LECTURE 1

CORPORATE GOVERNANCE

21.09.2017
 CORPORATION
• INCORPORATED ASSOCIATION (COMPANY ACT)
• ARTIFICIAL LEGAL SYSTEM (ENTITY IS ENTIRELY SEPARATED FROM THAT OF
SHAREHOLDERS THE LIABILITY IS LIMITED TO CAPITAL INVESTMENT).
• PERPETUAL EXISTENCE (LAW CREATES COMPANY AND LAW CAN ONLY DISSOLVE)
• COMMON SEAL
• EXTENSIVE MEMBERSHIP (NO MAXIMUM LIMIT TO THE MEMBERSHIP OF JOINT
STOCK CO.
• SEPARATION OF MANAGEMENT FROM OWNERSHIP
• LIMITED LIABILITY (LIABILITY OF SHAREHOLDER IS LIMITED TO THE AMOUNT
UNPAID ON THEIR SHARES IRRESPECTIVE TO OBLIGATION OF CO.
• TRANSFERABILITY OF SHARES
 THEORETICAL BASIS OF CORPORATE
GOVERNANCE
THERE ARE FOUR BROAD THEORIES TO EXPLAIN AND ELUCIDATE
CORPORATE GOVERNANCE.
1. AGENCY THEORY
2. STEWARDSHIP THEORY
3. STAKEHOLDERS THEORY
4. SOCIOLOGICAL THEORY
 AGENCY THEORY
AGENTS ARE THE MANAGERS, PRINCIPALS ARE THE OWNERS AND THE BOARDS OF
DIRECTORS ACT AS THE MONITORING MECHANISM

Monitoring costs are incurred when the

principals attempt to monitor or restrict the
actions of agents.
Bonding costs are incurred by the agent.
An agent may commit to contractual
obligations that limit or restrict the agent's
activity.
Agency costs=monitoring
costs+bonding costs+residual loss.
Residual loss: loss incurred "by the
principal" because the agent's decisions
do not serve its interests.
 MECHANISM FOR REDUCING AGENCY
COST
• FAIR AND ACCURATE FINANCIAL DISCLOSURES
• EFFICIENT AND INDEPENDENT BOARD OF DIRECTORS
 STEWARDSHIP THEORY
• IN CONTRAST TO AGENCY THEORY, STEWARDSHIP THEORY PRESENTS A
DIFFERENT MODEL OF MANAGEMENT, WHERE MANAGERS ARE
CONSIDERED GOOD STEWARDS WHO WILL ACT IN THE BEST INTEREST
OF THE OWNERS .THE FUNDAMENTALS OF STEWARDSHIP THEORY ARE
BASED ON SOCIAL PSYCHOLOGY, WHICH FOCUSES ON THE BEHAVIOUR
OF EXECUTIVES.
• THIS THEORY ASSUMES THAT MANAGERS ARE TRUSTWORTHY
• MANAGERS ATTACH SIGNIFICANT VALUE TO THEIR OWN PERSONAL
REPUTATIONS
• MANAGER IS STEWARD OF PRINCIPAL
 COMPARATIVE DIFFERENCE B/W AGENCY
AND STEWARDSHIP THEORY
Behavioral differences
Agency Theory
Managers act as agents(EXERT POWER
OR POWER TO ACT)
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 Theory
Managers act as Stewards (CARETAKER)
Governance approach is sociological
and psychological
Behavior pattern is collectivistic, pro
organizational and trustworthy
Managers are motivated by the
principal’s objectives
Interest 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
Psychological mechanisms
Agency Theory Stewardship Theory

