CHAPTER 2

THE THEORY
AND PRACTICE
OF
CORPORATE
GOVERNANCE
 OBJECTIVES

Over the past three decades, the concept of

corporate governance has gone through a
metamorphosis. Theoretically, from one that
was related to agency cost, it is now perceived
to encompass everyone’s interests. This
chapter discusses the theoretical basis,
mechanisms and the divergent models of
corporate governance and culminates in the
identification of an ideal corporation.
 CHAPTER OUTLINE
 The Concept of Corporation
 Theoretical Basis of Corporate Governance
 Agency Theory
 Stewardship Theory
 Stakeholder Theory
 Corporate Governance Mechanisms
 Corporate Governance Systems
 What Is Good Corporate Governance
 Obligation to Society at Large
 Obligation to Investors
 Obligation to Employees
 Obligation to Customers
 Managerial Obligation
 What is a Corporate?

The term “corporate” refers to an association of

many persons, who contribute money or money’s
worth to a common stock and employ it in some
trade or business, and who share the profit and
loss arising therefrom. The common stocks so
contributed is denoted in money and is the capital
of the company. The persons who contribute it, or
to whom it belongs, are its members. The
proportion of the capital to which each member is
entitled is his share. Shares are always
transferable, although the right to transfer them is
often more or less restricted.
 What is Governance?

Governance is the process of decision making

and the process by which decisions are
implemented or not implemented.
Characteristics of a Corporation

o Incorporated Association
o Artificial Legal Existence
o Perpetual Existence
o Common Seal
o Extensive Membership
o Separation of Management and Ownership
o Limited Liability
o Transferability of shares
 Theoretical Basis of Corporate
Governance

o Agency Theory
o Problems with the Agency Theory
o Stewardship Theory
o Shareholder Vs Stakeholder Approaches
o Stakeholder Theory
o Criticisms of the Stakeholder Theory
o Sociological Theory
 Agency Theory
 Management as agents of stockholders
 Agency Cost raise issues (Trade-off)
 Mechanisms reducing agency cost
 Fair and Accurate Financial Disclosures
 Financial and Non-Financial Disclosures
 Efficient and Independent BoDs
 Stewardship Theory
 Managers are trustworthy
 Managers attach significant value to their
own personal reputations
 Manager is steward of principal
 Steward will do good for organization
 Controls will demotivate stewards
 The theory defines
 Managers are not motivaed by individual
goals but with the objectives of principles
 A steward will choose the interessts of
his/her organization, and will not entertain
self-serving behavior
 Control can be potentially
counterproductive
 Behavioural Differences
THEORY AGENCY STEWARDSHIP
Managers act as Agents Stewards

Governance Approach Materialistic Sociological and

Psychological
Behaviour Pattern o Individualistic o Collectivistic
o Opportunistic o Pro-organisational
o Self-serving o Trustworthy

Managers motivated by Their own Principal’s objectives

objectives
Manager’s and Principal’s Differ Converge
Interests
Management Structures Monitor and Facilitate and empower
control
Owners’ Attitude Risk Avoidance Risk taken

Principal – Manager Control Trust

Relationship based on
 Psychological Mechanisms

PSYCHOLOGICAL STEWARDSHP
AGENCY THEORY
RESPONSES THEORY

Motivation o Lower order o Higher order needs

needs o Intrinsic needs
o Extrinsic needs

Social comparison Compatriots Principal

Attachment Little attachment to Great attachment to

company company

Power Institutional Personal

 Situational Mechanisms
SITUATIONAL STEWAREDSHIP
AGENCY THEORY
RESPONSES THEORY

Management Control oriented Involvement oriented

Philosophy
While dealing with Greater controls Training and
increasing More supervisions empowering people
Uncertainty and risk Making jobs to be
more challenging and
motivating
Risk orientation Through a system of Through trust
control
Time frame Short term based Long term based

Objective Cost control Improving

performance
Cultural differences Individualism Collectivism
Large power Small power distance
 Shareholder Vs. Stakeholder
Theory
• Shareholders are investors of the firm
• Stakeholders are all-interest groups
• Employees, customers, dealers, government

and the society at large

• Ethics of care, theory of property rights and

so on
• Not applicable in practice
• Criticism
• Difficulty in defining the concept
• Who is genuine stakeholder?
• Practical?
 Sociological Theory
• Focuses on:
• Board Composition
• Power and Wealth Distribution in Society
• Power in few hands (privilege class)
• Challenge to equity and social progress
• To promote equity and fairness
• Board composition, financial reporting,

disclosure and auditing

Corporate Governance Mechanisms

o The Importance of Corporate Governance

o Contemporary Corporate Governance Situation
o Growing Awareness and Societal Responses

