Corporate governance theories and issues
Introduction
The term ‘Corporate Governance’ was at one time a term used to indicate a slightly touchy-feely set of considerations which were often regarded as optional: being indicative of such loose ideas as ‘best practice’, and other phrases open to multiple interpretations. Since those days, the term has evolved to become much more embedded in corporate consciousness (Catherine, 2009).
Corporate governance as a term has no universally accepted meaning, different corporations and scholars defined it in their own views and according to its usage. However, OECD (1999) describes it “as a range of issues relating to the ways in which organizations or companies may be directed and controlled”. Ensuring proper accountability, probity and openness as a core business of corporate governance in an organizations’ business conduct has variety of differing systems and processes of realization.
The beginning of the 21st century witnessed a series of corporate demise arising from managerial fraud, misconduct, and negligence caused a massive loss of shareholder wealth and confidence, as a result, the issue of corporate governance became clearly important. According to Kent & Ronald (2010) “in the 21st century, corporate governance has become critical for all medium and large organizations, those without a governance strategy face significant risks; those with one perform measurably better”.
corporate governance from the USA
The seeds of modern ideas of corporate governance were probably sworn by the Watergate scandal during the Nixon presidency in the US. Subsequent investigations on the scandal revealed that the regulators and legislative bodies failed to control and stop several major corporations from making illegal political contributions and bribing government officials. As a consequence, the Foreign and Corrupt Practices Act of USA 1977 was enacted which made provision for the maintenance and review of systems of internal control in corporations.
A mandatory financial reporting of corporations was also introduced by Securities and Exchange Commission in the same year. The collapse of high profile business such as Savings and loan, and others rock the US in 1985. The government appointed the Treadway Commission to identify the main causes of misrepresentation in financial reports and also to recommend better ways of reducing such occurrences. In 1987 the Commission identified the need for a proper environmental control, independent audit committees and an objective Internal Audit System. The Commission highlighted the need for effective internal organization control by publishing their reports and also advised the sponsoring organizations to develop an integrated set of internal control criteria to enable corporations improve their control mechanisms. As a result, the Committee of Sponsoring Organizations (COSO) was established, and in 1992 COSO specified a control framework for the functioning of corporations properly.
Corporate governance in England
In the late 1980s and early 1990s, the UK experienced series of corporate scams and collapses of business organizations which worried banks and investors about their investments and led the UK government to realize the ineffectiveness of their existing legislation and self-regulation. Famous corporations which witnessed spectacular growth during boom time became disastrous failures later due to poor management and lack of effective control. Such firms are; Polly Peck, Bank of Credit and Commerce International (BCCI), British & Commonwealth and Robert Maxwell’s Mirror Group International collapsed like a pack of cards.
When it was realized in England that the existing rules and regulations were not adequate to curb unlawful and unfair practices of corporate so as to protect the unwary investors, it was thought necessary to look at the issues involved afresh and look for remedial measures. It was with this view a committee under the chairmanship of Sir Adrian Cadbury was appointed by the London Stock Exchange in 1991.
The Cadbury Committee was assigned the duty of drafting a code of practices to help corporations in England defining and applying internal controls to minimize their exposure to financial losses in which ever ways it came. The Committee consisted of representatives drawn from the high levels of authority of British industry.
The main aim of the committee was “ to assist in raising the standards of corporate governance and the level of confidence in financial reporting and auditing by setting out clearly respective responsibilities of those involved and what it is believe is expected of them”. The Committee in their pioneering recommendation effort investigated extensively the accountability of the board of directors to shareholders and to the society. In 1992 December, the Committee submitted their report along with the “Code of Best Practices”. The report was globally well received and the committee explained the methods of governance needed to achieve a balance between the essential powers of the board of directors and their proper accountability. The recommendations were not mandatory in character though, but listed companies on the London Stock Exchange were charged to state clearly in their accounts, whether or not the code has been followed by them, and if not complied with, were advised to give their reasons for non-compliance. “The Cadbury Code of Best Practices had recommendations which were in the nature of guidelines relating to the board of directors, non-executive directors and those on reporting and control” (Fernando, 2009).
The aftermath of Cadbury Report
The recommendations of the Cadbury Committee’s Report contained in the Code of Best Practices surprised the corporate world in Britain and elsewhere. ”Its most revolutionary recommendations reverberated several transformational changes that were to be incorporated in the corporate sector everywhere and its ramifications vibrated not only in the advanced countries of the West, but also could be heard in emerging and transition economies like those of Russia, India and those in South East Asia” (Fernando, 2009).
