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Theory and Practice of Corporate Governance

• The concept of Corporate Governance • The joint stock company known as the corporation is the nucleus of all business activities in modern economies. • All corporations do not however enjoy equal share of power; they also do not have the same size and degree of operations.

• “The business corporation is an instrument through which capital is assembled for activities of producing and distributing goods and services and making investments. • Business corporation - its objective • Enhancing the corporation’s profit and gains of the corporation’s owners

According to Chief Justice John Marshall (1801)
• “A corporation is an artificial being, invisible, intangible, and existing only in the contemplation of the law. Being the mere creature of the law, it possesses only those properties which the charter of its creation confers on it, either expressly or as incidental to its very existence. These acts are supposedly best calculated to effect the object for which it was created.

• Important property – immortality • Allowed, individually • A perpetual succession of many persons are considered the same and may act as a single individual

What is Corporate?
• In the capitalist economy, capital accumulation takes place through development and growth • The corporation of today has replaced the sole proprietor of old days and tries to maximize profits and generate wealth. • Differs on two counts: 1. More rational in decision making as it is run by a board of directors 2. Take decisions based on cost accounting, budget analysis, data collection and processing, and managerial consulting

Characteristics of a corporation
1. 2. 3. 4. 5. 6. 7. 8. Incorporated or registered under the Companies Act of a country Artificial legal existence- equal to that of a natural person with its own legal entity Perpetual existence – Law creates a company and only law can dissolve it Common seal – an artificial person can not sign documents Extensive membership – no limitation on the number of members Separation of management from ownership Limited liability (owners risk is limited unlike in the case of partnerships, individual ownerships) Transferability of shares

Concept of governance
• As old as human civilization. • Governance stands for decision making and implementing it. • Corporate governance, international governance, national governance, local governance. • Companies, Associations, NGOs, Cooperatives, political, parties, police and so on are governed • All except government and the armed forces are part of the “civil society”.

Theoretical basis for corporate governance
A. Agency Theory

The fundamental theoretical basis of corporate governance is agency costs. Adam Smith identified the agency problem (managerial negligence and profusion). Shareholders are the owners and the principals too. The management, the board, are the agents. Principals may want to carry out the objectives of the company but the agents may not quite exactly match the requirements. The cost of the “dissonance” caused by the agency problem is the agency cost. Management may go counter to the objectives of the shareholders such maximizing shareholder returns. Ostentatious life styles of directors, empire building etc. are examples.

Mechanisms that help reduce agency costs: 1. Fair and accurate financial disclosures 2. Efficient and independent board of directors


Stewardship Theory Managers not motivated by individual goals As stewards whose motives aligned with the objectives of their principals Managers are trustworthy and have high reputations. Their behavior will not run counter to the interests of the company. A significant emphasis on the responsibility of the board to the shareholders in a corporate governance model that is emboldened by stewardship and trusteeship. These concepts of stewardship and trusteeship are traceable in the scriptures of India and Christendom.

Basic behavioral differences between Agency & Stewardship Theories
Managers act as agents Governance approach is materialistic Behavior pattern is individualistic, opportunistic, and self serving Managers are motivated by their own objectives Interests of the managers and principals differ The role of the management is to monitor and control Owners’ attitude is to avoid risks Principal-manager relationship is based on control

Managers act as stewards Governance is sociological and psychological Behavior pattern is collectivistic, proorganizational, and trustworthy Managers are motivated by the principals’ objectives Interests of the managers and principals converge The role of the management is to facilitate and empower Owners’ attitude is to take risks Principal-manager relationship is based on trust

Issues in Shareholder Versus Stakeholder
• Shareholder approaches - corporations have limited responsibilities • Just obeying laws and maximizing shareholder wealth• Will automatically maximize societal utility. • But this argument presupposes that there will be perfect competition which is rather suspect in many situations. • Stakeholder approaches dwell upon the theme that corporate managements have responsibilities toward other stakeholders. • Responsibilities of the companies should be subject to obligations toward others.

