Chapter5 Eth

5
Chapter
Corporate
Governance
Learning Outcomes
At the end of this chapter, you should be able to:

 Explain the meaning of corporate governance
 Explain in what way could the separation of ownership and control
in public corporations lead to corporate governance problems
 Elaborate the meaning of conflict of interest in the context of the
relationship between shareholders and professional managers
 Explain the implications of the Malaysian corporate ownership
structure to corporate governance
 Describe the nature of the principal-agent relationship in the
context of corporate governance
Business Ethics All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2014 1– 3
Learning Outcomes
 Explain the stakeholder, property and social institution

theories that are applied to the corporate governance
discipline
 Describe the role of various corporate governance
mechanisms in protecting the interest of the shareholders
and stakeholders
 Describe the various ethical issues in corporate governance

Defining Corporate Governance

Corporate Governance and PLCs
 Why does CG mainly concerns PLCs?

 PLCs have many shareholders – impossible to run the
business on their own
 So, they hire professional managers to control the
business
 Hence, shareholders own the business but control is
surrendered to managers
 In private firms, owners manage their own firm – goals of
owners are the same as the goals of firm.
 In PLCs, owners delegate power to professional managers to
manage firms – goals of managers might not be in line with
goals of owners.
(continued)
 Corporate structure of a PLC
 Owners contribute capital but
have limited power
 Board of directors hire top
managers to run the business
daily and give them power
 Powerful top managers do not
necessarily and consistently
pursue shareholders’ goals
 Conflicting goals known as
Type I agency conflict

8
 Managers and shareholders have conflicting goals

(interest).
 Shareholders want maximization of profit and wealth.
 Personal interests of managers may not be in line with
shareholders’ interests.
Corporate
CorporateGovernance
Governance
Conflict of Interest
Conflict of Interest Issues
Issues
 CG is needed to reduce the extent of conflict of interest

between shareholders and managers to protect the
former and make everyone happy.
The figure above illustrates the relationship between board of

directors and top management (controllers) with shareholders

Concentrated Ownership–
Malaysian PLCs
 In Malaysia, CG issues mainly
originate from typical high degree
of ownership concentration as
efi n i t i o n: opposed to diffused ownership.
D
n c e n t r a te d
Co
h i p r e f e rs t o  Large owners have great control
owner s
rd i n a r y share due to high number of voting
o el y
s h i p l a r g rights as opposed to minority
owner d u als,
i n d iv i shareholders.
held by f
a group o  We focus on family and
a l s , f a m ily
individ u government owners that have
,
members large percentage of
i t u t i o n s and
ins t shareholdings.
en t
governm
Malaysian PLCs (continued)
 Family owners originate from founders that initially
contributed capital and established the business.
 When the firm goes public, founders still hold large
percentage of shares and usually hold top positions.
 Government owners are typically government agencies
that invest on behalf of the Malaysian government.
 Historically, Malaysian government has been involved in
business enterprises ever since the introduction of the
New Economic Policy in 1971, followed by privatization
of key state companies.

Malaysian PLCs
 Implications of concentrated ownership
 A few large shareholders and minority shareholders
 The nature of agency conflict differs from PLCs with diffused
ownership
Between managers and shareholders – principal
Type I Between managers and shareholders – principal
and agent conflict
and agent conflict
Type II Between large shareholders and minority
Between large shareholders and minority
shareholders – principal-principal conflict
shareholders – principal-principal conflict
 Type I still exists but to a lesser extent than Type II.
 In this type of ownership environment, CG is meant to reduce
Type II conflict to protect minority shareholders.
Development of Corporate
Governance in Malaysia
 Started off during Asian financial crisis in 1997–1998: many
PLCs experienced financial trouble.
 Poor CG was one of key causes of financial crisis due to
blatant power abuse and questionable business and financial
transactions.
 The government established a committee in 1999 to
investigate CG in PLCs and to recommend improvement
measures.
 Significant outcome – Malaysian Code on Corporate
Governance (MCCG) launched in year 2000.
 MCCG sets out principles and best practices aimed at
enhancing the quality of CG in PLCs.