The Cadbury’s recommendations most controversial issue was the requirement that ‘directors should report on the effectiveness of a company’s system of internal control”. This was the extension of control beyond the financial matters that caused the controversy.
Five years later of the Cadbury Report, investors’ confidence in England was again threatened by further scandals in corporations. As a consequence, a “Committee on Corporate Governance” was constituted chaired by Ron Hampel with a view to keep up the momentum by assessing the impact of Cadbury Report and developing further guidelines. In 1998 Hampel Committee submitted a report that contained some important and progressive guidelines, more especially the extension of directors’ responsibilities to “all relevant control objectives including business risk assessment and minimizing the risk of fraud”. Earlier in 1995, another Committee chaired by Greenbury submitted its Report which addressed the issue of directors’ remuneration. A mixture of all these codes known as the Combined Code was subsequently derived. This Combined Code is added to the listing rules of the London Stock Exchange and its compliance is mandatory for all listed companies in the UK.
Revival of corporate governance
issues in the new millennium
In early 200, the US stock market began to experience a decline, and a number of highly rated companies in the US started to collapse. Of them all was the dramatic collapse of Enron. Serious problems were also reported at WorldCom, Adelphia, Global Crossing, Dynegy, Sunbeam, and Tyco. This resulted to anguished complaints of corruption, fraud, deception, insider trading and self-dealing at famous corporations, which few months ago looked invincible and also infallible. Between the period 2000 and 2002, fraud in corporations in the US were of high magnitude and inflicted such damages on investors’ the company reputations were irreparably destroyed and investors’ confidence dipped to a new low. Severe and widespread impacts of declining stock prices and erosion of billions of dollars of investors were witnessed. As a consequence, Congress, the Securities and Exchange Commission (SEC), and the State Attorney General in New York started investigations. All these enquiries and the conclusions put their teeth in a comprehensive Act. The Sarbanes-Oxley Act (SOA) was enacted into law on 30 July 2002 (A.C. Fernando 2009).
Theories of corporate governance
There are different theoretical frameworks developed to explain and analyze corporate governance. Different terminology has been used by each of these frameworks in approaching corporate governance in a slightly different ways, and view corporate governance from a different perspective, arising from different disciplines (e.g. the agency theory paradigm arises from the fields of finance and economics, whereas transaction cost theory arises from economics and organizational theory). While frameworks like stakeholder theory, arises from a more social-orientated perspective on corporate governance. Although there are marked differences between the various theoretical frameworks, as they each attempt to analyze the same problems but from different perspectives, they do share significant commonalities. Furthermore, the frameworks overlap theoretically. This work will focus on two of these theoretical frameworks.
Agency theory
The occasional controversy between the separation of ownership and control and the managerial revolution remain subjects of interest, not much of the steam left the debate with the long period of post Second World War expansion of the Western economies, the sustained increase in international trade and the unchecked growth of the multinational corporations. The neoclassical economics neglected the economic analysis of the productive sphere of the economy in their attempt to develop a theory of resource allocation based on market exchange. A number of later schools of economic thought broke further from the economic ideal of neoclassical economics than the market imperfections approach, and attempted explanations for economic governance based on a new understanding of economic activity and resource allocation. In the last decade of the 20th century, agency theory became the dominant force amongst the new economic theory of the firm in the theoretical understanding of corporate governance. Agency theory emerged from the seminal papers of Alchian and Demsetz (1972) and Jensen and Meckling (1976) explaining the firm as a nexus of contracts among individual factors of production (Thomas Clarke, 2004).
Agency costs are the fundamental theoretical basis of corporate governance. Shareholders are owners of any joint stock, limited liability Company, and are the principals of the same. The principals define the objectives of a company by virtue of their ownership. Agents are the management directly or indirectly selected by shareholders to pursue their corporate objectives. While the principals generally assumes that the agents would invariably carry out their objectives, it is often not so. In many instances, the objectives of managers are at variance from those of the shareholders. For example, a CEO may use the company’s funds to finance an unrelated diversification to increase his managerial empire and personal stature which could reduce long term shareholder value. The shareholders and other stakeholders of the company may not be able to counteract this because of inadequate disclosure about such a decision and because the principals may be too scattered or even not motivated enough to effectively block such a move. Such mismatch of objectives is called the agency problem; the cost inflicted by such dissonance is the agency cost. The core of corporate governance is designing and putting in place disclosures, monitoring, “oversight” and corrective systems that can align the objectives of the two sets of players as closely as possible and, hence, minimize agency costs.
