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Corporate Governance – An Economic Perspective by Rupanjana De 2

Corporate Governance – An Economic Perspective by Rupanjana De 2

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Published by: routraykhushboo on May 04, 2011
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Corporate Governance – An Economic Perspective
Rupanjana De, ACS, Director, Nandi Resources Generation Technology Pvt. Ltd.,Kolkata.
e-mail :rupanjana_de@yahoo.com
Corporate Governance does not start and end with a set of rules, guidelines andpolicies to be complied with but has wider implications and impact on the economyof the nation. How, is what this write up seeks to explain.
"In a more globalized, interconnected and competitive world,the way that environmental, social and corporate governanceissues are managed is part of companies’ overall management quality needed to compete successfully. Companies that  perform better with regard to these issues can increaseshareholder value by, for example, properly managing risks,anticipating regulatory action or accessing new markets whileat the same time contributing to the sustainable development of the societies in which they operate. Moreover these issuescan have a strong impact on reputation and brands, anincreasingly important part of company value.”-
reported inUN Global Compact Financial Sector Initiative, 2004.There is abundance of information on corporate governancein various journals and newspapers particularly in the wake of major corporate frauds and scandals across the past one andhalf decades. Conventionally, corporate governance isunderstood as the plethora of rules, regulations, customs,policies, laws and guidelines the compliance of which is vitalas they affect the way of administration of a company to agreat extent. It binds the company in a relationship with thestakeholders like the shareholders, directors, employees,customers, creditors, suppliers and the society at large. Becausethe directors and officers of a company are bound by theirfiduciary duty towards the stakeholders in general, incontrolling the management of the company they need to usegood business practices and have accountability and integrity.However, while the above is the traditional practice of definingcorporate governance, a large many other viewpoints of corporate governance is also available and a lot of researchwork has been involved on the same over the years. In thefollowing paragraph a different view of the concept is expressedwhile analyzing good corporate governance as an indicator of economic efficiency.
Economic theories of Corporate Governance
Ideally, to narrow down the meaning of the term ‘corporategovernance’ into a bunch of mere rules, regulations, policiesand laws would be doing injustice to this much researchedconcept. The boundary of this topic is vast. An economicanalysis of it has led to a great debate between two conflictingnotions of corporate governance and accordingly two theorieshave evolved; the shareholder theory and the stakeholdertheory. While the former is a narrower version, the latter ismuch wide in scope. As per the restricted shareholder theorythe main aim of an organisation is to maximise the wealth of shareholder who are the real owners of it. This theory stemsfrom the traditional economic concept of ‘principal-agent’ or‘Agency contract’ as the source of existence of companies. A‘principal-agent’ relationship arises when the owner of anorganisation does not manage it himself. In case of companiesthe owners or shareholders appoint persons to manage andcontrol the affairs. Here the shareholders are the principalsand they appoint directors as agents to run the company ontheir behalf. The arrangement is mutually beneficial.Shareholders in general lack specialized business knowledgethat goes behind generating large returns on their investmentand maximising their wealth, and managers may lack the fundwhich the former provide them with. For maximisation of shareholder net wealth what is required is the optimumallocation of resources, putting them to most productive uses,etc. Hence, it is the duty of the directors and management of the company to see that the organisation is run on the best
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possible manner in the interest of shareholders. However, dueto this separation of ownership and control, shareholders whoare the true owners of a company, do not control it, the controlrather lies in the hands of the managers and directors who donot own the organization. Under this theory, the main problemin corporate governance is this separation that fuels divergenceof interests and the directors may divert from the profitmaximising aim and be rather interested in maximising theirself interest like increasing their perks and salaries, theirreputation (which may be at the cost of shareholder benefit),diversion of company assets for personal uses etc. Such adivergence of interest can be the root cause of bad corporategovernance.While the shareholder theory of corporate governance attachessupreme importance to the shareholders as owners of thecompany, the much wider view presented by the stakeholdertheory takes into account all the formal and informal, writtenand unwritten relations of a company viz., creditors, employees,suppliers, customers, other contractual parties, members of the society, institutions with various interests like those forenvironmental health hazards, governments and so on. Thistheory takes a broader notion of corporate governance andholds companies to be “socially responsible” organisations thatare typically to be managed in the interest of the public. Thus,the performance of a company is not only to be judged by theincrease in shareholder value but also from timely creditorpayments, enhancement of employee salaries and bettermentof job conditions, increase in market share, better relationswith suppliers, customers, the government (which wouldencompass the better compliance with rules and regulationspart) etc. Therefore, companies with better corporategovernance are those that have dedicated and long standingsuppliers, customers, creditors and employees, and those withgood compliance record and little or no litigation against.There are problems with both the theories as also with theprincipal-agent concept. In a company, the principal-agentproblem and the divergence of interests would not have arisenif it were possible to write ‘complete contracts’ at the veryinception of the company. A complete contract in this casewould have meant a contract specifying every contingencyand every single mandatory act for the agents or directors inevery possible situation. The problem is, it is not possible toforesee every contingency
