Corporate Governance: Theoretical Aspect and Models

Theoretical basis of corporate governance

• agency theory
• stakeholder theory
• stewardship theory

International corporate governance models

• Anglo-American models (US and UK)
• Network-Oriented models (Germany, Japan and France)
Theories Affecting Corporate Governance Development

Agency Theory
- Based on the agency relationship where one party, the principal ( owners)
delegates work to another party, the agents ( managers)

Transaction Cost Theory

- Theory views the firms itself as governance structure.
- The choice of appropriate governance structure can help align interest of
directors and shareholders
Theories Affecting Corporate Governance Development

Stakeholder Theory
- Takes in account of wider group of constituents rather focusing on
shareholders
- Governance structure of company may provide for some direct
representation of the stakeholder groups

Stewardship Theory
- Regards managers as stewards of the company’s asset
- Managers will be predisposed to act in the best interest of shareholders
Theories Affecting Corporate Governance Development

Class Hegemony Theory

- Views directors as an elite at top of the company
- Directors will recruit / promote to new director appoints taking into account
how well new appoints might fit into elite

Managerial HegemonyTheory
- Management of a company, with its knowledge of day to day operations
may effectively dominate directors and weaken the influence of directors
Agency Theory

• Developed by Jensen and Meckling (1973) and Fama and Jensen (1983)

• Employs a simple financial model to observe corporate governance

problems in corporations

• Understanding the consequences and solutions caused by conflict of

interest arising in the Berle and Means corporations due to the separation
of ownership and control

• Financiers of capital (principal) appoint managers (agents) with

specialized human capital to look after their funds and generate return on
that fund
Agency Theory
• The firm in this perspective is conceived as a nexus (of contract) between
various contracting parties

• The principal and agent both sign a contract that specifies what managers can
do with funds and how profits generated from these funds will be distributed
among the parties

- A contract under which one or more persons (the (principal(s)) engage another
person to perform some service on their behalf which involves delegating some
decision making authority to the agent. If both parties to the relationship are
utility maximizers there is a good reason to believe that the agent will not
always act in the best interest of the principal (Jensen & Meckling, 1976 p. 308)

• The problem arises because it is not feasible to write a complete feasible

contract keeping in view the unforeseen future and principals to grant the
agents (managers), the residual control over the firm.

• Manager’s control of the firm emanates conflict of interest between the principal
and the agents
Agency Problem

• Managers having better access of information than shareholders, and

discretion over investment decisions of finance.

• Imperfect information asymmetry and uncertainty in the corporation with

the separation of ownership and control, two agency problems arise:

 Adverse selection (bounded rationality) : principals cannot verify whether

managers (agents) are good or bad resource allocators, and how actually
they have behaved

 Moral hazard (opportunism) : where managers in their position of resource

allocators may pursue their own interest and not necessarily the interest
of company principals
Agency Cost

• Shareholder incur some cost to mitigate against these agency problems

due to separation of ownership and control.

• These costs are referred to as agency cost that can be seen as a loss of
shareholder arising partially due to inability of writing completely feasible

• Jensen and Meckling (1976) points that shareholders bear three types of
agency cost:

 monitoring cost,

 bonding cost, and

 the residual loss

Agency Cost

Monitoring cost

- Cost borne by the principals to monitor the aberrant behavior of the

agents due to divergence of interest.
- These costs are control costs that arise such as for handsomely
remunerating managers and keeping independent directors on the Board.

Bonding cost

- Cost incurred to align agent interest with that of the principal.

- Includes cost of information disclosure to the shareholders, and cost of
preparing audited financial statements for the company.

Residual loss

- Cost that arises as the cost of fully enforcing principal-agent contract far
outweighs, the benefits derived from doing so.
Limitations of Agency Theory

• Agency theory is directly applicable to corporations of the outsider system

with diffuse ownership structures, such as US and UK, where shareholder
primary is dominant and are as only residual claimants.

• Shareholders are the only determinants of the corporate functioning as

per say of the agency theory.

• The major limitation and criticism of agency theory is on the account of its
ignorance of other important stakeholders of the corporation, and
considering it only as a property of shareholders.
Stakeholder Theory

• Freeman (1984) developed stakeholder theory and first made choice of

the word “stakeholder” in place of then traditionally used economic term
“stockholder”.

• He loosely defined it as “any group of individual who is affected by or can

affect the achievement of an organization’s objectives”.