Agency theory main thrust runs like this. In the modern corporation, in which share ownership is widely held, managerial actions depart from those required to maximize shareholder returns. In agency theory terms, the owners are principals and the managers are agents and there is an agency loss which is the extent to which returns to the residual claimants, the owners, and fall below what they would be if the principals, the owners themselves, exercised direct control of the corporation. Agency theory specifies mechanisms which reduces agency loss. These include incentive schemes for managers which reward them financially for maximizing shareholder’s interests. Such schemes typically include plans whereby senior executives obtain shares, perhaps at a reduced price, thus aligning financial interests of executives with those of shareholders. Other similar schemes tie executive compensation and levels of benefits to shareholders, returns and have part of executive compensation deferred to the future to reward long-run value maximization of the corporation and deter short-run executive action which harms corporate value.
Problems with the Agency Theory
Total control of management is neither feasible nor required under this theory.
The underlying assumption in the trade-off that shareholders make on employing agents is that they must accept a certain level of self-interested behaviors in delegating responsibility to others. The objective of agency theory is to check the abuse in this trade-off, but its limited success raises the question of its utility as a theoretical model to promote corporate governance. Besides, in agency theory the assumption is with the complexities of invest-board relationship in large organizations, shareholders should correct and adequate information to wield effective control.
Equity investors rarely get these and besides they rarely make clear their exact target returns, and yet delegate authority to meet the target. It is also to be understood that in terms of controls, equity investor hardly have sanctions over boards. Instead, they have to rely on self-regulation to ensure that an orderly house is maintained.
There are two broad mechanisms that help reduce agency costs and hence, improve corporate performance through better governance (Fernando, 2009). These are:
1. Fair and accurate financial disclosures: financial and non-financial disclosures, which relate to the role of the independent, statutory auditor\s appoint by shareholders to audit a company’s account and present a “true and fair” view of the financial health of the corporation. Indeed, the quality and independence of statutory auditors are fundamental to achieve the purpose. While it is the job of the management to prepare the accounts, it is the responsibility of the statutory auditors to scrutinize such accounts, raise queries and objections (if the need arises), arrive at a true and fair view of the financial position of the company, and report their independent findings to the board of directors and through them, to the shareholders and investors of the company.
A company that discloses nothing can do anything. Improving the quality of financial and non-financial disclosures not only ensures corporate transparency among a wide group of investors, analysts and the informed intelligentsia, but also persuades companies to minimize value destroying deviant behavior. This is precisely why law insists that companies prepare their audited annual accounts, and these being provided to all shareholders and is deposited with the Registrar of companies. This is also why a good deal of effort in global corporate governance reform has been directed to improving the quality and frequency of disclosures (Fernando, 2009).
2. Efficient and independent board of directors: a joint-stock company is owned by the shareholders, who appoint directors to supervise management and ensure that it does all that is necessary by legal and ethical means to make the business grow and maximize long-term corporate value. Directors are fiduciaries of the shareholders, not of the management. They are accountable only to the shareholders. “Independence” has of late become a critical issue in determining the composition of any board (Fernando, 2009).
Since 1970s the stakeholder theory has developed gradually. One of the first expositions of stakeholder theory, couched in the management discipline, was presented by Freeman (1984), who proposed a general theory of the firm, incorporating accountability to a broad range of stakeholders. There has been an abundance of writing based on stakeholder theory since then, across a wide array of disciplines. Increasing attention has been received on the role of companies in society over time, with their impact on employees, the environment, local communities, as well as their shareholders, becoming the focus of debate. Social and environmental lobby groups have gathered information on business activities and have targeted companies that have treated their stakeholders in an unethical manner.
