Corporate

NEW FORMS OF CORPORATE GOVERNANCE

 NEW FORMS OF CORPORATE GOVERNANCE

By

Manu Gupta

Symbiosis Law School

INTRODUCTION

The term “corporate governance” is a relatively new one both in the public and academic debates, although the issues it addresses have been around for much longer, at least since Berle and Means (1932) and the even earlier Smith (1776)

Corporate governance is the set of processes, customs, policies, laws, and institutions affecting the way a corporation (or company) is directed, administered or controlled. An important theme of corporate governance is the nature and extent of accountability of particular individuals in the organization, and mechanisms that try to reduce or eliminate the principal-agent problem.

Corporate governance also includes the relationships among the many stakeholders involved and the goals for which the corporation is governed. In contemporary business corporations, the main external stakeholder groups are shareholders, debt-holders, trade creditors, suppliers, customers and communities affected by the corporation’s activities. Internal stakeholders are the board of directors, executives, and other employees.

A related but separate thread of discussions focuses on the impact of a corporate governance system on economic efficiency, with a strong emphasis on shareholders’ welfare; this aspect is particularly present in contemporary public debates and developments in regulatory policy.

There has been renewed interest in the corporate governance practices of modern corporations since 2001, particularly due to the high-profile collapses of a number of large corporations, most of which involved accounting fraud. Corporate scandals of various forms have maintained public and political interest in the regulation of corporate governance.

CORPORATE GOVERNANCE MODELS AROUND AROUND THE WORLD

There are many different models of corporate governance around the world. These differ according to the variety of capitalism in which they are embedded. The Anglo-American “model” tends to emphasize the interests of shareholders. The coordinated or multi-stakeholder model associated with Continental Europe and Japan also recognizes the interests of workers, managers, suppliers, customers, and the community.

Continental Europe:

Some continental European countries, including Germany and Holland, require a two-tiered Board of Directors as a means of improving corporate governance. In the two-tiered board, the Executive Board, made up of company executives, generally runs day-to-day operations while the supervisory board, made up entirely of non-executive directors who represent shareholders and employees, hires and fires the members of the executive board, determines their compensation, and reviews major business decisions.

India:

India’s SEBI Committee on Corporate Governance defines corporate governance as the “acceptance by management of the inalienable rights of shareholders as the true owners of the corporation and of their own role as trustees on behalf of the shareholders. It is about commitment to values, about ethical business conduct and about making a distinction between personal & corporate funds in the management of a company.” It has been suggested that the Indian approach is drawn from the Gandhian principle of trusteeship and the Directive Principles of the Indian Constitution, but this conceptualization of corporate objectives is also prevalent in Anglo-American and most other jurisdictions.

The United States and the United Kingdom:

The so-called “Anglo-American model” (also known as “the unitary system”) emphasizes a single-tiered Board of Directors composed of a mixture of executives from the company and non-executive directors, all of whom are elected by shareholders. Non-executive directors are expected to outnumber executive directors and hold key posts, including audit and compensation committees. The United States and the United Kingdom differ in one critical respect with regard to corporate governance: In the United Kingdom, the CEO generally does not also serve as Chairman of the Board, whereas in the US having the dual role is the norm, despite major misgivings regarding the impact on corporate governance.

In the United States, corporations are directly governed by state laws, while the exchange (offering and trading) of securities in corporations (including shares) is governed by federal legislation. Many U.S. states have adopted the Model Business Corporation Act, but the dominant state law for publicly-traded corporations is Delaware, which continues to be the place of incorporation for the majority of publicly-traded corporations. Individual rules for corporations are based upon the corporate charter and, less authoritatively, the corporate bylaws. Shareholders cannot initiate changes in the corporate charter although they can initiate changes to the corporate bylaws.

LEGAL ENVIRONMENT – GENERAL

Corporations are created as legal persons by the laws and regulations of a particular jurisdiction. These may vary in many respects between countries, but a corporation’s legal person status is fundamental to all jurisdictions and is conferred by statute. This allows the entity to hold property in its own right without reference to any particular real person. It also results in the perpetual existence that characterizes the modern corporation. The statutory granting of corporate existence may arise from general purpose legislation (which is the general case) or from a statute to create a specific corporation, which was the only method prior to the 19th century.