Stakeholder theory
• Dating back to 1930s, this theory represents a synthesis of a fair bit of economics, behavioral science, business ethics, and stakeholder concept. • Deals with the common interests of employees, customers, dealers, government, and the society • Often criticized as “wooly minded liberalism” because it is not applicable in practice by companies. • The defense is that managers can act efficiently only by drawing upon the resources of the stakeholders • A “contract” between the company and the stakeholders. • But then who are all genuine stakeholders? • Bizarre choices like terrorists, dogs, trees and to the least questionable like employees and customers!

Corporate Governance Mechanisms
• The joint-stock, limited liability company is becoming the most preferred organization for running any business. It has been successful in providing employment, generating wealth, and contributing to economic and social development. In the limited liability company, the business is incorporated as an independent legal entity separate from its owners.

• Shareholders’ liability for debts is limited to the amount of capital they have agreed to subscribe for. • The company as a legal person has the rights to sell, buy, to own assets, to incur debts, to employ, to contract, and to sue and be sued upon. • Company has a long life span different from those of its innumerable shareholders.

• Companies need to be governed as well as managed. • The board of directors is central and its structure and processes are fundamental • The board’s relationships with its shareholders, regulators, auditors, top management, and other legitimate stakeholders.

• Companies’ shareholders are of diverse nature – private individuals, institutional investors such as banks and pension funds, insurance companies, and other companies who might have business relationship with the company. • This make it a very complex situation.

• There has been a growing awareness of corporate governance around the world. • A number of studies and official reports have followed as a result of the growing awareness and societal responses. • These provided a code of best practices for the governance.

• Many a major company today operate through group structures of wholly-owned subsidiary companies, partly owned subsidiaries in which other external parties have a minority equity interest and associated companies in which the holding company has a significant but not dominant holding. In an era of globalization, major companies are getting engaged in a variety of joint ventures and strategic alliances.

Corporate governance systems
• • • The role of the management (which mostly appears in the organizational chart and not the board) is to run the business The board oversees that it is run well and in the right direction. Management operates as a hierarchy. There is an ordering of responsibility, authority, delegation downwards through the firm and accountability upwards to the top brass. By contrast, the board members need to work together as equals reaching agreement by consensus or if necessary by voting. Each director bears the same duties and responsibilities.

The Anglo-American Model
Board of directors (Supervisors)




Appoints & supervises

Officers (Managers)

Manage Creditors Own Lien on Company Monitors & regulates Regulatory Legal System Stake in

The German Model
Appoint 50% Supervisory Board Appoints & Supervises Employees & Labor Unions Management Board (incl. labor relations officer) Manage Own Shareholders Appoint 50%


The Japanese Model

Provides managers . monitors, acts in emergencies

Supervisory Board
(including the President)

Ratifies the President’s decisions President Shareholders Consults Executive Management (Primarily Board of Directors) Manages

Provides managers

Main Bank

Provides loans


Indian Corporate Governance Model
Government regulations, policies, guidelines , etc

External Environment

Corporate culture, structure, characteristics, Influences

Internal Environment
Company Act SEBI, Stock Exchange Company vision, mission, policies, norms Internal stakeholders Auditors Board of Directors Depositors, borrowers, customers and other external stakeholders

Proper governance

Corporate Governance System

Shareholder value

Corporate governance outcomes/Benefits to society
Transparency Concern for customer Healthy corporate sector development

Investor protection

What is good Corporate Governance?
• Bad governance is being recognized as the major root cause for corrupt societies • Investors and institutions provide loans and aid stressing that the reforms that ensure good governance are adopted by the companies • Good corporates are not born, rather they are the result of the combined efforts and contributions of all stakeholders, board of directors, government, and the society at large • There are obligations to society at large, investors, employees, and customers • Managerial obligations too are important

Values, Concerns , Duties, Responsibilities Society expects from Corporates
• If a corporate has to survive, grow, and wants to be counted, its vision should focus on the ways and means of becoming a responsible and responsive corporate citizen.

Our Credo
We believe that 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 consistently strive to reduce 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 on 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 out 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 program 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.