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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 everyones 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
Indian Model of Governance
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
moneys 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

Artificial Legal Existence

Perpetual Existence

Common Seal

Extensive Membership

Separation of Management and Ownership

Limited Liability

Transferability of shares

Theoretical Basis of Corporate


Governance
o

Agency Theory

Problems with the Agency Theory

Stewardship Theory

Shareholder Vs Stakeholder Approaches

Stakeholder Theory

Criticisms of the Stakeholder Theory

Sociological Theory

Behavioural Differences
THEORY

AGENCY

STEWARDSHIP

Managers act as

Agents

Stewards

Governance Approach

Materialistic

Sociological and
Psychological

Behaviour Pattern

o Individualistic
o Opportunistic
o Self-serving

o
o
o

Managers motivated by

Their own
objectives

Principals objectives

Collectivistic
Pro-organisational
Trustworthy

Managers and Principals Differ


Interests

Converge

Management Structures

Monitor and
control

Facilitate and empower

Owners Attitude

Risk Avoidance

Risk taken

Principal Manager
Relationship based on

Control

Trust

Psychological Mechanisms
PSYCHOLOGICAL
RESPONSES
Motivation

AGENCY THEORY

STEWARDSHP
THEORY

o Lower order

o Higher order

needs
o Extrinsic needs

needs
o Intrinsic needs

Social comparison Compatriots

Principal

Attachment

Little attachment
to company

Great attachment to
company

Power

Institutional

Personal

Situational Mechanisms
SITUATIONAL
RESPONSES

AGENCY THEORY

STEWAREDSHIP
THEORY

Management
Philosophy

Control oriented

Involvement
oriented

While dealing with


increasing
Uncertainty and
risk

Greater controls
More supervisions

Training and
empowering people

Risk orientation

Through a system
of control

Through trust

Time frame

Short term based

Long term based

Objective

Cost control

Improving
performance

Making jobs to be
more challenging
and motivating

Cultural differences Individualism


Large power

Collectivism
Small power

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

Shareholders

Elect

Appoints &
Supervises

Creditors
Own

Stakeholders

Board of Directors
(Supervisors)

Lien
on

Stake
in

Legal/Regulatory Monitors &


System
Regulates

Officers
(Managers)

Manag
e
Company

Fig.2 : The German Model

Shareholde
rs

Appoint
50%

Appoint
50%

Supervisory Board
Appoints and
Supervises
Management Board
(Including Labour
Relations Officer)
Manage

Employee
s and
Labour
Unions

Company

Fig.3 : The Japanese Model


elect

Shareholde
rs

Provides
Loans

Supervisory Board
(Including President)
Ratifies the
Presidents
Decisions

President
Provides
Managers
Monitors & Acts
in
Emergencies

Consults
Executive Management
(Primarily Board of
Directors)

Manages
Main
Bank

Own
Owns

Provides Loans

Company

Fig.4 : Indian Corporate Governance Model


External Environment
Government Regulations,
Policies, Guidelines etc.

Corporate Culture, Structure,


Characteristics, Influences

Company Acts

SEBI
Stock Exchanges

Depositors, Borrowers,

Internal Environment

Customers and other


External Stakeholders

Company vision; mission, policies, norms


Internal
Stakeholders
Directors

Auditors
Board of

CORPORATE
GOVERNANCE
SYSTEM

Proper governance
Shareholder value
Corporate Governance Outcomes / Benefits to Society
Transparency
Investor protection
Concern for customer
Healthy corporate sector development

What Is Good Corporate


Governance?
o National Interest

Obligation to society at large


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

Environment-friendliness

Health, Safety and Working Environment

Competition

Trusteeship

Accountability

Effectiveness and Efficiency

Timely Responsiveness

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
o Customer Satisfaction

Obligation to employees
o Fair Employment Practices
o Equal-opportunities Employer
o Encouraging Whistle Blowing
o Humane Treatment

Participation

Empowerment

Equity and Inclusiveness

Participative and Collaborative Environment

Managerial obligation
o Protecting Companys 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 & Johnsons 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

Corporate Governance in
India
Problems
o Inadequate Sanction and Enforcement.
o No clear demarcation of control mechanisms

between SEBI, DCA and Stock Exchanges.


o Lack of Professionalism of Directors
o Institutional Investors show poor commitment
o Indian boards are not professional
o Unindependent Independent directors
o Whistle Blower Policy not in place

Too many unlisted companies

Accounting gimmicks

Poor Shareholder participation

Obliging auditors

Soft State, lethargic judiciary, inefficient market


regulator, poor enforcement machinery, and a value
system which is indifferent to moral turpitudes.

However things are improving now


o

The market is competition driven

Professional new players are coming in

High growth in market capitalisation

Well-focussed, well-researched portfolio investors

Media influences

Influence of banks and financial institutions

Realisation among Indian companies of the benefits


of corporate governance and

Impending Capital Account Convertibility will exert its


own pressure.