Corporate Governance-MBA

Corporate Governance
Module- 3: Evolution of Corporate Governance
1. Theories of Corporate Governance: Stakeholders Theory and Stewardship Theory, Agency Theory,
Separation of Ownership and Control
2. Corporate Governance Mechanism: Anglo-American Model, German Model, Japanese Model, Indian
Model
3. OECD Principles
4. SOX Act 2002

Introduction:
The idea of corporate governance was originally developed in 1962 as a way of ensuring that investors
receive a fair return on their investment by having a certain protection against management abuse or poor
use of their investment capital. Corporate governance refers to control of corporations and to systems of
accountability by those in control. It is about ensuring that executives and boards are accountable to
shareholders while managing risks and enhancing competitiveness on a corporate and national level.
According to Organization for Economic Co-operation and Development (OECD, 2004), “Corporate
governance involves a set of relationships between a company’s management, its board, its shareholders and
other stakeholders. Corporate governance also provides the structure through which the objectives of the
company are set, and the means of attaining those objectives and monitoring performance are determined.
Good corporate governance should provide proper incentives for the board and management to pursue
objectives that are in the interests of the company and its shareholders and should facilitate effective
monitoring”. A more comprehensive definition has been given by The Institute of Company Secretaries of
India. It states “Corporate Governance is the application of best management practices, compliance of law in
true letter and spirit and adherence to ethical standards for effective management and distribution of wealth
and discharge of social responsibility for sustainable development of all stakeholders”.

Key Issues in Corporate Governance:

(i) Application of best management practices - It may include laying down of balanced objectives, putting
decision-making processes in place, defining clearly roles of key players, designing reporting systems to
ensure transparency and accountability, continuous monitoring, etc.
(ii) Compliance of law in true letter and spirit - Systems and procedures should be laid down to ensure strict
compliance to applicable laws and regulations applicable to the entity.
(iii) Adherence to ethical standards for effective management - All the stakeholders should make a
continuous effort to adhere to maintenance of ethical standards. Code of Ethical Conduct, Whistle blower
policy, Policy on Executive Remuneration, Institutionalising of severance practices, are some of the ways to
ensure such adherence.
(iv) Distribution of wealth and discharge of social responsibility - Corporates should distribute wealth and
discharge their social responsibility by giving ESOPs, building schools and hospitals, skilling women and
youth, providing financial support to encourage use of non-conventional uses of energy and adopting other
such programmes.
(v) Sustainable development of all stakeholders - Expectations of all the present and future stakeholders
(local community, employees, customers, government, suppliers) and needs of the environment should be
taken into account while carrying on business activities.

Benefits of Corporate Governance:

(i) Safeguards the money of investors: Good corporate governance ensures transparency and adequate
disclosures which are necessary to make an informed decision by the investors and safeguard their money
from unscrupulous promoters.
(ii) Ensures success of the corporate: A corporation is a congregation of various stakeholders such as
employees, investors, customers, vendors, government and society at large. For the growth and success of a

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corporate it is important that interests of various stakeholders do not come in conflict. In such situations
decisions are taken to ensure a fair deal to all stakeholders and, thus, the success of the entity.
(iii) Gives ease of access to cheap funds: Good corporate governance procedures include putting a check on
insider trading, handling of investor grievances efficiently, disclosure of interest by management in financial
and non - financial deals and similar practices.
(iv) Lays foundation for good corporate citizenship: Good corporate governance aims at enhancing welfare
of all the stakeholders and creating sustainable value for them and also maintaining a balance between
economic and social benefit. Adoption of these good practices converts any entity for being a mere
‘corporate’ to a good ‘corporate citizen.’
(v) Attaches Global Perspective: In an era in which trade barriers have being progressively removed and
capital flows are crossing shores, good corporate governance is an important consideration for foreign
institutional investors and also for those who bring in foreign direct investment.

Theories of Corporate Governance:

1. Stakeholders Theory:
In 1983, Freeman first coined the concept of stakeholder theory. Stakeholder theory refers to the ethical
concept that addresses the outcome of business decisions, trends, profits, etc., and its collective impact on all
stakeholders, including the shareholders, employees, financers, government, customers, suppliers, etc.

