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Term Paper on Corporate Governance
Term Paper # 1. Meaning of Corporate Governance:
Corporate Governance (CG) refers to the rules, processes and manner in which a company is run and controlled. CG norms address issues arising from the divergence of interests between ownership and management.
Agency theory, based upon the division between ownership and management in corporate firms, states that the interests of the company’s management need not always align with the needs of its shareholders. As the agent of the shareholders (the principal), management may not always work in the interests of the principal, and as Fama and Jensen (1998) stated ‘does not bear a major share of the wealth effects of decisions’. Ensuring that management interests and shareholder interests are aligned, results in agency costs.
Corporate governance practices continue to evolve in response to financial frauds and corporate indifference to issues beyond short- and medium-term profitability. The global financial crisis (2007) was the latest in a long list of events that redrew the battle lines to protect the interests of the shareholders. This article provides a review of corporate governance and its significance for the MNC’s operations.
Though Agency theory is central to Corporate Governance debates, CG regulations and implementation have been customized to accommodate a variety of factors. We now look at the evolution of the concept of CG and how it is linked to the different aspects of the corporate organization.
Term Paper # 2. Brief History of Corporate Governance:
Corporate governance arose from a need to resolve non- synchronicity between the objectives of the management and stakeholders of large, publicly listed companies with dispersed ownership (in the USA, UK) or concentrated ownership (Germany and Japan). The structure of ownership (dispersed versus concentrated), the extent and multiplicity of relationships that government-owned entities had with a company (as owners/creditors/vendors/customers), and the role of the government (as owner and/or regulator), formed the basis for the development of CG models that offered the best ‘fit’ for CG issues.
CG evolved at a distinct and different pace in different geographic regions, since the structure of ownership displayed geographical differences (dispersed in USA and UK, concentrated in Japan, Germany, and Asia), as did the existence of family held corporate groups, the domination of state owned financial institutions in contribution to private sector fund raising, the tri way relationship between the ruling political elite, financial institutions and family held firms, the monopolistic nature of state owned enterprises in financial and industrial sectors, and the role of the state in private enterprise.
The evolution of CG as a discipline was a post-World War II phenomenon. Its fortunes are inextricably linked to the emergence of the stock market as a wealth creator, and the growing articulation of investor expectations regarding corporate financial performance. During the twentieth century, CG redefined corporate performance, shifting it from a focus on corporate bottom lines, to a more dispersed concern for stakeholder welfare.
This also exacerbated the difficulty in monitoring, measuring, and ensuring corporate adherence to CG above and beyond the letter of the law. In the 1990s, the concept of CG self- regulation emerged as international agencies began enunciating codes of governance, and reputational risk became a crucial aspect of enterprise risk management.
A substantial part of CG literature is devoted to country-wise differences in legal systems, cultures and values, as an explanation for inter-country variations in CG laws, their enforcements, and punitive responses to non-compliance. In the twenty- first century, voluntary CG has been empirically linked to superior corporate financial performance and shareholder wealth creation.
A glance at the publication dates of CG codes provides compelling evidence of CG coming of age after the 1990s. The OECD’s corporate governance guidelines were published in 1998, the United Nation’s Global Compact (a non-binding set of standards on CG and corporate social responsibility) in 1999, the Berlin Initiative code of corporate governance in 2000, and the Equator principles in 2003.
USA’s Sarbanes Oxley Act (SOX) came into effect in 2002, Hong Kong’s Code on Best CG Practices in 2004, and Sweden’s Code for CG in 2004. UK’s CG code was reviewed by the Financial Reporting Council in 2005. In India, there have been the Kumar Mangalam Birla Committee Report (2000) and the Narayana Murthy Committee Report (2003). SEBI’s Clause 49 came into effect in 2002 and its amendment, in 2008.
The French Association of Private Enterprises (AFEP) and the French Employers’ Federation (MEDEF) published a CG Code in December 2008. Stock exchanges across countries as diverse as Australia, Bangladesh, India, Pakistan, New Zealand, the EU, Canada, and USA have made CG mandatory. A whistleblower policy has become a standard part of CG, as corporate disclosure studies, content analysis and disclosure metrics using published indices (such as the Association of Investment Management and Research—AIMR—in USA) shape stakeholder perceptions of corporate conduct.
