Theory and Practice of Corporate Governance

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

Characteristics of a corporation
1. 2. 3. Incorporated or registered under the Companies Act of a country Artificial legal existence- equal to that of a natural person with its own legal entity Perpetual existence Law creates a company and only law can dissolve it Common seal an artificial person can not sign documents Extensive membership no limitation on the number of members Limited liability (owners risk is limited unlike in the case of partnerships, individual ownerships) 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.

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.

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

1. 2.

Mechanisms that help reduce agency costs:

Fair and accurate financial disclosures Efficient and independent board of directors

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.

Basic behavioral differences between Agency & Stewardship Theories

Agency
Managers act as agents Governance approach is materialistic Behavior pattern is individualistic, opportunistic, and self serving Managers are motivated by their own objectives Interests of the managers and principals differ The role of the management is to monitor and control Owners attitude is to avoid risks Principal-manager relationship is based on control

Stewardship
Managers act as stewards Governance is sociological and psychological Behavior pattern is collectivistic, proorganizational, and trustworthy Managers are motivated by the principals objectives Interests of the managers and principals converge The role of the management is to facilitate and empower Owners attitude is to take risks Principal-manager relationship is based on trust

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 maximizing

profits toward the shareholders should be subject to obligations

toward others.

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 corporatemix. 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?

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

Theoretical basis of CG
Agency Cost Stewardship Theory Stakeholder Theory Sociological Theory

Corporate governance systems

The role of the management (which mostly appears in the organizational chart and not the board) is to run the business while the board oversees that it is run well and in the right direction. Management operates as a hierarchy. There is an ordering of responsibility, authority, delegation downwards through the firm and accountability upwards to the top brass. By contrast, the board members need to work together as equals reaching agreement by consensus or if necessary by voting. Each director bears the same duties and responsibilities.

Conti
Corporate governance systems vary around the world: 1.The Anglo-American Model 2.The German Model 3.The Japanese Models

The Anglo-American Model

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 has the 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

Cont
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 nominees to the board. They were merely asked to put in their approval for the board nominee

The Anglo-American Model

Board of directors (Supervisors)

Shareholders

Elect

Stakeholders

Appoints & supervises

Officers (Managers)

Manage Creditors Own Lien on Company Monitors & regulates Regulatory Legal System Stake in

Features of Anglo-American Model

1. 2. 3. Ownership equally divided among individual and institutional shareholders Directors are rarely independent of management Companies run by professional managers with negligible ownership stakes clear separation of ownership and management Institutional investors are reluctant activists if not satisfied with the company, they just sell shares and pack off Disclosure norms are comprehensive rules against insider trading, penalties for price manipulation, protection for small investors, discourage large investors from taking active role in corporate governance

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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 not entirely 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

The German Model

Appoint 50% Supervisory Board Appoints & Supervises Employees & Labor Unions Management Board (incl. labor relations officer) Manage Own Shareholders Appoint 50%

Company

Features of Japanese Model

1. The financial institution has accrual role in governance shareholders and main bank together appoint the Board of Directors and the President 2. The President who consults the supervisory board and the executive management is included 3. Importance of the lending bank is highlighted

The Japanese Model

Appoint

Provides managers . monitors, acts in emergencies

Supervisory Board
(including the President)

Ratifies the Presidents decisions President Shareholders Consults Executive Management (Primarily Board of Directors) Manages

Provides managers

Main Bank

Provides loans
Own

Company
Owns

Features of Indian Model

1. Indian companies are governed by the Companys Act of 1956 2. Follows more or less the UK model 3. Private companies are closely held or dominated by a founder, his family, and associates 4. In the wake of economic liberalization, India has adopted the key tenets of the AngloAmerican external and internal control mechanism

Indian Corporate Governance Model

Government regulations, policies, guidelines , etc

External Environment

Corporate culture, structure, characteristics, Influences

Internal Environment
Company Act SEBI, Stock Exchange Company vision, mission, policies, norms Internal stakeholders Auditors Board of Directors Depositors, borrowers, customers and other external stakeholders

Proper governance

Corporate Governance System

Shareholder value

Corporate governance outcomes/Benefits to society

Transparency Concern for customer Healthy corporate sector development

Investor protection

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 meeting their 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 to make a fair profit.

We are responsible to our employees, the men and women who work with us throughout the world. Everyone must be considered as an individual. We must respect their dignity and recognize their merit. They must have a sense of security on their jobs. Compensation must be fair and adequate, and working conditions clean, 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 for employment, development and advancement for those qualified. 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 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.

Our final responsibility is to our stockholders. Business must 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.