Principles of Stakeholders Theory -

a) Principle of Entry & Exit – An entity should have clear rules for hiring, firing, and work profile of the
employees with no ambiguity.
b) Principle of Externalities – The decisions taken by an entity may affect people who have no relations with
the entity. The theory suggests that people who may be affected by the findings of a business are also to be
treated at par with other stakeholders.
c) Principle of Agency – The shareholders appoint the company’s management to run the entity’s business.
Management is not the owner of the entity but an agent acting on behalf of the company.
d) Principle of Governance – Any changes affecting the relationship between stakeholders and the company
need to be approved by them unanimously.
e) Principle of Contract Cost – The stakeholder should bear any cost on an equal basis, i.e., one should not
pay more than another. Furthermore, the cost-sharing should be similar or proportionate to the advantage
gained.

Benefits of Stakeholder Theory:

a) Stakeholder theory benefits the organization and employees by increasing productivity, employee
satisfaction, improved mental health, and lower turnover rates.
b) Stakeholder theory benefits the organization through positive feedback from regular customers of the
entity. Happy customers become unpaid marketers of the company products.
c) With the growing stage of cash flows, the finance providers are assured about the repaying capacity of the
entity.
d) The government also provides incentives for expanding the company’s business in new sectors or areas of
the country. In addition, it helps the entity to manage its cash flows.

Criticism/Limitations:
a) Stakeholder theory focuses on all people who are or may be affected by the results or decisions of the
entity. However, the view is majorly criticized, with the management focusing lower on the entity’s
shareholders.
b) The shareholders have invested their money to maximize their returns. The administration is obliged to
keep their interest in focus compared to others.
c) The theory is also criticized since the entity cannot fulfill everyone’s interests. You cannot provide a
higher quality product by not increasing the prices. You cannot suffer to meet the hunger of various non-
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financial stakeholders. If there is a lower demand for the products, you cannot just pile up your inventory to
please the suppliers. With an increase in pay of your employees, you cannot satisfy the providers
of finance who are concerned with the cash flows retained by the entity.

2. Stewardship theory
There is no conflict of interest between the shareholders and BoD and managers. According to stewardship
theory top management acts as stewards for the organization. Davis, Schoorman & Donaldson has stated, “a
steward protects and maximises shareholders’ wealth through firm performance, because by so doing, the
steward’s utility functions are maximised”. Stewardship theory sates that in order to protect their reputation
and retain trust of the shareholders, executives and directors will work to maximize financial performance of
the entity as well as shareholders’ profits. Mechanism such as ESOPs, high bonuses and good compensation
are there to ensure benefits of good financial performance are shared between shareholders and stewards.
Indeed, this can minimize the costs incurred for monitoring and controlling behaviours. The theory suggests
unifying the role of CEO and the chairman.

Principles of Stewardship theory:

a) Managers are trustworthy individuals and so are good stewards of the resources entrusted by them by the
shareholders.
b) Senior managers have superior access to important information and are, thus, able to make informed
decisions.
c) The theory holds “Theory Y” view of managerial motivation.
d) The shareholders trust the stewards and give them autonomy.
e) Employees or executives act to ensure the shareholders’ returns are maximized.

Benefits of Stewardship theory:

a) Trust is high and stewards are motivated to work in the interest of the organization.
b) New ideas can be implemented leading to growth of the firm.
c) Agency costs get automatically reduced.

Criticism/Limitations:
a) While Agency/Shareholder theory paints agent as self-centered, stewardship theory paints an excessively
benevolent picture of the steward who is ready to subordinate his interest to that of shareholders.
b) This theory takes into account interest of only employees and shareholders and does not refer to interest
of other stakeholders.
c) Causal relationship between governance and financial performance cannot be assessed using this theory.

3. Agency Theory
Jensen and Meckling defined the Agency/Shareholder relationship “as a contract under which one or more
person (the principals) engage another person (the agents) to perform some service on their behalf which
involves delegating some decision-making authority to the agent” Agency theory is a concept used to
explain the important relationships between principals and their relative agent. Agency theory is also often
referred to as the “agency dilemma” or the “agency problem.”

Principles of Agency theory:

a) In terms of business, the principal is considered to be a shareholder, while the agent is considered to be a
company executive. 
b) In the most basic sense, the principal is someone who heavily relies on an agent to execute specific
financial decisions and transactions that can result in fluctuating outcomes.
c) Because the principal relies so heavily on the agent to make the right decision, there may be an assortment
of conflicts or disagreements.
d) Each of their actions greatly affects the position of one another.