Motivation revolves around: lower order Motivation revolves around: Higher

needs and extrinsic needs (motivated to order needs and Intrinsic needs
perform a behavior or engage in an (engaging in a behavior because it is
activity to earn a reward or avoid personally rewarding; essentially,
punishment like; study due to grade etc) performing an activity for its own sake
rather than the desire for some external
reward; like sports etc)
Social comparison is between Social comparison is between principals
compatriots
There is little attachment to the company There is great attachment to the
company
Power rests with the institution Power rests with the personnel
Situational mechanisms
Agency Theory
Management philosophy is control oriented
To deal with increasing uncertainty and risk, To deal with increasing uncertainty and risk
the theory advocates exercise of greater
controls and more supervisions
Risk orientation is done through a system of
control
Time frame is short term
The objective is cost control
Cultural differences revolve around
individualism, large power distance
Stewardship Theory
Management philosophy is involvement
oriented
, the theory advocates exercise of: training
and empowering people, making jobs more
challenging and motivating
Risk orientation is done through firm
Time frame is long term
The objective is improving performance
Cultural difference revolve around:
Collectivism, small power distance
 STAKEHOLDER THEORY
• THE STAKEHOLDER THEORY IS GROUNDED IN MANY NORMATIVE,
THEORETICAL PERSPECTIVES INCLUDING ETHICS OF CARE, THE ETHICS OF
FIDUCIARY RELATIONSHIPS (R/S TRUSTEES AND BENEFICIARY) , SOCIAL
CONTRACT THEORY, THEORY OF PROPERTY RIGHTS, AND SO ON.
STAKEHOLDERS THEORY IS OFTEN CRITICIZED, MAINLY BECAUSE IT IS NOT
APPLICABLE IN PRACTICE BY CORPORATIONS.
• THIS THEORY CENTERS ON THE ISSUES CONCERNING THE STAKEHOLDERS
IN AN INSTITUTION. IT STIPULATES THAT A CORPORATE ENTITY INVARIABLY
SEEKS TO PROVIDE A BALANCE BETWEEN THE INTERESTS OF ITS DIVERSE
STAKEHOLDERS IN ORDER TO ENSURE THAT EACH INTEREST
CONSTITUENCY RECEIVES SOME DEGREE OF SATISFACTION.
• HOWEVER, THERE IS AN ARGUMENT THAT THE THEORY IS NARROW
BECAUSE IT IDENTIFIES THE SHAREHOLDERS AS THE ONLY INTEREST
GROUP OF A CORPORATE ENTITY. HOWEVER, THE STAKEHOLDER THEORY
IS BETTER IN EXPLAINING THE ROLE OF CORPORATE GOVERNANCE THAN
THE AGENCY THEORY BY HIGHLIGHTING DIFFERENT CONSTITUENTS OF A
FIRM.
 SOCIOLOGICAL THEORY

• THE SOCIOLOGICAL THEORY HAS FOCUSED MOSTLY ON BOARD

COMPOSITION AND WEALTH DISTRIBUTION. UNDER THIS THEORY
BOARD COMPOSITION, FINANCIAL REPORTING, AND DISCLOSURE
AND AUDITING ARE OF UTMOST IMPORTANCE TO REALIZE THE
SOCIO-ECONOMIC OBJECTIVES OF CORPORATIONS.
• THE CONCENTRATION OF PRIVILEGED CLASS ARE VIEWED AS MAJOR
CHALLENGES TO EQUITY AND SOCIAL PROGRESS.
 MODELS OF CORPORATE GOVERNANCE
• THE ANGLO AMERICAN MODEL
• GERMAN MODEL
• THE JAPANESE MODEL
• INDIAN MODEL OF GOVERNANCE
• PAKISTAN MODEL
 THE ANGLO AMERICAN MODEL

This model is also called unitary board model in which all

directors participate in a single board comprising both
executive and non-executive directors in varying proportions.

This approach is share holder oriented

It is also called Anglo-Sexon approach to corporate

Governance being the basis of corporate governance in
America, Britain, Canada, Australia and other common wealth
countries.
 FEATURES OF ANGLO-AMERICAN MODEL

The ownership of companies is more or less equally divided between individual shareholders and
institutional shareholders.

Directors are rarely independent of management.

Companies are typically run by professional managers who have negligible ownership stakes. There
is a fairly clear separation of ownership and management.

Most institutional investors are reluctant for certain activities. They view themselves as portfolio
investors interested in investing in a broadly diversified portfolio of liquid securities. If they are not
satisfied with a company’s performance, they simply sell the securities in the market and quit.

The disclosure norms are comprehensive, the rules against insider trading are tight, and the
penalties for price manipulations stiff, all of which provide adequate protection to the small investor
and promote general market liquidity. Incidentally, they also discourage large investors from taking
an active role in corporate governance.
 GERMAN MODEL
• IT IS ALSO KNOWN AS TWO-TIER BOARD MODEL. CORPORATE
GOVERNANCE IN THE GERMAN MODEL IS EXERCISED THROUGH TWO
BOARDS, IN WHICH THE UPPER BOARD SUPERVISES THE EXECUTIVE
BOARD ON BEHALF OF STAKEHOLDERS AND IS TYPICALLY SOCIETAL-
ORIENTED.
• IN THIS MODEL, ALTHOUGH SHAREHOLDERS OWN THE COMPANY,
THEY DO NOT ENTIRELY DICTATE THE GOVERNANCE MECHANISM.
THEY ELECT 50 PERCENT OF MEMBERS OF SUPERVISORY BOARD AND
THE OTHER HALF IS APPOINTED BY LABOR UNIONS ENSURING THAT
EMPLOYEES AND LABORERS ALSO ENJOY A SHARE IN THE
GOVERNANCE. THE SUPERVISORY BOARD APPOINTS AND MONITORS
THE MANAGEMENT BOARD.
 THE JAPANESE MODEL

