 Theory and Practice of Corporate Governance

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Theory and Practice of

Corporate Governance


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Definition

By a company is meant an association of many

persons, who contribute money to a common

stock & invest in some trade or business, and

who share the profit & loss arising. there from


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Characteristics of a corporation

1. Incorporated or registered under the Companies Act ofa country

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

3. Perpetual existence Law creates a company andonly law can dissolve it

4. Common seal an artificial person can not signdocuments

5. Extensive membership no limitation on the number

of members6. Limited liability (owners risk is limited unlike in the caseof partnerships, individual ownerships)

7. Transferability of shares


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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.


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Conti

The mismatch of objectives between principal & agents is called

agency problem & 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.

Ostentatious life styles of directors, empire building etc. are

examples.


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Conti

The core of CG is designing & putting in place disclosures,

monitoring, oversight & corrective systems that can align the

objectives of 2 set players as closely as possible & minimize

agency costs

Mechanisms that help reduce agency costs:

1. Fair and accurate financial disclosures

2. Efficient and independent board of directors


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Conti

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.


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Basic behavioral differences between Agency &

Stewardship Theories

Agency StewardshipManagers 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

convergeThe 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


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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.

Stakeholder approaches dwell upon the theme that corporate

managements have responsibilities toward other stakeholders. In

other words responsibilities of the companies in terms of maximizingprofits toward the shareholders should be subject to obligations

toward others.


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C.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?


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D. Sociological theory

It has focused mostly on board composition & implications for power

& wealth distribution in society

Under this theory, board composition, financial reporting, disclosure

& auditing are necessary mechanisms to promote equity & fairness

in society


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Theoretical basis of CG

Agency Cost

Stewardship Theory

Stakeholder Theory Sociological Theory


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Corporate governance systems

The role of the management (which mostly appears inthe organizational chart and not the board) is to run thebusiness while the board oversees that it is run well andin the right direction. Management operates as a

hierarchy. There is an ordering of responsibility,authority, delegation downwards through the firm andaccountability upwards to the top brass.

By contrast, the board members need to work togetheras equals reaching agreement by consensus or if

necessary by voting. Each director bears the sameduties and responsibilities.


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Conti

Corporate governance systems vary

around the world:

1.The Anglo-American Model

2.The German Model

3.The Japanese Models


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This is a typical liberal model of governance, which is prevalent in

the US, UK, and many English speaking countries of the former

British Empire.

This model calls for governance by the board of directors, which hasthe power to choose the CEO.

While the CEO has the power delegated by the board to manage the

company on a daily basis, he or she needs board approval for

certain major decisions.

Duties of the board includes policy making, decision making,

monitoring, management performance, control, facilitating CEO to

function under set policy & guidelines

The Anglo-American Model


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In this model, the board of directors is responsible towards the

shareholders;

Contrary to the spirit of good corporate governance, individual

shareholders are not given the opportunity to choose their nomineesto the board.

They were merely asked to put in their approval for the board

nominee

Cont


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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


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Features of Anglo-American Model

1. Ownership equally divided among individual andinstitutional shareholders

2. Directors are rarely independent of management

3. Companies run by professional managers with

negligible ownership stakes clear separation ofownership and management

4. Institutional investors are reluctant activists if notsatisfied with the company, they just sell shares andpack off

5. Disclosure norms are comprehensive rules againstinsider trading, penalties for price manipulation,protection for small investors, discourage largeinvestors from taking active role in corporategovernance


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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 notentirely 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


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Appoints &

Supervises

Manage

Own

Appoint 50%Appoint 50%

Employees &Labor Unions

Supervisory Board

Management Board (incl.labor relations officer)

Company

Shareholders

The German Model


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Features of Japanese Model

1. The financial institution has accrual rolein governance shareholders and mainbank together appoint the Board of

Directors and the President2. The President who consults the

supervisory board and the executivemanagement is included

3. Importance of the lending bank ishighlighted


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Ratifies the Presidents

decisions

President

Supervisory Board(including the President)

Consults

Manages

Company

Executive Management

(Primarily Board of Directors)

Shareholders

Provides loans

Owns

Providesmanagers

Appoint

Own

Provides managers .

monitors, acts in

emergencies

Main Bank

The Japanese Model


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Features of Indian Model

1. Indian companies are governed by theCompanys Act of 1956

2. Follows more or less the UK model

3. Private companies are closely held ordominated by a founder, his family, andassociates

4. In the wake of economic liberalization, India

has adopted the key tenets of the Anglo-American external and internal controlmechanism

Indian Corporate Governance Model


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CorporateGovernance

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


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Our CredoWe 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 meetingtheir 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 tomake a fair profit.


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

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

have a sense of security on their jobs. Compensationmust be fair and adequate, and working conditionsclean, 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 foremployment, development and advancement for thosequalified. We must provide competent management, and

their actions must be just and ethical.


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We are responsible to the communities in which we liveand 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.


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Our final responsibility is to our stockholders. Businessmust 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.

Documents

Theory and Practice of Corporate Governance