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Different Agency Theory Relationships:

When it comes to business and the concept of agency theory, there several types of relationships that are
closely intertwined and are faced with some sort of disagreement. Shown below are some of the most in-
depth and connected relationships in businesses that involve a principal-agent relationship and qualify for
the agency theory:
a) Shareholders and Company Executives- As mentioned, the shareholder is represented by the principal. It
is because the shareholder invests in an executive’s business, in which the executive is responsible for
making decisions that affect the shareholder’s investment. If the company executive acts negatively and
reduces the worth of the shareholder’s stock, it will spark a disadvantageous relationship. On the other hand,
if the company executive were to act ethically resulting in some sort of financial boost in the shareholder’s
stock, a positive connection will form.
b) Investor and Fund Manager- In such a case, the investor is the principal because they are giving a portion
of their income to the fund manager to allocate on their behalf. If the fund manager were to invest in volatile
stocks and yield a return less than expected from the investor, a negative relationship begins to form.
Conversely, if the fund manager goes above and beyond and nets a profit outside of the realm of
expectation, the investor praises the fund manager and there is a healthy linkage.
c) Board of Directors and CEO- Up in the hierarchy, the board of directors is represented by the principal
because their financial position and status are decided by the CEO. If the CEO were to make a wrong
financial decision that put the organization at a deficit, the board of directors is more likely to vote against
the CEO in the next election. Oppositely, if the CEO were to introduce a new business sector that provided
unprecedented innovation in the market, they would be praised by the board of directors and would likely
stay in power for years to come.

Causes of Agency Problems:

The agency theory explores the distinctive relationship between a principal and their agent. Throughout the
relationship, there are a number of actions and decisions that are made by the agent on behalf of the
principal. The same actions and decisions are what generate disagreements and conflict between the two
parties. Agency problem results in Agency costs, for example, monitoring costs in large corporations. To
explain in more depth, listed below are the main causes of agency problems:
a) When a conflict of interest arises between the principal and the agent
b) When the agent is making decisions on behalf of the principal that is not in the best interest of each
associated party
c) The agent may act independently from the principal in order to obtain some sort of previously agreed
upon incentive or bonus
d) Confidentiality breach regarding the personal and financial information of the principal
e) Insider trading with the information provided by the principal
e) When the principal acts against the recommendations provided by the agent.

Reducing Agency Problems:

In order to reduce the likelihood of conflict, there are certain measures and principles that can be followed
by both the principal and agent:
a) Transparency- To reduce the potential influx of agency problems, it is crucial for both the principal and
the agent to be completely transparent with one another. Decisions and transactions that will be implemented
must be agreed upon by each party and must be reasonably fair.
b) Restrictions- Imposing restrictions or abolishing negative restrictions is a good way to significantly
reduce the effect of agency loss. Setting specific restrictions on factors such as agency power allows the
principal to feel more confident in their relative agent. Conversely, abolishing negative restrictions is
beneficial because it instills trust within the agent and allows them to make decisions freely on behalf of the
principal.
c) Bonuses- Introducing and eradicating incentives and bonuses lessens the chances of a relationship that
consists of conflicts and disagreements. Introducing bonuses is a good way to motivate an agent and will
allow them to make decisions with the best intentions of the principal in order to achieve their desired
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incentive. Contrarily, bonuses may motivate the agent to make decisions just for financial gain, disregarding
the best intentions of the principal to only achieve the incentive.

Criticism/Limitations:
a) The Agency/Shareholder theory puts too much emphasis on shareholders and ignores the interest of other
stakeholders.
b) It does not have universal application. It has better applicability in US and UK markets and is not suitable
for countries which have companies with large family and/or institutional holdings.
c) The theory assumes the employees to be individualistic and of bounded rationality where rewards and
punishment are the only things which matter to them.
d) It, certainly, is a myopic view of human beings.