In addition to the statutory laws of the relevant jurisdiction, corporations are subject to common law in some countries, and various laws and regulations affecting business practices. In most jurisdiction, corporations also have a constitution that provides individual rules that govern the corporation and authorize or constrain its decision-makers. This constitution is identified by a variety of terms; in English-speaking jurisdictions, it is usually known as the Corporate Charter or the [Memorandum and] Articles of Association. The capacity of shareholders to modify the constitution of their corporation can vary substantially.

 

MECHANISMS AND CONTROL

Corporate governance mechanisms and controls are designed to reduce the inefficiencies that arise from moral hazard and adverse selection. For example, to monitor managers’ behavior, an independent third party (the external auditor) attests the accuracy of information provided by management to investors. An ideal control system should regulate both motivation and ability.

Internal corporate governance controls monitor activities and then take corrective action to accomplish organizational goals. Examples include:

Monitoring by the board of directors: The board of directors, with its legal authority to hire, fire and compensate top management, safeguards invested capital. Regular board meetings allow potential problems to be identified, discussed and avoided. Whilst non-executive directors are thought to be more independent, they may not always result in more effective corporate governance and may not increase performance. Different board structures are optimal for different firms. Moreover, the ability of the board to monitor the firm’s executives is a function of its access to information. Executive directors possess superior knowledge of the decision-making process and therefore evaluate top management on the basis of the quality of its decisions that lead to financial performance outcomes, ex ante. It could be argued, therefore, that executive directors look beyond the financial criteria.

Internal Corporate Governance Controls

Internal control procedures and internal auditors: Internal control procedures are policies implemented by an entity’s board of directors, audit committee, management, and other personnel to provide reasonable assurance of the entity achieving its objectives related to reliable financial reporting, operating efficiency, and compliance with laws and regulations. Internal auditors are personnel within an organization who test the design and implementation of the entity’s internal control procedures and the reliability of its financial reporting

Balance of power: The simplest balance of power is very common; require that the President be a different person from the Treasurer. This application of separation of power is further developed in companies where separate divisions check and balance each other’s actions. One group may propose company-wide administrative changes, another group review and can veto the changes, and a third group check that the interests of people (customers, shareholders, employees) outside the three groups are being met.

Remuneration: Performance-based remuneration is designed to relate some proportion of salary to individual performance. It may be in the form of cash or non-cash payments such as shares and share options, superannuation or other benefits. Such incentive schemes, however, are reactive in the sense that they provide no mechanism for preventing mistakes or opportunistic behavior, and can elicit myopic behavior.

In publicly-traded U.S. corporations, boards of directors are largely chosen by the President/CEO and the President/CEO often takes the Chair of the Board position for his/herself (which makes it much more difficult for the institutional owners to “fire” him/her). The practice of the CEO also being the Chair of the Board is known as “duality”. While this practice is common in the U.S., it is relatively rare elsewhere. It is illegal in the U.K.

External corporate governance controls encompass the controls external stakeholders exercise over the organization. Examples include:

  • Competition
  • Debt covenants
  • Demand for and assessment of performance information (especially financial statements)
  • Government regulations
  • Managerial labour market
  • Media pressure
  • Takeovers

LITERATURE REVIEW

 

  1. Zingales (1998) expresses the view that “allocation of ownership, capital structure, managerial incentive schemes, takeovers, board of directors, pressure from institutional investors, product market competition, labour market competition, organizational structure, etc., can all be thought of as institutions that affect the process through which quasi-rents are distributed”. He therefore defines “corporate governance” as “the complex set of constraints that shape the ex-post bargaining over the quasi-rents generated by a firm (p. 4)”. Williamson (1985) suggests a similar definition.
  2. Garvey and Swan: Viewing the corporation as a nexus of explicit and implicit contracts, Garvey and Swan (1994) assert that “governance determines how the firm’s top decision makers (executives) actually administer such contracts”. They also observe that governance only matters when such contracts are incomplete, and that a consequence 4is that executives “no longer resemble the Marshallian entrepreneur.
  3. Shleifer and Vishny (1997) define corporate governance by stating that it “deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment”. A similar concept is suggested by Caramanolis Cötelli (1995), who regards corporate governance as being determined by the equity allocation among insiders (including executives, CEOs, directors or other individual, corporate or institutional investors who are affiliated with management) and outside investors.
  4. John and Senbet (1998) propose the more comprehensive definition that “corporate governance deals with mechanisms by which stakeholders of a corporation exercise control over corporate insiders and management such that their interests are protected ”. They include as stakeholders not just shareholders, but also debt-holders and even non-financial stakeholders such as employees, suppliers, customers, and other interested parties. Hart (1995) closely shares this view as he suggests that “corporate governance issues arise in an organization whenever two conditions are present. First, there is an agency problem, or conflict of interest, involving members of the organization – these might be owners, managers, workers or consumers. Second, transaction costs are such that this agency problem cannot be dealt with through a contract”