• Definition of stakeholders futher refined as “those groups who are vital to

the survival of the organization”.

• Stakeholder theory, rather than conceiving the corporation as a bundle of

assets that only belongs to the shareholders, construe it as the property of
all those who contribute their specific resources to it.

• The corporation is conceived as institutional arrangement for managing

the relationship between all the parties, who have a stake in it.
Stakeholder Theory

• Stakeholder theory posits that successful managers must systematically

attend to the interests of various stakeholder groups.

• Mmanagers must formulate and implement processes that maximize the

wealth of not only the shareholders, but all the stakeholders of the
business.

• The main task in this process is to manage and integrate relationships in

the interest of all stakeholders (shareholders, community, suppliers,
customers, employees, and other groups) in such a way that it guarantees
long-term success of the firm.

• The manager’s job is to maintain the support of all of these groups,

balancing their interests, while making the organization a place where all
stakeholder interests can be maximized over time.
Stakeholder Theory

• Stakeholder theory extends the view of agency theory that solely focuses
on shareholder to include other stakeholder groups.

• If the job of the management is to maximize the total wealth of enterprise

rather than just the value of the shareholder’s stake, then management
must take into account the effect of corporate decisions on all the
stakeholders, including the social, environmental and other ethical
considerations.

• Taking into account the stakeholder perspective, Porter (1992, p. 17)

suggest that corporations should “seek long-term owners and give them a
direct voice in governance” (i.e. relationship investors) and to “nominate
significant owners, customers, suppliers, employees, and community
representatives to the board of directors”.
Stakeholder Theory

• The stakeholder theory identifies the corporate governance problem of

relationship-based system (as prevalent in Germany and Japan)

• due to stakeholder involvement in governance process

• where separation of ownership and control is not a contentious

issue, and

• corporate governance propensity is to safeguard all the

stakeholders’ interest.
Stakeholder Theory - Limitations

• Stakeholder theory has some limitations and critisim

• Stakeholder theory has not much effect on corporate governance policy

making.

• Identifying and defining stakeholders is both problematic and impractical,

and arbitrary discretion deems to happen in different contexts.

• It is infeasible to good corporate governance mechanism while

considering all the stakeholders of the corporations.
Stewardship Theory

• Developed by Donaldson and Davis (1991) and presents an alternative

view to the agency theory,

• Theory disregardds that there is a conflict between managers and

shareholders

• Main assumption of theory is that managers are trustworthy and attach

significant value to their reputation.
Stewardship Theory

• Managers are considered to be stewards of the company, with

their objective aligned with the interest of the shareholders.
Therefore, their behaviour will not deviate from the interest of the
organization.

• Governance mechanism to control the behaviour of managers is

not good because it lowers motivation of managers to work
towards the goals of the company.

• Theory supports a strong relationship between the shareholders

and managers.
Stewardship Theory

• The theory shows a preference for an insider dominated board of

directors.

• Financial reporting and disclosure are considered important, but only to

the extent that confirms the trustworthiness of the managers.

• Market for managers is considered as the most important mechanism

under this theory that controls manager’s behaviour as more trustworthy
and reputable managers will be able to have better compensation than
others.
Corporate Governance Systems around the World

• Roe (1994) and Bebchuk and Roe (1999) developed path dependence
theory

• Critical choice about a given corporate governance system in a country:

- political forces devising ways of regulating and controlling the

corporation

- institutional arrangement and different legal customs and traditions

• US in early 1930s were against the concentrated ownership and or

industrial monopolies leading to establishment of dispersed ownership
and financing through the stock market.

• The political forces in 1930s instituted corporate laws, such as Glass-

Steagal Act and other regulations, pivotal in establishing a shareholder
oriented outsider corporate governance system in the US.
Corporate Governance Systems around the World

• Every country, therefore, has its own unique system of corporate

governance with peculiar traits and features.

• Together with ownership structure, the legal system and its related
corporate law, the development of capital and product market, other
political and economic institutions define the myriad varieties of capitalism
that ultimately characterize corporate governance systems.