Separation of Ownership and Control

In 1932, Adolphe Berle and Gardiner Means published a book named ‘The Modern Corporation and Private
Property’ that would have a huge impact in the vision of corporate ownership. It has been argued that US
modern public corporations are subject to a separation between ownership and control. Accordingly,
shareholders have only a passive role in the direction of the corporation due to their very little influence in
the decision-making. Therefore, control is left to the managers giving them the free charge of running the
corporation.
In Berle and Means’ view, the separation of ownership and control can be explained by two main factors-
a) The higher and higher rise of public corporations and dispersed ownership has contributed to the fact that
no one shareholder has enough shares to be able to control the company.
b) Shareholders have only few opportunities in the case of a board’s election. He can refrain from voting, he
can attend the annual meeting and vote his stock, or he can sign a proxy transferring his voting power to
certain individuals selected by the management of the corporation, the proxy committee.
As a matter of fact, Berle and Means have outstandingly demonstrated the large passivity characterising the
role of shareholders in modern corporations.

Benefits: According to the Berle and Means’ thesis, some authors claimed the positive effects of the
separation between ownership and control in accordance with efficient corporate governance. They argue
that -
a) The separation is natural and inevitable, because the process of the public modern company itself causes
it.
b) The separation of ownership and control is well justified by the fact that managers are professionals more
trained and qualified than shareholders for such a role.
c) It is doubtful to believe that shareholders will act at any time for the best interests of the company. In this
view, it has been argued that shareholders can frequently be motivated by suspicious incentives, which may
be detrimental for the corporation.
d) Investors may prefer liquidity to control, especially when stock markets provide them with an easy way of
flowing in and out of a given company.
e) As soon as the management acts without checks, this will lead to the suppression of the majority abuse
towards minority shareholders.
f) An absence of shareholder control leads to the fact that managers are in better place to eliminate any kind
of oppression and make greater balance between the different stakeholders.
g) In case of mismanagement, the market will control mismanagement effectively, since market forces
prevent and limit managerial abuse of misuses of power.
h) Maladministration from managers would be harmful to their own self-interests “as it will lead eventually
to the bankruptcy of the firm and to managers’ future employment prospects becoming spoiled, as a result of
competition from better managed rivals”.
Considering the above-mentioned reasons, shareholders’ passivity is inevitable for the company. Based on
the Berle and Means’ theory, proponents argue that the most efficient corporate governance cannot run in a
system in which shareholders control management.
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Corporate Governance Mechanism/Models

Anglo-American Model
Under the Anglo-American Model of corporate governance, the shareholder rights are recognised and given
importance. They have the right to elect all the members of the Board and the Board directs the management
of the company. It is also called Anglo-Saxon approach to corporate governance being the basis of corporate
governance in Britain, Canada, America, Australia and Common Wealth Countries including India.

Features:
a) This is shareholder oriented model.
b) Directors are rarely independent of management.
c) Companies are run by professional managers who have negligible ownership stake.
d) There is clear separation of ownership and management.
e) Institutional investors like banks and mutual funds are portfolio investors. When they are not satisfied
with the company’s performance they simply sell their shares in market and quit.
f) The disclosure norms are comprehensive and rules against the insider trading are tight.
g) The small investors are protected and large investors are discouraged to take active role in corporate
governance.

German Model
This is also called European Model. It is believed that workers are one of the key stakeholders in the
company and they should have the right to participate in the management of the company. The corporate
governance is carried out through two boards, therefore it is also known as two-tier board model. These two
boards are Supervisory Board and Management Board.

Features:
a) Stock corporations represent the largest firms in Germany.
b) Stock corporations are required by law to have a two-tier board system, consisting of a management
board and a supervisory board.
c) The shareholders elect the members of Supervisory Board.
d) Employees also elect their representative for Supervisory Board which are generally one-third or half of
the Board.
e) The Supervisory Board appoints and monitors the Management Board.
f) The Supervisory Board has the right to dismiss the Management Board and re-constitute the same.

Japanese Model
The Japanese model radically differs from the first two, which is based on the principles of reciprocal
shareholding, the formation of large associations with diverse participants, known as keiretsu (literally a
system, a grouping of enterprises) and the subordination of dividends. Japanese companies raise significant
part of capital through banking and other financial institutions. Since the banks and other institutions stakes
are very high in businesses, they also work closely with the management of the company. The shareholders
and main banks together appoint the Board of Directors and the President. In this model, along with the
shareholders, the interest of lenders is recognised.

