The Theory & Practice of Corporate Governance

1. The Theory & Practice of Corporate Governance Chapter No 2

2. What is a Corporate? “ By a company is meant an association of many persons, who contribute money or money's worth to a common stock and invest it in some trade or business, and who share profit and loss (as the case may be) arising there from. The common stocks so contributed is denoted in money and is the capital of the company. The persons who contributed it, or to whom it belongs, are members. The proportion of 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.” Justice Lindlay

3. Characteristics of a Corporation • Incorporated Association • Artificial Legal Existence • Perpetual Existence • Common Seal • Extensive Membership • Separation of Management from Ownership • Limited Liability • Transferability of Shares

4. The Concept of Governance Governance means the process of decision-making and the process by which decisions are implemented (or not implement).

5. Theoretical Basis of Corporate Governance • Agency Theory • Stewardship Theory • Stakeholder Theory • Sociological Theory

6. Agency Theory • Owners (shareholders) / Principals • Management / Agents • Agency Problem • Agency Cost • Agency Loss • Problems with The Agency Theory • Mechanisms to Reduce Agency Cost • Fair & Accurate Financial Disclosures • Efficient & Independent Board of Directors

7. Stewardship Theory • Stewards whose motives are aligned with the objectives of their principals. • A steward’s behavior will not depart from the interests of his / her organization. • Control can be potentially counter productive, because it undermines the pro- organizational behavior of the steward, by lowering his / her motivation. “Stewardship refers to the responsibility of the board to oversee the conduct of the business and to supervise management which is responsible for the day-to-day conduct of the business. In addition, as stewards of the business, the directors function as the catch-all to ensure no issue affecting the business and affairs of the company falls between cracks.” Canadian Guidelines

8. Agency Theory Manager acts as agents Governance approach is materialistic Behavior pattern is individualistic, opportunistic & 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 Stewardship Theory Managers act as stewards Governance approach is sociological & psychological Behavior pattern is collectivistic, pro-organizational & trustworthy Managers are motivated by the principal’s 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 Agency Theory Vs Stewardship Theory A) Behavioral Differences

9. Agency Theory Motivation revolves around Lower order needs Extrinsic needs Social comparison is between compatriots There is little attachment to the company The power rests with the institution Stewardship Theory Motivation revolves around Higher order needs Intrinsic needs Social comparison is between principals There is great attachment to the company The power rests with the personnel B) Psychological Mechanism

10. Agency Theory Management philosophy is control oriented To deal with increasing uncertainty & risk, the theory advocates exercise of Greater controls More supervisions Risk orientation is done through a system of control Time frame is short term The objective is cost control Cultural differences revolve around Individualism Large power distance Stewardship Theory Management philosophy is involvement oriented To deal with increasing uncertainty & risk, the theory advocates exercise of Greater training & empowering people Making jobs more challenging & motivating Risk orientation is done through trust Time frame is long term The objective is improving performance Cultural differences revolve around collectivism Small power distance C) Situational Mechanisms

11. Stakeholder Theory Stakeholders = Shareholder Group + Non-shareholder Group Employees Customers Dealers Government Society at Large

12. Criticism of the Stakeholder Theory • Not applicable in practice by Corporation • Comparatively little empirical evidence • Difficulty of defining the concept • Leading to chaos • Opening doors to corruption

13. Shareholder vs Stakeholder Approaches Shareholder • Obeying the law • Maximizing shareholder’s wealth • Assumption – Perfect Competition Stakeholder • Board & Management have responsibilities to parties other than shareholders. • Profit maximization subject to the constraint of respecting obligations owed to such stakeholders.