• Therefore, distinct corporate governance systems predominate in the

contemporary world that is explicitly linked to the nature of capitalism.
Corporate Governance Systems around the World

Emerging (family based)

corporate governance system

Network based corporate Market based corporate

governance system governance system

Personal
Capitalism

Alliance Managerial
Capitalism Capitalism

Stakeholder Shareholder
Orientation Orientation
Corporate Governance System

Carney and Gedajlovic (2001) define corporate governance system as :

Evolving institutional structure designed to exploit the advantages of the

corporate form of organization, while mitigating concomitant agency cost in a
manner consistent with society’s legal political and social traditions. Through
both formal and informal means, a system of corporate governance
embodies a particular network of economic incentives and disincentives that
shape corporate behavior. Viewed in such manner, a system of corporate
governance is itself integral to the context in which corporate decisions are
made (Carney & Gedajlovic, 2001 p. 336).
Market Oriented Corporate Governance System

• Market oriented model, is also known as “Anglo-Saxon model” or

“shareholder model” and often referred to as outsider system of
corporate governance.

• the ownership structure of corporations is characterized by diffusion

across a plentiful number of shareholders.

• The model is exemplified by the separation of ownership of the

corporation among a large number of arms-length investors, who just
provide their capital for investing and are not involved in day-to-day
operations of the business.

• This manifestation of control of the corporation by managers in Anglo-

Saxon economies is termed as “Managerial Capitalism”.

• Anglo-American countries, primarily exemplified by the United States and

United Kingdom, while Canada, Australia, New Zealand and Ireland are
rapidly imitating it.
Market Oriented Corporate Governance System

• In Anglo-American economies, shareholders are the only contemplated

stakeholders of the corporations, whose interest maneuvers the
managerial decision-making.

• Equity financing of the corporations through a large number of investors

makes the capital markets of outsider economies like that of the US and
UK, highly developed, strong and very liquid.

• The ownership structure of the corporation in the outsider system

necessitates that all the agents (including shareholders) have equal
access to sufficient and timely information, so that, they can make
prudent decisions before investing.

• These countries have stringent norms for shareholder protection with

robust accounting and disclosure standards that clearly represents the
economic position of the firm to the public.
Market Oriented Corporate Governance System

• The common law system followed in these countries accords greater

protection to the investors.

• A well-developed legal framework exists for demarcating the rights and

responsibilities of major actor of corporations (management, directors and
shareholders), and enforcing the contractual obligation between them

• Public corporations financed predominately through equity capital have

very low debt to equity ratio.

• A thriving equity culture prevails in outsider system countries allowing

investors and corporations to contribute significantly towards economic
growth of these economies
Market Oriented Corporate Governance System

Strength of Capital Market in Different Corporate Governance Systems

Year 2010 France Germany India Japan UK US

Market Capitalization Of
Listed Companies
(Mkt Cap) ( in Bn US$) 1926.49 1429.71 1615.86 4099.59 3107.04 17138.98
Gross Domestic Product
(GDP) ( In US$) 2560.0 3309.67 1729.01 5497.81 2246.08 14582.40
Mkt Cap /GDP
( In Percentage) 75.25 43.20 93.46 74.57 138.33 117.53
Stock Traded/ GDP
( In Percentage) 32.34 42.45 61.12 77.86 133.86 208.85

(Source: World Bank Database)

Market Oriented Corporate Governance System- Issues
• Apart from shareholders, the other stakeholders, in particular the labor
and other business suppliers have minimal say in the functioning of the
corporation.

• Information asymmetry creates opportunity for managers to involve in

insider trading, a customary practice in market centric governance
system.

• Managers also reward themselves with excessive remuneration, even for

non-performance.

• Excessive power to wanton manager creates sufficient apertures to

instigate huge fraud like Enron, WorldCom, Maxwell, Tyco, BCCI and
many others.

• Short-term economic horizon of investment by shareholders conditions

managers to behave only myopically.
Market Oriented Corporate Governance System- Mechanism

• Market for corporate control is one of the dominant forms of external

market based governance control mechanism to punish erring or under-
performing managers.
• If managers do not perform as per the expectations of the investors, they
may discount company share value. Company valuation in that case may
plunge to such a level that it easily becomes a target for a hostile
takeover.
• Mergers, acquisitions, tender offers, proxy fight and leveraged buyouts
are common the takeover devices and recurring feature of the market
centric model.
• The single tier board structure is characteristic of outsider system, which
abodes both executive and non-executive directors of the corporation.
• Both decision management (executive directors) and decision control
(non-executive directors) functions are combined in a single board.
• A board with a majority of independent directors upholds stringent internal
decision control over the decision management of executive directors.
Market Oriented Corporate Governance System- Mechanism

• Anglo-Saxon governance model has the prominence of insurance

companies, pension funds and mutual funds as the institutional investors.