Malaysian Code on Corporate
Governance
 Adopted a hybrid approach to implement recommendations to
improve CG in PLCs.
 Why hybrid?
 CG was lacking, thus need to set standards for PLCs to
implement
 Flexible implementation due to varying needs, size of
business and financial resources
 Flexible – ‘comply or explain’ model.
 Emphasizes structure, procedures and responsibility of board
of directors to establish strong CG – extensive
recommendations to improve board of directors.
Governance

Governance

Governance
 The board of directors is to be properly structured with
sufficiently experienced, skilled and knowledgeable members.
 Composition of board should be balanced by executive, non-
executive and independent directors.
 Committees of board should be established to carry out review
and recommend matters on auditing, financial reporting,
remuneration and nomination.
 Establishment of a system to evaluate and access risks and
internal control – risk management.
 Sufficient care should be devoted in financial reporting and
disclosure.
 Constructive communication and dialogue with shareholders
and individual directors should be encouraged.
Theories of Corporate
Governance
Agency
AgencyTheory
Theory Stakeholder
StakeholderTheory
Theory
CG
CG
Theories
Theories Property
PropertyRights
Rights
Social
SocialInstitution
Institution
Theory
Theory
Theory
Theory

18
Agency Theory
 Examines the relationship

between parties in an agency
relationship.
n:
Definitio  The appointment of an agent
Agency involves the principal delegating
ip
relationsh some decision-making authority
w h e n o ne
exist s to the agent.
y (p r in c ip al )
p art  Helps to explain the behaviours
p o in t s t he
ap of those contributing to CG
th e r p a r ty
o
t) t o a c t or problems.
(agen on  CG is primarily meant to protect
rm ta s k
perfo f
his behal shareholders.
Nature of Principal–Agent
Relationship
 Based on trust between shareholders and controllers i.e. can

be described as a trusting relationship (a contract).
 Trust is developed based on remuneration and monitoring.
 Shareholders employ directors (cost) to manage the company
and they need to monitor (cost) the activities and
performance of directors closely.
 Trusting relationship comes with fiduciary duty.
 Fiduciary duty (FD) of directors (agents) is to act in the best
interest of shareholders (principals).

Principal–Agent Problem
21
 Relevance of agency theory to CG?

 Argues that company is property of its owners
 So, its main goal is to maximize returns to owners and give
priority to their interests
 Explains root cause of CG problems – conflict of interest
between shareholders and controllers
 Shareholders need to overcome or minimize this conflict of
interest by having CG mechanisms to monitor activities of
controllers.
 Both finding out and introducing mechanisms will incur costs in
terms of money spent, resources consumed or time taken.

Stakeholder Theory
 The company serves a broader

n i t i o n: objective – must make profit for
D e fi
d e r i s any owners to survive and at same
Stakeh o l
p t h a t h as a time balance this interest with
grou rest
o r i n t e welfare of stakeholders.
claim
o p e r a t i ons of  In essence, companies have
in
m p a n y t ha t
a co or multiple obligations because all
a ff e c t
can by stakeholder groups must be
e c t e d
be aff considered.
’s
company
r
policies o  Shareholders are not supreme
activities i.e. not the main priority.

Property Rights Theory
 The company is a legal entity that brings together various

constituents to conduct a business.
 Those constituents have conflicting demands against a
company, which cause controllers to determine whose
interest to be given a priority.
 As shareholders own the company, they have property
rights that need to be preserved.
 Property rights accord shareholders right to control the
company.
 Hence, priority of controllers is to serve interest of
shareholders.
Social Institution Theory
 The company cannot exist by itself – it requires sanction

and support of the society – though the state (law).
 Conducting a business is not a right but a privilege.
 The company needs to serve both the interests of the entire
society and the shareholders.
 The entire society refers to various stakeholder groups.
 Controllers need to balance conflicting demands or needs
of various stakeholders.
 Profit making is still the main objective, but controllers
should not achieve this by ignoring the welfare of
stakeholders.
Corporate Governance
Mechanisms
To monitor activities and behaviour of controllers to

align their interest with those of shareholders and
OBJECTIVES
to protect welfare of stakeholders.