Features:
a) Currently, there are seven main keiretsus – Mitsui, Sumitomo, Dai-Ichi Kangyo, Industrial Bank of Japan,
Mitsubishi, Fuyo and Tokai.
b) Almost all keiretsus are based on pre-existing incorporations, which have evolved from vertical
centralization to horizontal integration.
c) The keiretsus are mainly run by “inner circles” – the insiders.
d) Banks, as a “core” of keiretsus, play a particularly pivotal role in their management.
e) The core bank usually prepares and implements large investment projects within its group.
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f) Other institutional units, such as insurance companies and other financial organizations, also operate
within keiretsus.
g) Employment contractors are actively involved in the process of running the organization, often
identifying themselves with the organization.
h) The absence of radical change in the short run enables the creation of long-term sustainable prospects for
both individual groups and the overall economy.

Indian Model
The Indian corporates are governed by the Company’s Act of 1956 that follows more or less the UK model.
In India there are mainly three types of companies’ viz. private companies, public companies and public
sector undertakings. Each of these companies has distinct kind of shareholding pattern. Thus the corporate
governance model in India is a mix of Anglo-American and German Models. India used to share many
features of the German/Japanese model earlier, but of late, recommendations of various committees and
consequent legislative measures are driving the country to adopt increasingly the Anglo-American model.

Features:
a) The Companies Acts 2013 has provisions concerning Independent Directors, Board Constitution, General
meetings, Board meetings, Board processes, Related Party Transactions, Audit Committees, etc.
b) SEBI (Securities and Exchange Board of India) Guidelines ensure the protection of investors and have
mandated the companies to adhere to the best practices mentioned in the guidelines.
c) Accounting Standards issued by the ICAI (Institute of Chartered Accountants of India) for the disclosure
of financial statements is mandatory.
d) Standard Listing Agreement of Stock Exchanges applies to the companies whose shares are listed on
various stock exchanges.
e) Secretarial Standards Issued by the ICSI (Institute of Company Secretaries of India) are to be followed on
‘Meetings of the board of Directors’, General Meetings’, etc.

OECD Principles
Organisation for Economic Co-operation and Development (OECD) is an international, intergovernmental
economic organization of 38 countries. OECD was founded in the year 1961 to stimulate world trade and
economic progress. Most OECD members are high-income economies with a very high Human
Development Index (HDI) and are regarded as developed countries. OECD members are democratic
countries that support free-market economies. The OECD Principles of Corporate Governance were
endorsed by OECD Ministers in 1999 and have since become an international benchmark for policy makers,
investors, corporations and other stakeholders worldwide. They have advanced the corporate governance
agenda and provided specific guidance for legislative and regulatory initiatives in both OECD and non
OECD countries. These are -
a) Ensuring the Basis for an Effective Corporate Governance Framework-
i) The corporate governance framework should be developed with a view to its impact on overall economic
performance, market integrity and the incentives it creates for market participants.
ii) The legal and regulatory requirements that affect corporate governance practices in a jurisdiction should
be consistent with the rule of law, transparent and enforceable.
iii) The division of responsibilities among different authorities in a jurisdiction should be clearly articulated
and ensure that the public interest is served.

b) The Rights of Shareholders and Key Ownership Functions-

i) Basic shareholder rights should include the right to secure methods of ownership registration, transfer
shares, obtain relevant and material information on the corporation on a timely and regular basis.
ii) Shareholders should have the right to participate in, and to be sufficiently informed on, decisions
concerning fundamental corporate changes.
iii) Shareholders should have the opportunity to participate effectively and vote in general shareholder
meetings and should be informed of the rules, including voting procedures.
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iv) Capital structures and arrangements that enable certain shareholders to obtain a degree of control
disproportionate to their equity ownership should be disclosed.
v) Markets for corporate control should be allowed to function in an efficient and transparent manner.

c) The Equitable Treatment of Shareholders-

i) All shareholders of the same series of a class should be treated equally.
ii) Insider trading and abusive self-dealing should be prohibited.
iii) Members of the board and key executives should disclose to the board whether they directly or indirectly
have a material interest in any transaction or matter directly affecting the corporation.