CG codes lay down the minimum requirements that companies should fulfill with respect to corporate governance. Invariably they contain directives with respect to Board composition and structure, the minimum number of ‘independent’ Directors, the need for and the role of an audit committee, and disclosure requirements. This is in consonance with the fact that the onus of good governance rests with the Board of Directors since it is the bridge between the company and its owners.
The recommendations of successive CG committees, notably the pioneering comments of the Cadbury Committee Report (1992), and the underlying assumption of information asymmetry—management knows more about the internal happenings of the company than do the shareholders do— mean greater levels of transparency and disclosure are essential. CG is not just about indiscriminate exercise of shareholder power through the right to vote. Staggered Boards and super majority provisions are mechanisms that impose limits on the voting power.
The Code of Best Practices lay down by the Cadbury Committee Report (1992) recommended the separation of the posts of Chairman and CEO, and suggested that three of the Directors on the Boards of listed companies in the UK should be outsiders. The objective of the recommendations was to ensure openness (and hence the emphasis on disclosure of information) and accountability of the Board of Directors.
The Report conceded that rules and guidelines are inadequate to enhance corporate governance—the company’s willingness to observe the spirit as well as the rules was a necessary prerequisite. The Report spoke at length about the structure of the Board, duties and responsibilities of the Chairman, executive and non-executive Board members, the need for training Board members to assume their onerous responsibilities, the need for an audit committee and a remuneration committee, the importance of internal controls and internal audit, and the contents of interim financial reports.
According to the Kumar Mangalam Birla Committee Report (2000) ‘the fundamental objective of corporate governance is the enhancement of shareholder value, keeping in view the interests of other stakeholder’. It identified the rights and responsibilities of the three key constituents of corporate governance—management, the Board of Directors and the shareholders.
It concurred with the Cadbury Committee Report that rules of corporate governance were not enough—corporate governance should become a part of corporate ethos. The Narayana Murthy Committee Report (2003) echoed some of the observations of the Cadbury Committee, in terms of the emphasis on disclosure, and the role of the audit committee. It recommended disclosure of risks faced by the business, in the annual report. In line with Agency theory, it stated that CG was about management accepting the ‘inalienable right’ of shareholders as the true owners of the company.
Term Paper # 3. Corporate Governance and Voting Rights:
The equity shareholder’s right to vote is a necessary but not sufficient condition for good governance, for a number of reasons. First, the right to vote is exercised only once a year at annual general body meetings, while corporate governance is woven into the daily decision making process at all levels of the organization. Shareholders may be unaware of the methods by which CG can be made part of organizational systems, processes and strategic decisions, the hierarchical distribution of accountability and responsibility, the degree of good governance in an organization, or whether corporate governance violations have occurred and their consequences.
Second, in an era of non-voting shares and golden shares (shares with voting power in excess of the one share-one vote norm), voting power is not linked to the number of shares held. Third, voting power ignores the influence exerted on all aspects of the business by promoters and families in family controlled chaebols, kieretsus, and other Asian business structures, in which minority block-holders forge long-term bonds with an incumbent management and a handpicked Board.
Shareholding is not the only basis through which influence is exerted on strategic and operational decision-making in companies. Influential investors such as banks, sovereign wealth funds, and other institutional investors can and do exert influence through their debt holdings.
Term Paper # 4. Corporate Governance and Institutional Investors:
Though shareholders have a say in a company’s affairs, they might prefer to vote with their feet, by selling their equity stake and driving down market valuation. Shareholder activism emerged in the USA in the 1980s. Institutional investors are presumed to have a moral duty to enforce good governance by virtue of their large block-holdings (in 2000, they held 60% of the total equity investment in OECD countries), seats on the Board, and privy to strategic decisions.
The fiduciary capacity in which institutional investors operate, and their expertise in investment decision-making vests them with the power to take an active interest in CG compared to geographically dispersed, uninformed and perhaps uninterested, individual investors. ‘Engaged’ institutional investors such as CALPERS and Norway’s pension fund impose market discipline and contribute to deep capital markets. Institutional investors do not always assume the mantle of improving corporate governance, even in the west.
In the 1990s, US pension funds endorsed shareholder proposals originating from religious organizations; hedge funds tend to intervene and effect management changes to protect their interests and this may or may not have governance implications. Institutional activism is often ‘behind doors’ and its corporate governance enhancing motives and consequences are difficult, if not impossible, to ascertain.
Term Paper # 5. Corporate Governance and Capital Markets:
There is compelling evidence that good governance makes good business sense, as companies with better CG have superior triple bottom lines, and are rewarded by the market through higher valuations. Capital flows into countries perceived to have (and enforce) higher CG standards. Not coincidentally such countries also tend to have strong capital markets.