• The majority of individual investors in the US and UK invests in

companies through these institutional investors

• Institutional investor holds about 55% and 45% of the US and UK equity
at the end of year 2006.

• They are the principal investors in the US and UK, and play an active role
in safeguarding shareholder rights (Mayer, 1998).

• The national association of pension funds (NAPS) in the UK and

CalPERS in the US are such examples, who are actively engaged in
fostering governance standard in their invested companies.
Market Oriented Corporate Governance System- Mechanism

• Availability of sound managerial labor market in the Anglo-Saxon

economies also helps in alleviating the governance problem.

• In a corporation, an ill-functioning manager can be easily replaced with

outside competent managerial people.

• Long-term incentive based executive remuneration tools like stock-option

have been designed as a governance mechanism to persuade managers
think like an owner of the corporation, which may align their interest with
shareholders of the corporation
Network Oriented Corporate Governance System

• Network oriented model, is also known as “relationship based model” or

“stakeholder model” and often referred to as insider system of corporate
governance.

• Insider system is characterized by confederacy ownership and control of

the corporation by relatively closely held identifiable network of insiders

• Insider system adopts a pluralistic approach of withholding all stakeholder

interest.

• Insiders, including company stakeholder such family shareholders, banks,

allied and affiliated companies and labor through a network of their ties (
including equity, debt and commercial) provide an effective basis for
monitoring each other behavior in insider system, referred to as Alliance
Capitalism.
Network Oriented Corporate Governance System

• Corporations here are controlled through complex network of cross-

shareholding between companies, families and banks.

• Most of companies reciprocally own and control each other through

interlocking shareholding, resulting in network of relationship that has
mutual ownership.

• Network oriented system of corporate governance has been embraced by

a number of the Continental European countries, and Japan.
Network Oriented Corporate Governance System

• Corporation in network-oriented system is conceived as a nexus of

contract among multiple stakeholders: bankers, creditors, laborer,
customers and shareholders.

• The corporate governance problem arises here due to “the conflict

between the firm itself – including, particularly, its owners- and other
parties with whom the firm contracts, such as creditors, employees, and
customers.

• Here the difficulty lies in assuring that firm, as agent, does not behave
opportunistically towards these various other principles- such by
expropriating creditors, exploiting workers, or misleading consumers”

• Different stakeholders have their own interest in the corporation that giving
rise to a conflict of interest among these stakeholders.

• Corporate governance mechanism are aimed at harmonizing and

safeguarding each of the stakeholder’s interest.
Network Oriented Corporate Governance System

• Corporation in network-oriented system is conceived as a nexus of

contract among multiple stakeholders: bankers, creditors, laborer,
customers and shareholders.

• The corporate governance problem arises here due to “the conflict

between the firm itself – including, particularly, its owners- and other
parties with whom the firm contracts, such as creditors, employees, and
customers.

• Here the difficulty lies in assuring that firm, as agent, does not behave
opportunistically towards these various other principles- such by
expropriating creditors, exploiting workers, or misleading consumers”

• Different stakeholders have their own interest in the corporation that giving
rise to a conflict of interest among these stakeholders.

• Corporate governance mechanism are aimed at harmonizing and

safeguarding each of the stakeholder’s interest.
Network Oriented Corporate Governance System

German relationship based system –

• commercial banks play a dominant role and a major actor of corporate

control, in a relatively less developed capital market.

• Apart from holding equity ownership of themselves, they are in a

leadership position of monitoring the management as representative of all
the shareholders (Nester & Thompson, 2000).

• Many other European countries, such as the Netherlands, Austria,

Switzerland and other Scandinavian countries imitate the German based
governance model.
Network Oriented Corporate Governance System

Latin System

• French system is the epitome of the Latin system with Italy, Spain and
Belgium

• the state is the dominant shareholder and companies mutually control

each other through a web of complex cross holding known as
“verrouillage”.

• The state plays a central monitoring role through its direct or indirect
control over the French entities commonly referred as “dirigisme”.
Network Oriented Corporate Governance System

Japaense System

• In Japanese model, ownership and control of the corporations is through

“Keiretsu” system, where bank and other financial companies playing the
apex role

• banks take a leadership role and performing monitoring role in guiding the
firm activities
Network Oriented Corporate Governance System

• Banks are axis for corporate financing for corporations

• Corporations are generally dependent on the corporate financing by

banks for their requirements and show debt equity ratio.