These numerous definitions all share, explicitly or implicitly, some common elements. They all refer to the existence of conflicts of interest between insiders and outsiders, with an emphasis on those arising from the separation of ownership and control (Jensen and Meckling, 1976) over the partition of wealth generated by a company. A degree of consensus also exists regarding an acknowledgement that such corporate governance problem cannot be satisfactorily resolved by complete contracting because of significant uncertainty, information asymmetries and contracting costs in the relationship between capital providers and insiders (Grossman and Hart, 1986, Hart

and Moore, 1990, Hart, 1995). And finally, one can be led to the inference that, if such a corporate governance problem exists, some mechanisms are needed to control the resulting conflicts. The precise way in which those monitoring devices are set up and fulfill their role in a particular firm (or organization) defines the nature and characteristics of that firm’s corporate governance. As the following sections show, such mechanisms can be external or internal to the company.

There are several basic reasons for the growing interest in corporate governance. In the first place, the efficiency of the prevailing governance mechanisms has been questioned (see for instance, Jensen, 1993, Miller, 1997 and Porter, 1997).

Secondly, this debate has intensified following reports about spectacular, high-profile financial scandals and business failures (e.g. Polly Peck, BCCI), media allegations of excessive executive pay (see for example, Byrne, Grover and Vogel, 1998, the adoption of anti-takeover devices by managers of publicly-owned companies and, more recently, a number of high visibility accounting frauds allegedly perpetrated by managers (Enron, WorldCom).

CONCLUSION

The Satyam incident in India , though unfortunate, exposed some big loopholes in the system. Just as the United States needed the Enron Scandal to clean up its act, perhaps India needed the Satyam fiasco to introduce sweeping changes in its own financial reporting system. It cannot be denied that the Satyam episode was a stark failure of the code of Corporate Governance in India. Corporate governance refers to an economic, legal and institutional environment that allows companies diversify, grow, restructure and exit, and do everything necessary to maximize long term shareholder value. It is not something which can be enforced by mere legislation; it is a way of life and has to imbibe itself into the very business culture the company operates in. Ultimately, following practices of good governance leads to all round benefits for all the parties concerned. The company’s reputation is boosted, the shareholders and creditors are empowered due to the transparency Corporate Governance brings in, the employees enjoy the improved systems of management and the community at large enjoys the fruits of better economic growth in a responsible way. The loyalty of a typical Indian investor is far greater than his counterparts in the USA or Britain. But, our companies must not make the mistake of taking such loyalty as a given. To nurture and strengthen this loyalty, our companies need to give a clear-cut signal that the words “your company” have real meaning. That requires well functioning boards, greater disclosure, better management practices, and a more open, interactive and dynamic corporate governance environment. Quite simply, shareholders’ and creditors’ support are vital for the survival, growth and competitiveness of India’s companies. Such support requires us to tone up our act today.

LIST OF REFERENCES

  • Agrawal, A., and C. Knoeber, 1998, “Managerial Compensation and the Threat of Takeover”, Journal of Financial Economics 47, 219-239
  • Bacon, C., M. Cornett, and W. Davidson, III, 1997, “The Board of Directors and Dual-Class Recapitalizations”, Financial Management 26, 5-22
  • Beck, P., and T. Zorn, 1982, “Managerial Incentives in a Stock Market Economy”, Journal of Finance 37, 1151-1167
  • Berger, P., and E. Ofek, 1995, “Diversification’s Effect on Firm Value”, Journal of Financial Economics 37, 39-65
  • Berger, P., E. Ofek and D. Yermack, 1997, “Managerial Entrenchment and Capital Structure Decisions”, Journal of Finance 52, 1411-1438
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