CG can be assessed at two levels:
i. Whether a country’s legislation protects aspects of stakeholder rights, namely creditor protection, investor protection and environmental protection.
ii. Whether firms in the country are made to toe the line in terms of greater transparency and disclosure by capital market regulators and accounting bodies.
Capital market development and improvements in CG share a symbiotic relationship. In a country with a shallow, thin and underdeveloped capital market, there is little connection between firm performance and its market valuation on the one hand, and corporate governance on the other. So there is little incentive at the firm level to pay more attention to, adopt, and invest in CG enhancing behaviour, and at the country level to enact corporate governance enhancing laws. There is a greater onus therefore, on regulations to impose CG initiatives at the firm level.
As capital markets are strengthened, share valuations increasingly reflect the performance augmenting effects of good governance. CG moves from the realm of regulatory imposition to voluntary participation. At the country level, this leads to a reduction in cost of capital, a higher ratio of stock market capitalization to GDP, higher firm valuations, and a reduced risk of financial crises.
CG is not just about transparency, disclosure, accountability and ethical ways of conducting business. It also makes contributions to the bottom line. The Kumar Mangalam Birla Committee (2000) drew a link between levels of CG and corporate performance, stating the well managed companies with high CG have higher valuations.
Since the publication of the Cadbury Committee Report in 1992, there have been several non-binding standards on CG and corporate social responsibility by the OECD, the UN’s Global Compact (1999), and binding CG requirements on corporate governance specified by stock exchanges. Several global financial services companies agreed to adhere to the Equator Principles, while others reiterate their commitment to the Millennium Development Goals.
Term Paper # 6. Country Effect and Corporate Governance:
In the USA, where shareholder activism emerged before spreading to the rest of the world, protecting the shareholders’ interests is viewed as the crux of the corporate governance debate. The Anglo-Saxon model of CG echoes the clear division between ownership and management in U.S. companies. It seeks to align management actions so as to maximize shareholder welfare. Board autonomy and market discipline are considered sufficient to making CG part of corporate philosophy.
In Germany and Japan, institutional investors (especially banks) have a long-term interest in corporations through their dual relationship as equity shareholders and lenders. Banks take close interest in corporate affairs in their advisory, fiduciary and ownership capacities. There is less of a conflict between ownership and management, and the Rhineland model of CG reflects this reality.
In Asian countries, promoters (individuals members of a business family) control a company through minority block-holding, and pyramiding is prevalent. Their control rights exceed their ownership rights, and being the dominant shareholders they enjoy the right to appoint members of the Board of Directors. Corporate governance, then, is about protecting the majority shareholders from the dominant, minority, controlling shareholders, who run the company.
There is often a close relationship between business groups and the government at the national level. Corporate Governance policy is framed with this in view. The ‘insider’ model of corporate governance is designed to describe the often cozy, and long-term relationship between a group of insiders and the company (whether listed or unlisted). State-owned domestic institutional investors in Asia are large but silent block-holders, not known for shareholder activism, or being active advocates of corporate governance, even though they have seats on the Board of Directors.
They are often passive investors that do not upset the status quo. Business groups (often families with inter-generational transfer of power) directly control companies through minority (and sometimes majority) block-holding of equity, and indirectly control other companies through pyramiding. The Asian model of CG is more concerned with protection of shareholders in general from the minority ‘business family’ block-holder who enjoys control that is out of proportion to the voting power.
The legal system from which the country’s law is derived—English Common Law, French Civil Law, German Civil Law, or Scandinavian Civil Law—have influence on CG. In Common Law countries (such as the UK and India), shareholders’ rights protection has been found to be higher than in Civil Law countries (Korea, Taiwan, Japan). The ‘inalienable right to vote’ conferred on shareholders of Asian companies does not carry the same power as it does in companies in the West.
The dilemma of protecting the small investor from the large investor is confronted daily by regulatory authorities, and companies alike. This is reflected in the OECD’s observation that there is no single CG model. The Anglo-Saxon CG model emphasizes its positive impact on shareholder value, through its ability to resolve an agency conflict. In Asia and the Middle East (with chaebols, keiretsus and family controlled businesses) control of management by powerful minority shareholders, is seen less as an ‘agency conflict’ issue, and more as a survival mechanism that is central to corporate success.