Theory, Practice - CG Summary

8/3/2019 Theory, Practice - CG Summary

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Theory and Practice of

Corporate Governance



• The concept of Corporate Governance

• The joint stock company known as thecorporation is the nucleus of all businessactivities in modern economies.

• All corporations do not however enjoyequal share of power; they also do nothave the same size and degree ofoperations.



• “The business corporation is an instrument

through which capital is assembled foractivities of producing and distributing

goods and services and makinginvestments.

• Business corporation - its objective

• Enhancing the corporation’s profit and

gains of the corporation’s owners



According to Chief Justice JohnMarshall (1801)

• “A corporation is an artificial being, invisible,

intangible, and existing only in thecontemplation of the law. Being the mere

creature of the law, it possesses only thoseproperties which the charter of itscreation confers on it, eitherexpressly or as incidental to itsvery existence. These acts aresupposedly best calculated toeffect the object for which it wascreated.



• Important property – immortality

• Allowed, individually

• A perpetual succession of many personsare considered the same and may act as asingle individual



What is Corporate?

• In the capitalist economy, capital accumulationtakes place through development and growth

• The corporation of today has replaced the soleproprietor of old days and tries to maximize

profits and generate wealth.• Differs on two counts:1. More rational in decision making as it is run by

a board of directors

2. Take decisions based on cost accounting,budget analysis, data collection andprocessing, and managerial consulting



Characteristics of a corporation

1. Incorporated or registered under the Companies Act of a country2. Artificial legal existence- equal to that of a natural person with its

own legal entity3. Perpetual existence – Law creates a company and only law can

dissolve it

4. Common seal – an artificial person can not sign documents5. Extensive membership – no limitation on the number of members6. 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

• As old as human civilization.

• Governance stands for decision making andimplementing it.

• Corporate governance, internationalgovernance, national governance, localgovernance.

• Companies, Associations, NGOs, Cooperatives,

political, parties, police and so on are governed• All except government and the armed forces are

part of the “civil society”.



Theoretical basis for corporategovernance

A. Agency Theory

The fundamental theoretical basis of corporate governance is agency costs .Adam Smith identified the agency problem (managerial negligenceand profusion).

Shareholders are the owners and the principals too.The management, the board, are the agents.Principals may want to carry out the objectives of the company butthe agents may not quite exactly match the requirements.The cost of the “dissonance” caused by the agency problem is theagency cost.

Management may go counter to the objectives of the shareholderssuch maximizing shareholder returns.Ostentatious life styles of directors, empire building etc. areexamples.



• Mechanisms that help reduce agencycosts:

1. Fair and accurate financial disclosures

2. Efficient and independent board ofdirectors



B. Stewardship TheoryManagers not motivated by individual goalsAs stewards whose motives aligned with the objectives oftheir principalsManagers are trustworthy and have high reputations.

Their behavior will not run counter to the interests of thecompany.A significant emphasis on the responsibility of the board tothe shareholders in a corporate governance model that isemboldened 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 StewardshipManagers act as agents Managers act as stewards

Governance approach is materialistic Governance is sociological andpsychological

Behavior pattern is individualistic,opportunistic, and self serving Behavior pattern is collectivistic, pro-organizational, and trustworthy

Managers are motivated by their ownobjectives

Managers are motivated by theprincipals’ objectives

Interests of the managers and principals

differ

Interests of the managers and principals

convergeThe role of the management is to monitorand control

The role of the management is tofacilitate and empower

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

Principal-manager relationship is basedon control

Principal-manager relationship is basedon trust



Issues in Shareholder VersusStakeholder• Shareholder approaches - corporations have limited

responsibilities

• Just obeying laws and maximizing shareholder wealth-

• Will automatically maximize societal utility.

• But this argument presupposes that there will be perfectcompetition which is rather suspect in many situations.

• Stakeholder approaches dwell upon the theme thatcorporate managements have responsibilities toward

other stakeholders.• Responsibilities of the companies should be subject to

obligations toward others.



Stakeholder theory

• Dating back to 1930s, this theory represents a synthesisof a fair bit of economics, behavioral science, businessethics, and stakeholder concept.