• THIS IS THE BUSINESS NETWORK MODEL, WHICH REFLECTS THE CULTURAL

RELATIONSHIPS SEEN IN THE JAPANESE KEIRETSU NETWORK(GROUPING
OF ENTERPRISES, ORDER OF SUCCESSION IS A SET OF COMPANIES WITH
INTERLOCKING BUSINESS RELATIONSHIPS AND SHAREHOLDINGS. IT IS A
TYPE OF INFORMAL BUSINESS GROUP, THE KEIRETSU MAINTAINED
DOMINANCE OVER THE JAPANESE ECONOMY FOR THE SECOND HALF OF
THE 20TH CENTURY),
• THE BOARDS TEND TO BE LARGE, PREDOMINANTLY EXECUTIVE AND
OFTEN RITUALISTIC/CEREMONIAL. THE REALITY OF POWER IN THE
ENTERPRISE LIES IN THE RELATIONSHIPS BETWEEN TOP MANAGEMENT IN
THE COMPANIES IN THE KEIRESU NETWORK. THE APPROACH BEARS SOME
COMPARISON WITH KOREAN CHAEBOLT(HERE ARE SEVERAL DOZEN
LARGE KOREAN FAMILY-CONTROLLED CORPORATE GROUPS WHICH FALL
UNDER THIS DEFINITION).
 FEATURES OF JAPANESE MODEL

The president who consults both

the supervisory board and the
executive management is included.

Importance of the lending bank is

highlighted.
 INDIAN MODEL OF GOVERNANCE
The Indian companies are governed by the Company’s Act of 1956 which follows
more or less the UK model. The pattern of private companies is mostly that of
closely held or dominated by a founder, his family and associates. India has
adopted the key tenants of the Anglo-American external and internal control
mechanism after economic liberalization.
ISLAMIC MODEL OF CORPORATE
GOVERNANCE
 CORPORATE GOVERNANCE MECHANISM
A. BOARDS OF DIRECTORS
I. SIZE OF BOARD
II. BOARD COMPOSITION
III. CEO DUALITY
IV. AUDIT COMMITTEE
B. OWNERSHIP STRUCTURE
I. INTERNAL OWNERSHIP
II. EXTERNAL OWNERSHIP
III. INSTITUTIONAL OWNERSHIP
IV. FAMILY CONTROLLED BUSINESS
 CONTD…….

EXTERNAL GOVERNANCE MECHANISMS

A. THE TAKEOVER MARKET
I. DOMESTIC
II. INTERNATIONAL
B. THE LEGAL SYSTEM
I. CIVIL LAWS
II. CRIMINAL LAWS
III. CORPORATE LAWS
CORPORATE GOVERNANCE PRACTICES
INTERNATIONAL COMPARISON
Key Parameters Organization for Economic Co-operation and
elucidated by OECD Development (OECD) Guidelines
Rights of Shareholders  Their rights to attend and participate in
AGMs, to elect Board members, to receive
dividends and to avail relevant, timely,
regular and accurate information.
 Rights to transfer shares.
 To know capital structures and
arrangements that confer on some
members, disproportionate controlling
rights.
 Corporate control mechanism should
function efficiently and transparently.
 Transparent transactions; accountable
management.
Equitable treatment of  All shareholders including minority and
Shareholders foreign shareholders receive equitable
treatment.
 Effective redressal for rights violations.
 Change in voting rights subject to their
vote.
 Prohibition of insider-trading and self-
dealing.
 Directors to avoid decisions concerning
their own interests.
Role of Stakeholders  Recognition of their rights as established
by law.
 Encourage their active cooperation in
creating sustainable enterprises.
 Permit performance enhancing mechanisms.
 Access relevant information.
Disclosure and Accurate and timely disclosure on company
Transparency objective: major share ownership and voting
rights: financial and operating results; directors
and key executives and their remuneration;
significant, foreseeable risk factors; governance
structures and practices; material issues
regarding employees and other stakeholders.
Responsibilities of the Specifically key responsibilities of the Board-
Board of Directors overseeing the process of disclosure and
communication, monitoring the effectiveness of
International Corporate Governance Network Asia-Pacific Economic Co-Operation (APEC)
(ICGN) Global Governance Principles Principles
 Major organizational changes require their Establishment of rights and responsibilities of all
prior approval. shareholders.
 They have the opportunity to exercise their
voting rights.
 Right to have timely disclosure of the result
resolutions.
 Adherence to one –Share, one vote
standard. Institutional investors have proxy
responsibilities to exercise voting rights.
 One share, one vote. Equitable treatment of all shareholders
 Protection of the rights of minority and
foreign shareholders.
 Directors should build good and productive Establishment of effective and enforceable
relationship with stakeholders. account-ability standards.
 Directors are responsible for providing
accountability to shareholders.
 Timely and full disclosure of all Timely and accurate disclosure of financial and
information. non-financial information with regard to company
 Disclosure of share-holding and the status performance.
of voting rights.
 Disclosure of Directors, compensation
policies.
 Annual audits by external statutory
auditors.
 Judgement of Directors, independent of Formation of Board of Directors and deciding their
management operation. remuneration.
 Establishment and nomination of