To ensure board of directors fulfill fiduciary duty.
To contribute to improve corporate performance
and to create long-term shareholder value.
 Can be classified into internal and external mechanisms – known

as monitors.
 To be effective, these mechanisms need to be put in place
together, as opposed to a piecemeal basis.

Mechanisms (continued)

The Board of Directors
 The board of directors is the most important mechanism – it is

the shareholders’ first line of defence.
 Accountable directly to shareholders and main task to ensure
professional managers do not engage in self-interest activities.
 Prior corporate scandals show that when boards failed in their
duties, it is highly likely that the company failed or was in
financial trouble.
 A board has both leadership and control roles.
 Leadership role: supervises formulation and implementation of
business strategy.
 Control role: monitors performance and activities of
professional managers.

The Board of Directors
(continued)
 The board of directors enjoy independence from influence and
control of professional managers. This is achieved by:
 Leadership structure: different individuals holding Chairman
and CEO posts, which will prevent unfettered powers in one
person
 Appointing sufficient number of independent directors
 Chairman should be an independent director
 The board of directors should also establish independent board
committees.
 They must also ensure that remuneration of professional
managers are based on performance and they do not set their
own pay package.
 They should also ensure all directors attend induction and regular
training.
Mechanisms
Internal Control: a system established by boards to
protect assets and investment against risk exposure and
expropriation.
Internal Audit: an independent process to help boards to

verify reliability and effectiveness of internal control.
External Audit: an independent process to assist

shareholders to verify accuracy and reliability of financial
reports.
Shareholder Activism: shareholders actively monitor the
development in their company by exercising voting rights
during general meetings and through a two-way dialogue.
Regulation: regulate corporate behaviour so that the
public has confidence in the business environment –
mandatory compliance.
Ethical Issues in Corporate
Governance
Financial Inflated Excessive Poor

manipulation directors business risk communication of
remuneration taking, lack of information
Most common risk control
issue as evidenced Excessive Shareholders are
by previous remuneration; Managers pursue kept ‘in the dark’
corporate scandals, reward not based risky strategy about affairs and
e.g. fictitious sales on performance. without proper performance of
to inflate profit and
assessment and company, which
use of creative
management of results in the latter
accounting to hide
risks involved. being unable to
huge debts in
make informed
balance sheet.
decisions.


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5

At the end of this chapter, you should be able to:

Business Ethics All Rights Reserved

 Explain the stakeholder, property and social institution

Business Ethics All Rights Reserved

Business Ethics All Rights Reserved

 Why does CG mainly concerns PLCs?

Business Ethics All Rights Reserved

 Managers and shareholders have conflicting goals

 CG is needed to reduce the extent of conflict of interest

The figure above illustrates the relationship between board of

Business Ethics All Rights Reserved

Business Ethics All Rights Reserved

Business Ethics All Rights Reserved

Business Ethics All Rights Reserved

Business Ethics All Rights Reserved

Business Ethics All Rights Reserved

 Examines the relationship

 Based on trust between shareholders and controllers i.e. can

Business Ethics All Rights Reserved

 Relevance of agency theory to CG?

Business Ethics All Rights Reserved

 The company serves a broader

Business Ethics All Rights Reserved

 The company is a legal entity that brings together various

 The company cannot exist by itself – it requires sanction

To monitor activities and behaviour of controllers to

to protect welfare of stakeholders.

 Can be classified into internal and external mechanisms – known

Business Ethics All Rights Reserved

Business Ethics All Rights Reserved

 The board of directors is the most important mechanism – it is

Business Ethics All Rights Reserved

Internal Audit: an independent process to help boards to

External Audit: an independent process to assist

Financial Inflated Excessive Poor

Business Ethics All Rights Reserved

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