• Deals with the common interests of employees,customers, dealers, government, and the society

• Often criticized as “wooly minded liberalism” because itis not applicable in practice by companies.

• The defense is that managers can act efficiently only bydrawing upon the resources of the stakeholders

• A “contract” between the company and the stakeholders.• But then who are all genuine stakeholders?• Bizarre choices like terrorists, dogs, trees and to the

least questionable like employees and customers!



Corporate GovernanceMechanisms

• The joint-stock, limited liability company isbecoming the most preferred organizationfor running any business. It has been

successful in providing employment,generating wealth, and contributing toeconomic and social development. In the

limited liability company, the business isincorporated as an independent legalentity separate from its owners.



• Shareholders’ liability for debts is limited to the

amount of capital they have agreed to subscribefor.

• The company as a legal person has the rights tosell, buy, to own assets, to incur debts, toemploy, to contract, and to sue and be suedupon.

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



• Companies need to be governed as wellas managed.

• The board of directors is central and itsstructure and processes are fundamental

• The board’s relationships with its

shareholders, regulators, auditors, topmanagement, and other legitimatestakeholders.



• Companies’ shareholders are of diverse

nature – private individuals, institutionalinvestors such as banks and pension

funds, insurance companies, and othercompanies who might have businessrelationship with the company.

• This make it a very complex situation.



• There has been a growing awareness ofcorporate governance around the world.

• A number of studies and official reportshave followed as a result of the growingawareness and societal responses.

• These provided a code of best practicesfor the governance.



• Many a major company today operate throughgroup structures of wholly-owned subsidiarycompanies, partly owned subsidiaries in which

other external parties have a minority equityinterest and associated companies in which theholding company has a significant but notdominant holding. In an era of globalization,

major companies are getting engaged in avariety of joint ventures and strategic alliances.



Corporate governance systems

• The role of the management (which mostly appears inthe organizational chart and not the board) is to run thebusiness

• The board oversees that it is run well and in the rightdirection.

• Management operates as a hierarchy. There is anordering of responsibility, authority, delegationdownwards through the firm and accountability upwardsto the top brass.

• By contrast, the board members need to work togetheras equals reaching agreement by consensus or ifnecessary by voting. Each director bears the sameduties and responsibilities.



Elect

Appoints &supervises

Monitors &regulates

Lien on

Manage

Own Stake in

RegulatoryLegal System

Company

Creditors

Shareholders Board of directors

(Supervisors) Stakeholders

Officers(Managers)

The Anglo-American Model



Appoints &Supervises

Manage

Own

Appoint 50%Appoint 50%

Employees &Labor Unions

Supervisory Board

Management Board (incl.labor relations officer)

Company

Shareholders

The German Model



Ratifies the President’s

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 inemergencies

Main Bank

The Japanese Model

Indian Corporate Governance Model



CorporateGovernanceSystem

External Environment

Internal Environment

Company vision, mission, policies, norms

Internal

stakeholders

Auditors Board ofDirectors

Government regulations,policies, guidelines , etc

Company ActSEBI, StockExchange

Corporate culture,structure, characteristics,Influences

Depositors, borrowers,customers and otherexternal stakeholders

Propergovernance

Shareholder value

Corporate governance outcomes/Benefits to societyTransparency

Investor protection Concern for customer

Healthy corporate sector development

Indian Corporate Governance Model



What is good CorporateGovernance?

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

• Investors and institutions provide loans and aid stressingthat 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 allstakeholders, board of directors, government, and thesociety 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, andwants to be counted, its vision shouldfocus on the ways and means of becoming

a responsible and responsive corporatecitizen.



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 meetingtheir needs everything we do must be of high quality. Wemust 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.



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.



We are responsible to the communities in which we live

and work and to the world community as well. We mustbe good citizens – support good works and charities and

bear out fair share of taxes. We must encourage civicimprovements and better health and education. We mustmaintain in good order the property we are privileged touse, protecting the environment and natural resources.



Our final responsibility is to our stockholders. Business

must make a sound profit. We must experiment with newideas. Research must be carried on, innovative programdeveloped and mistakes paid for. New equipment mustbe purchased, new facilities provided, and new products

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

principles, the stockholders should realize a fair return.

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Theory, Practice - CG Summary