According to Wheeler et al. (2002) in Jill, (2007) Stakeholder theory may be viewed as a conceptual cocktail, concocted from a variety of disciplines and producing a blend of appealing sociological and organizational flavors. Indeed, stakeholder ‘theory’ is less of a formal unified theory and more of a broad research tradition, incorporating philosophy, ethics, political theory, economics, law and organizational social science. Stakeholder theory basis is that companies are so large and have a pervasive impact on society; as a result they should discharge accountability to many more sectors of society other than their shareholders. Stakeholder theory and stakeholders can be defined in many ways, depending on the perspective user’s discipline. According to Hill and Jones, (1992), ‘one commonality characterizing all definitions of stakeholders is to acknowledge their involvement in an ‘exchange’ relationship. Stakeholders are affected by companies and also companies are affected by stakeholders in some way. Stakeholders include shareholders, customers, suppliers, employees, communities, creditors and the general public. The most proponents of stakeholder theory suggest that the environment, animal species and future generations should be included as stakeholders. March and Simon, (1958), in Jill, (2007) described “the stakeholder relationship as one of exchange where the stakeholder groups supply companies with ‘contributions’ and expect their own interests to be satisfied via ‘inducement’”. The general public may be viewed as corporate stakeholders using this framework because they are taxpayers, thereby providing companies with a national infrastructure in which to operate. As a result, they expect companies as ‘corporate citizens’ to enhance, not degrade their quality of life in exchange. Every stakeholder indeed, represents part of the nexus of implicit and explicit contracts that constitutes a company. However, many writers refer to stakeholders’ simply as those who have a legitimate stake in the company, in the broadest sense.
The idea of corporate social responsibility is linked to stakeholder theory. In the current political and social climate, this is becoming a major issue for companies. Environmental lobby and social groups are actively encouraging companies to improve their attitudes toward stakeholders and act in a socially responsible manner. According to Jill, (2007) one motivation for encouraging corporate social responsibility derives from a belief that companies have a purely moral responsibility to act in an ethical manner. This pure ethics view assumes that companies should behave in a socially responsible way, satisfying the interests of all stakeholders, because this is ‘good’.
Similarities between agency and stakeholder theories
● Both theories are derived from perspectives on organizational phenomena.
● Both theories tends to increase or maximize shareholder value (i.e. shareholder is also a stakeholder).
● The principal-agent relationships are a subset of the more general class of stakeholder-agent relationships.
● Company managers are both agents and stakeholders
● Both theories influence each other.
● Both theories cannot differentiated practically
stakeholder theories
● Agency theory paradigm arises from the fields of finance and economics, whereas stakeholder theory arises from a more social-orientated perspective on corporate governance.
● Agency theory views the organization from the shareholder perspective whereas stakeholder theory views the organization from a more general and broad public or society perspective.
● The moral discourse of agency theory is based on self-interest whereas stakeholder theory is based duty and social responsibility.
● Agency theory definition is simplistic whereas stakeholder theory definition is infinite as is difficult to identify who are stakeholders.
Why is good corporate governance important
The growing importance of corporate governance has been proven to produce direct economic benefits to organizations. In December 2004, a study conducted at Georgia State University found that public companies with independent boards of directors have higher returns on equity, higher profit margins, larger dividend yields, and larger stock repurchases. This study was consistent with another study of 250 companies by the MIT Sloan School of Management which concluded that, on average, businesses with superior information technology (IT) governance practices generate 25 percent greater profits than firms with poor governance, given the same strategic objectives.
In another study carried out by Mckinsey and Company (2000) found that global investors were willing to pay a significant premium for companies which are well-governed. This was a salient finding as it indicates that the institutional investment community attaches a value to corporate governance and that corporate governance factors are therefore decision-useful. Furthermore, a study conducted by Harvard found that the best governed S&P 500 companies outperformed the worst governed by 8.5% per annum between 1990 and 1999. Further, research by Deutsche Bank Securities found that investment in the FTSE 100’s best governed companies would have produced 35% than investment in the worst governed over a three year period (Jill, 2007).
Organizations with good corporate governance are in a better position to prevent corporate scandals, fraud, and potential civil and criminal liability of the organization. It is also good business. Image of good corporate governance increases the general opinion of the organization and makes it more interesting to investors, suppliers, customers, and, contributors in the case of nonprofit organizations.