Corporate Governance Systems

o Anglo-American Model
o The German Model
o The Japanese Model
o Indian Model of Corporate Governance
 Fig.1 : The Anglo-American Model

Elect
Shareholders Board of Directors
(Supervisors)

Appoints & Supervises

Own
Creditors
Officers
Lie n on
(Managers)

Stakeholders
Stake in Manage

Legal/Regulatory Monitors & Regulates

Company
System
 Fig.2 : The German Model

Shareholders Appoint – 50%

Supervisory Board
Appoints and Supervises

Management Board
Appoint – 50%
(Including Labour
Relations Officer)

Manage

Employees
and Labour
Unions Company
 Fig.3 : The Japanese Model

Shareholders elect Supervisory Board

(Including President)
Provides Loans Ratifies the President’s
Decisions

President
Provides Managers
Monitors & Acts in Consults
Emergencies

Executive Management
(Primarily Board of Directors)

Manages

Own
Main Owns Company
Bank Provides Loans
What Is Good Corporate
Governance?
Obligation to society at large
o National Interest

o Political Non-alignment

o Legal Compliances

o Rule of Law

o Honest and Ethical Conduct

o Corporate Citizenship

o Ethical Behaviour

o Social Concerns

o Corporate Social Responsibility

 o Environment-friendliness
o Health, Safety and Working Environment
o Competition
o Trusteeship
o Accountability
o Effectiveness and Efficiency
o Timely Responsiveness
o Corporations Should Uphold the Fair Name of the Country

Obligation to investors
o Towards Shareholders
o Measures Promoting Transparency and Informed
Shareholder Participation
o Transparency
o Financial Reporting and Records
Obligation to customers
o Quality of Products and Services

o Products at Affordable Prices

o Unwavering Commitment to Customer

Satisfaction

Obligation to employees
o Fair Employment Practices

o Equal-opportunities Employer

o Encouraging Whistle Blowing

o Humane Treatment
 o Participation
o Empowerment
o Equity and Inclusiveness
o Participative and Collaborative Environment

Managerial obligation
o Protecting Company’s Assets
o Behaviour Towards Government Agencies
o Control
o Consensus Oriented
o Gifts and Donations
o Role and Responsibilities of Corporate Board and
Directors
o Direction and Management must be Distinguished
o Managing and Whole-Time Directors
Johnson & Johnson’s excellent Credo exemplarily
epitomises what an ideal corporate should aspire
to be.

Our Credo

We believe our first responsibility is to the doctors, nurses

and patients,
to mothers and fathers and all others who use our products
and services.
In meeting their needs everything we do must be of high
quality.
We must constantly strive to reduce our costs
in order to maintain reasonable prices.
Customers' orders must be serviced promptly and
accurately.
Our suppliers and distributors must have an opportunity to
make a fair profit.
 We are responsible to our employees,
the men and women who work with us throughout the world.
Everyone must be considered as an individual.
We must respect their dignity and recognize their merit.

They must have a sense of security in their jobs.

Compensation must be fair and adequate,
and working conditions clean, orderly and safe.
We must be mindful of ways to help our employees fulfill their
family responsibilities.
Employees must feel free to make suggestions and complaints.
There must be equal opportunity for employment, development
and advancement for those qualified.
We must provide competent management,
and their actions must be just and ethical.
We are responsible to the communities in which we live and work
and to the world community as well.
We must be good citizens – support good works and charities
and bear our fair share of taxes.
We must encourage civic improvements and better health and
education.
We must maintain in good order
the property we are privileged to use,
protecting the environment and natural resources.
Our final responsibility is to our stockholders.
Business must make a sound profit.
We must experiment with new ideas.
Research must be carried on, innovative programs developed
and mistakes paid for.
New equipment must be purchased, new facilities provided and
new products launched.
Reserves must be created to provide for adverse times.
When we operate according to these principles,
the stockholders should realize a fair return.
Johnson &
Johnson