, and that is whycontingencies are contingencies and not certainty. A completecontract could have ensured that there is no divergence of interests. Hence there would have been no need to worry aboutcorporate governance problems. We do worry becausecomplete contracts are not feasible and it is impossible topredict everything the future holds for us. The incompletenessprovides the scope of ‘residuals’ and the question arises as to‘how to efficiently allocate those residuals’. It is because of this that we need a mechanism that provides for efficientdecision making in situations that were not foreseen at theinception of the contract. Such efficient decision making wouldimply efficient use of discretion and accountability of directors.Thus good corporate governance is required to reduce thechances of ex-post opportunistic behaviour by directors andmanagers and divergence of their interest from the real ownersof a company so that investors do not shy away their investmentin companies due to non-reliance on directors. This wouldresult in a hold-up situation and adversely affect the economy.It is to check the occurrence of such situations that theshareholder theory of corporate governance has developed.As in the shareholder theory, even in the stakeholder theorythere are chances that all ‘investors’ (meaning all ‘stakeholders’here) shy away their investment because they do not get properreturns on their investment. To take an example, there may bea non-optimum investment of employees into the humancapital of the company, the suppliers may under-invest in theform of low quality raw-materials and customers may under-invest by buying less of the company products. Similarlycreditors may under-invest by unfavourable credit terms, whileunderinvestment from distributors may take the form of inefficient distribution network and so on. The basic idea of corporate governance is to ensure the most optimum investmentfrom all stakeholders and optimum allocation of all types of resources and that there is continuity and sustainability of efficient business relationship amongst all components of acompany that make firm specific investment.The right corporate governance strategy suitable for anenterprise can provide solutions to most of these problemsof divergence of interest, hold-up, inefficient allocation of financial and other resources, unproductive uses of resources,diversion of company’s assets for personal use etc.Meanwhile, before proceeding further into discussing whatwill be an ideal corporate governance mechanism, it isworthwhile to have a quick look at the various methods toalign the directors’ and managers’ interest with those of theshareholders:
To give more power to shareholders for overseeing andcontrolling management activity. This can take the formof certain legal protection in the form of minority rights,prohibitions of insider-dealing, increase of disclosurenorms etc.
To try and give incentives to managers for efficientmanagement and accountability in the form of attractiveperks, stock options, sweat equity etc.
To make laws stricter with respect to compliances andnorms to be followed (the kind of corporate governanceus professionals are more inclined to think of)
Corporate Governance – An Economic Perspective
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To use the markets for corporate control like take-oversetc.
Shareholder theory
. Stakeholder theory
Both the shareholder and stakeholder theories of corporategovernance have come in for criticisms. The followingcriticisms are often labeled against the shareholder theory:
There is an overemphasized and practically baselesspresumption of strong managers
. weak shareholdersconflict which has paved the way for all the corporategovernance theories of resolving monitoring and diverseinterest problems. The argument in favour of this is thatwidely dispersed ownership in companies is not thegeneral norm but more like an exception, and it wouldbe erroneous to think that corporate governance is justmeant for large public listed companies only. Each smallcompany is a unit in the economy and each makefractional contribution towards the betterment of theeconomy. After all, the sea is made up of millions andbillions of drops of water. One drop of contaminatedwater can bring down the quality of water of the entiresea. Unlike the widely-held companies where managersenjoy greater control rights
the shareholders,in closely held companies, the greatest power is generallyin the hands of controlling shareholder, usually someindividuals or a family, or a group of companies. Thereis no reason to think that these companies do not need toput emphasis on corporate governance. Even in suchcompanies due to dominance of majority shareholders,the minority shareholders’ rights might suffer.
The shareholder theory gives a narrow view of corporategovernance in the sense that it overemphasizesshareholders though they are not the only ones who makeinvestments in a company. A company is the outcomeof a bundle of people who make specific investments intheir capacity as customers, employees, creditors,suppliers and distributors apart from shareholders.Corporate success is thus a team effort. Any goodgovernance system cannot have optimum output unlessit takes into account all the parties involved, in otherwords, all the stakeholders.As against the above, the stakeholder theory is also not freefrom criticisms. The following are some criticisms labeledagainst it:
This theory is criticized by many as being too wide forcompanies to ensure compliance with. It is difficult toconsider the incentives and disincentives of allstakeholders involved. It is equally difficult to set theefficient levels of investment by all stakeholders.
The stakeholder theory leaves scope for the directors ormanagers of a company to take shelter under the widercoverage of the term stakeholder to avoid questions aboutcompany’s bad results.
The right approach
What follows from the above is that both theories havedrawbacks, but both equally have benefits. The shareholdertheory helps directors and managers fix the target for efficiencylevels to be reached based upon single criteria of shareholderwealth maximisation while the stakeholder theory helps themavoid underinvestment from a number of business componentsand thereby aids long-term growth of the company andultimately paces up economic growth. However consideringthe greater economic benefits to the nation, the stakeholdertheory definitely gains an edge over the shareholder theory.In order to make the stakeholder theory more suitable, a newstakeholder approach has developed and this new approachnarrows down the meaning of a stakeholder and considersonly those parties as stakeholders who have direct firm specificinvestment in the company. The contributions of allstakeholders are important and go hand in hand to increaseshareholder net wealth. Hence the shareholders have incentiveto take into account other interest groups in overall corporategovernance and the importance of developing long termrelations with various components by companies. In this waynot only is wealth maximized, but also jobs are secured andbusiness becomes more sustainable.As the views on corporate governance differ, for makingeffective policy recommendations for corporate governancebest practices, the proponents need to have an insight into thevarious theories developed and their relative merits anddemerits. It is only then that we can have the best corporategovernance structure. It is not just about having a fixed set of rules and regulations and making proper compliances withthem, it is much more. It is about putting the economy forwardin the path of growth.
. Corporate Governance
While discussing corporate governance and its widerimplications for the economy and the right approach tocorporate governance, a question that arises is whethercorporate governance is at all necessary in the presence of appropriate competition in the product market. Suchcompetition would provide positive incentives forcompanies to take care that it has the best governancestructure in place. Companies that are uncompetitivebecause of bad cost structure would automatically be wipedout of the market. This would mean that no externalregulatory intervention would be necessary. Things like
Corporate Governance – An Economic Perspective

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