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 o o o o o o 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
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

Behavioural Differences
THEORY Managers act as Governance Approach AGENCY Agents Materialistic
o Individualistic o Opportunistic o Self-serving

STEWARDSHIP Stewards Sociological and Psychological

o o o

Behaviour Pattern

Collectivistic Pro-organisational Trustworthy

Managers motivated by Managers and Principals Interests Management Structures

Their own objectives Differ Monitor and control

Principals objectives Converge Facilitate and empower

Owners Attitude
Principal Manager Relationship based on

Risk Avoidance
Control

Risk taken
Trust

Psychological Mechanisms
PSYCHOLOGICAL RESPONSES
Motivation AGENCY THEORY
o Lower order needs o Extrinsic needs

STEWARDSHP THEORY
o Higher order needs o Intrinsic needs

Social comparison Attachment

Compatriots

Principal

Little attachment to Great attachment to company company Institutional Personal

Power

Situational Mechanisms
SITUATIONAL RESPONSES Management Philosophy While dealing with increasing Uncertainty and risk AGENCY THEORY Control oriented Greater controls More supervisions STEWAREDSHIP THEORY Involvement oriented Training and empowering people Making jobs to be more challenging and motivating Through trust Long term based

Risk orientation Time frame

Through a system of control Short term based

Objective
Cultural differences

Cost control
Individualism Large power distance

Improving performance
Collectivism Small power distance

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

Creditors

Own

Officers (Managers)

Stakeholders

Stake in Monitors & Regulates

Manage Company

Legal/Regulatory System

Fig.2 : The German Model

Shareholders

Appoint 50%

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

Appoint 50% Employees and Labour Unions

Company

Fig.3 : The Japanese Model

Shareholders elect 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

Company

Provides Loans

Fig.4 : Indian Corporate Governance Model

External Environment Government Regulations, Policies, Guidelines etc.
Company Acts

Corporate Culture, Structure, Characteristics, Influences

Internal Environment Company vision; mission, policies, norms Internal Stakeholders Auditors Board of Directors

Depositors, Borrowers,

SEBI Stock Exchanges

Customers and other External Stakeholders

CORPORATE GOVERNANCE SYSTEM

Proper governance value Corporate Governance Outcomes / Benefits to Society Transparency Investor protection customer

Shareholder

Concern for Healthy corporate sector development

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

Environment-friendliness

o
o o o o o o

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 o o o

Towards Shareholders Measures Promoting Transparency and Informed Shareholder Participation Transparency 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

o o o o

Participation Empowerment Equity and Inclusiveness Participative and Collaborative Environment

Managerial obligation
o o o o o o o o

Protecting Companys Assets Behaviour Towards Government Agencies Control Consensus Oriented Gifts and Donations Role and Responsibilities of Corporate Board and Directors Direction and Management must be Distinguished 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
o o o o o

No clear demarcation of control mechanisms between SEBI, DCA and Stock Exchanges.
Lack of Professionalism of Directors Institutional Investors show poor commitment Indian boards are not professional Unindependent Independent directors Whistle Blower Policy not in place

o
o o o

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

o
o o o o o o

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.