• Banks have a complex relationship with a corporation with long-term

commitment of the capital driven by sustained firm growth rather than
myopic market returns.

• Capital markets are generally less developed and illiquid with low market
capitalization as compared to market centric governance model

• The transparency and disclosure norms are low, insiders can have
selective exchange of inside information

• Insider oriented economies largely endorse the civil law system, but grant
less protection to investors as compared to market centric economies.
Network Oriented Corporate Governance System - Issues

• All the stakeholders have mutual trust and commitment that helps them in
forging long-term and stable relationship with each other

• The sustainable relationship drives the creation of firm resources and

competencies.

• In spite of the benefit due to the strong relationship between multiple

stakeholders, firms in the relationship based system are averse to
innovation, entrepreneurship, risky ventures, professionalism of
management and restructuring in the case of discontinuous change due to
culture of reciprocity and ponderous stakeholder consultation

• Recurring infringement by state in the governance process, either through

its ownership or through regulatory control encumbers efficient functioning
of corporations.

• The ownership concentration and illiquid capital market results in

condensation of risk to the bank / state that may result in the collapse of
an entire economy in case of extreme business contraction or crisis.
Network Oriented Corporate Governance System

• Due to non-institutionalization of ownership among retail and institutional

investors like mutual funds, insurance and pension funds, these play a minor
role in the governance process.
• Banks on the other hand assume a leadership role in presence of different
stakeholders and have significant influence on managerial decision-making.
• External market mechanism like market for corporate control through
takeovers is absent in this system primarily due to high ownership
concentration and strong contractual relationship between management and
stakeholders.
• The system, therefore, entrust internal corporate governance mechanisms
family, bank and intertwined corporate relations, alliances and cross-holdings,
interlocking directorships and a two-tier board system to monitor the
management.
• Relationship based system generally abides to two tier board structure, with
option for unitary structure (in France single tier board structure is allowed, in
Japan a different board system)
Network Oriented Corporate Governance System

• Relationship based system generally abides to two tier board structure, with
option for unitary structure (in France single tier board structure is allowed, in
Japan a different board system).
• Supervisory board appoints executive/management and closely monitors its
functioning.
• An important feature of German and Japanese governance model is
“relational board structure” that embrace to include the key stakeholders such
as labor, lenders, customers and other suppliers, but employee playing a
dominant role in board decision making process.
• Unlike the external market for managerial labor in the Anglo-American
economies, network oriented economies have a strong internal labor market.
• The managers' performance is directly monitored by both by the firm, and the
employees executive (through representation on the board) that curtails the
moral hazard problem faced by managers in outsider economies, and guide
them in establishing long term stable relationship with a corporation
 Comparsion between Market and Network based System

Corporate Governance Market Oriented Corporate Governance Network Oriented Corporate

systems System Governance System
Countries US, UK, Australia, Canada, Ireland Continental Europe ( Germany, France,
Italy, Netherlands) and Japan
Ownership structure Dispersed equity ownership, most of the Concentration of ownership with
shares are in hands of dispersed group of interlocking and pyramidal structure
individuals and particularly institutional
investors
Control of Corporation Separation of ownership and control by Control of corporation by reciprocal
management ownership by companies and families
Shareholder/Stakeholder Recognizes primacy of shareholders in the Recognizes the role of all the
company stakeholder (including employees)
Transparency and High transparency and disclosure Low level of transparency and disclosure
disclosure standards standards
Finance to corporations Preference to use equity capital as a means Preference to use debt capital (Bank) as
of financing a means of financing, high debt to equity
ratio
 Comparsion between Market and Network based System

Corporate Governance Market Oriented Corporate Governance Network Oriented Corporate

systems System Governance System
Strength of Capital Fully developed and liquid capital market Comparatively weak and illiquid
Markets capital
Legal System Common law system Civil law system
Board Structure Unitary board structure Predominately dual board structure
(unitary structure optional)
Market for corporate Large and active market for corporate control Weak market for corporate control
Control
Relationship Orientation Short term relationship orientation Long term relationship orientation
Labor relationship Ready market for external managerial labor Strong internal labor market with
long term relationship
Engagement with Active role of institutional investors Active role of banks
Financers
Legal Protection Strong protection of shareholders in equity Comparatively weak protection to
market regulation shareholders but strong protection to
creditors