d) The Role of Stakeholders in Corporate Governance-

i) The rights of stakeholders that are established by law or through mutual agreements are to be respected.
ii) Where stakeholder interests are protected by law, stakeholders should have the opportunity to obtain
effective redress for violation of their rights.
iii) Performance-enhancing mechanisms for employee participation should be permitted to develop.
iv) Where stakeholders participate in the corporate governance process, they should have access to relevant,
sufficient and reliable information on a timely and regular basis.
v) Stakeholders, including individual employees and their representative bodies, should be able to freely
communicate their concerns about illegal or unethical practices to the board.

e) Disclosure and Transparency-

i) Disclosure should include, but not be limited to, material information on the financial and operating
results of the company, company objectives, major share ownership and voting rights, related party
transactions and remuneration policy for members of the board and key executives.
ii) Information should be prepared and disclosed in accordance with high quality standards of accounting
and financial and non-financial disclosure.
iii) An annual audit should be conducted by an independent, competent and qualified auditor.
iv) External auditors should be accountable to the shareholders and owe a duty to the company to exercise
due professional care in the conduct of the audit.

f) The Responsibilities of the Board

i) Board members should act on a fully informed basis, in good faith, with due diligence and care, and in the
best interest of the company and the shareholders.
ii) Where board decisions may affect different shareholder groups differently, the board should treat all
shareholders fairly.
iii) The board should apply high ethical standards. It should take into account the interests of stakeholders.
iv) The board should fulfil certain key functions, including reviewing and guiding corporate strategy, major
plans of action, risk policy, annual budgets and business plans.
v) The board should be able to exercise objective independent judgement on corporate affairs.

SOX Act 2002

The Sarbanes-Oxley Act (or SOX Act) is a U.S. federal law that aims to protect investors by making
corporate disclosures more reliable and accurate. The Act was spurred by major accounting scandals, such
as Enron and WorldCom that tricked investors and inflated stock prices. Spearheaded by Senator Paul
Sarbanes and Representative Michael Oxley, the Act was signed into law by President George W. Bush on
July 30, 2002. The SOX Act consists of eleven sections. The summary highlights of the most important
Sarbanes-Oxley sections for compliance are listed below:

i) Section 302: Corporate Responsibility for Financial Reports:

a) CEO and CFO must review all financial reports.
b) Financial report does not contain any misrepresentations.
c) Information in the financial report is "fairly presented".
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d) CEO and CFO are responsible for the internal accounting controls.
e) CEO and CFO must report any deficiencies in internal accounting controls, or any fraud involving the
management of the audit committee.
f) CEO and CFO must indicate any material changes in internal accounting controls.

ii) Section 401: Disclosures in Periodic Reports:

a) All financial statements and their requirement is to be accurate and presented in a manner that does not
contain incorrect statements or admit to state material information.
b) Financial statements should also include all material off-balance sheet liabilities, obligations, and
transactions.

iii) Section 404: Management Assessment of Internal Controls:

a) Companies must publish a detailed statement in their annual reports explaining the structure of internal
controls used.
b) The information must also be made available regarding the procedures used for financial reporting.
c) The statement should also assess the effectiveness of the internal controls and reporting procedures.
d) The accounting firm auditing the statements must also assess the internal controls and reporting
procedures as part of the audit process.

iv) Section 409: Real Time Issuer Disclosures:

a) Companies are required to disclose on a almost real-time basis information concerning material changes
in its financial condition or operations including acquisitions, divestments, and major personnel departures.
b) The changes are to be presented in clear, unambiguous terms.

v) Section 802: Criminal Penalties for Altering Documents:

a) Any company official found guilty of concealing, destroying, or altering documents, with the intent to
disrupt an investigation, could face up to 20 years in prison and applicable fines.
b) Any accountant who knowingly aids company officials in destroying, altering, or falsifying financial
statements could face up to 10 years in prison.

vi) Section 806: Protection for Employees of Publicly Traded Companies Who Provide Evidence of Fraud:
a) This section deals with whistle-blower protection.

vii) Section 902: Attempts & Conspiracies to Commit Fraud Offenses:

a) It is a crime for any person to corruptly alter, destroy, mutilate, or conceal any document with the intent to
impair the object's integrity or availability for use in an official proceeding.

viii) Section 906: Corporate Responsibility for Financial Reports:

a) It addresses criminal penalties for certifying a misleading or fraudulent financial report.
b) Penalties can be upwards of $5 million in fines and 20 years in prison.

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