Yes all companies should be treated
the same when it comes to good corporate governance
Although the Sarbanes-Oxley Act of 2002 applies almost exclusively to publicly held companies, the corporate scandals that gave rise to that legislation have increased pressure on all organizations (including family-owned businesses and not-for-profit organizations) to have better corporate governance. Private and not-for-profit organizations may feel pressure from lenders, insurance underwriters, regulators, venture capitalists, vendors, customers, and contributors to be Sarbanes-Oxley compliant. In addition, some courts and state legislatures may by analogy apply the enhanced corporate governance practices developed under Sarbanes-Oxley to private and not-for-profit organizations. Finally, a few provisions of Sarbanes-Oxley do affect private and not-for-profit organizations, such as the provisions relating to criminal liability for document destruction and for retaliation against whistleblowers.
Nonprofit organizations are not immune from scandal. Even before there was an Enron, there was the scandalous bankruptcy of AHERF (the Allegheny Health, Education and Research Foundation), a nonprofit organization. The scandals involving The Nature Conservancy, the United Way of the National Capital Area, and PipeVine, Inc., attest to the need for not-for-profit organizations to have at least the perception of good corporate governance. On August 16, 2005, it was reported in The Wall Street Journal that Cornell University Medical School agreed to pay $4.4 million in connection with fraudulent U.S. Government claims that allegedly occurred as a result of Cornell's failure to pay attention to a whistleblower who was a member of the Cornell faculty.
Private companies that intend to seek capital from financial institutions and institutional investors should also be sensitive to their corporate governance image, since this image is an important factor in the ultimate decision to provide capital to the organization. Family-owned private companies benefit from good corporate governance by avoiding the devastating effects of sibling rivalry and expensive litigation between family members who have different views concerning the business (Frederick & Keith, 2006).
practices
Government regulations are specifically intended to prevent shareholders losses (investors) and the general economy, by requiring corporations to modify their practices and comply with good practices. In order to compel businesses to comply with regulatory requirements, governments or regulatory bodies tend to impose penalties for non-compliance (i.e. fines and other sanctions). To have their intended effect (i.e. compelling businesses to adopt modifications in their practices or good corporate governance), those penalties tend to exceed both the compensation potentially due and owing in the future by business on the basis of the harmful business practice; and the cost of making the required modification (Brian, 2006).
However, in most developing and transition economies, corporate governance practices are not consistently and evenly enforced by law and regulatory bodies. In reality, however, such practices as self-dealing and insider trading are widespread. Such offenses mostly go unpunished, even if stiff penalties apply in theory (Organization for Economic Co-operation and Development (OECD), 2006).
Other options
Investor Activism
Institutional shareholder organizations have also emerged to provide guidance and give a voice to shareholders concerns.
One such organization is the Pensions & Investment Research Consultants Ltd. (PIRC), which was set up by public sector pension funds in the mid-1980s. The PIRC examines a corporation’s compliance with its own set of governance principles, and then invites management to discuss its conclusions. After completing this diligence process, the PIRC publishes a recommendation to shareholders with respect to the company as an investment. The influence of the PIRC is demonstrated by the fact that many companies have “quietly modified” their plans after a discussion with PIRC, rather than risk a negative recommendation. No matter what approach an investor organization takes, it is clear that groups of investors, once organized, will have a greater voice in influencing critical governance issues. Their capital and influence make investor organizations another institution capable of enforcing investor rights (Ira et al., 2005).
The Media
Finally, the impact of the media cannot be underestimated. Consider the power of public scrutiny – who would want to invest in a company which makes headlines because its majority shareholders sacrifice the interests of the minority shareholders for their own private gain? By bringing these stories to light, the financial media in developing countries can play an important role in facilitating the enforcement and recognition of investor rights (Ira et al., 2005).
Conclusion
Corporate governance has become a major issue in our increasingly global economy. To remain competitive in countries, attract capital, ensure sustainability, and combat corruption, companies need to put in place good governance institutions. As James Wolfensohn, former president of the World Bank, noted, “The governance of the corporation is now as important to the world economy as the government of countries.” At its most basic level, corporate governance sets up “rules of the game” to deal with issues related to separation of ownership and control. Boards of directors, which reconcile the interests of owners, managers, and others stakeholders, are considered to be the key to the effective functioning of companies within a corporate governance framework. In family owned firms, small and medium-sized enterprises or state-owned enterprises, these principles still apply, and should be adopted to enhance efficiency, minimize conflict, and ensure the transition of ownership from parent to heir. On a country level, corporate governance plays a more fundamental role in fostering good democratic governance and transparent business-state relations.
References
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