14. Sociological Theory • Power & Wealth Distribution • Board Composition • Financial Reporting • Disclosure • Auditing • Equity & Fairness

15. Why Corporate Governance? • Companies need to be governed as well as managed • The board of directors is central and its structure & processes are fundamental • The board’s relationship with the company’s shareholders, regulators, auditors, top management and other legitimate stakeholders

16. Corporate Governance System Board Management Interaction Between the Management And the Board

17. Corporate Governance Systems • The Anglo-American Model – Unitary Board Model • The German Model – Two-Tier Model • The Japanese Model – Business Network Model • The Subcontinent Model

18. The Anglo-American ModelUnitary Board Model (Anglo-Saxon) Elect Board of Directors (Supervisors) Stakeholders Appoints & supervises Officers (Managers) Manage Monitors & Regulates Lien on Creditors Regulatory/ Legal system Company Own Stake in

19. The Anglo-American ModelUnitary Board Model (Anglo-Saxon) Major Features • A single board comprising both executive and non executive directors in varying proportions. • The ownership of companies is more or less equally divided between individual shareholders and institutional shareholders. • Directors are rarely independent of management. • Typically managed by professional managers who have negligible ownership stakes. • There is fairly clear separation of ownership and management. • Most institutional investors are reluctant activists. • The disclosure norms are comprehensive, the rules against insider trading strict, & the penalties for price manipulations stiff, all of which provide adequate protection to the small shareholders and promote general market liquidity.

20. The German ModelTwo-Tier Board Model Appoint 50% Appoint 50% Supervisory Board Appoints & Supervises Employees & Labor Unions Management Board (Including Labor Relations Officer) Shareholders Manage Company Own

21. The German Model -Two-Tier Board Model Main Features • Corporate Governance is exercised through boards: Supervisory & Management Boards • The upper board supervises the executive board on behalf of stakeholders. • Corporate Governance approach is typically societal-oriented (Continental European approach). • Shareholders own the company, they do not entirely dictate the governance mechanism. • 50% of members of supervisory board is elected by the shareholders & remaining 50% is appointed by labor unions • The supervisory board appoints and monitors the management board. • The management board independently conducts the day-to-day operations of the company but reports to the supervisory board.

22. The Japanese Model – Business Network Model Provides Managers, Monitors & Acts in Emergences Appoint Supervisory Board (Including President) Provides Managers Ratifies the President’s decisions President Shareholders Consults Main Bank Executive Management (Primarily Board of Directors) Manages Provides Loans Own Company Owns

23. The Japanese Model – Business Network Model Main Features • Boards tend to be large, predominantly executive and often ritualistic. • The reality of power in the enterprise lies in the relationship between top management in the companies (keiretsu network or Korean chaebol) • The financial institution plays a crucial role in governance. • The shareholders and the main bank together appoint the board of directors and the president. • The president who consults both the supervisory board and the executive management.

24. Common Features in the German and Japanese Model • Banks and financial institutions have substantial stakes in the equity capital of companies. • Institutional investors in both the countries view themselves as long term investors. They play a fairly active role in corporate managements. • The disclosure norms are not very stringent, checks on insider trading are not very comprehensive and effective, and emphasis on liquidity is not high. • There is hardly any system of corporate control in these countries; mergers and take-overs are rare occurrences.

25. Subcontinent Model of Governance • Subcontinent corporates are governed by the Company’s Act of 1956 in the case of India & by the Company’s Ordinance of 1984 in the case of Pakistan that follows more or less the UK model • The pattern of companies in private sector is mostly that of closely held or dominated by a founder, his family and associates. A similarity that it shares with the German & the Japanese models.

26. Subcontinent Model of Governance External Environment Government Regulations, Policies, Guidelines etc. Corporate Culture, Structure Characteristics, Influences Internal Environment Company Vision; Mission, Policies, Norms Auditors Internal Board of Stakeholders Directors Depositors, Borrowers, Customers and Other Stakeholders Company’s Act SEC Stock Exchanges CORPORATE GOVERNANCE SYSTEM Proper Governance Shareholder Value Corporate Governance Outcome / Benefits to Society Transparency Investor Protection Concern for Customer Healthy Corporate Sector Development

27. National Interest Political Non-Alignment Legal Complication Rule of Law Honest & Ethical Conduct Corporate Citizenship Ethical Behavior Social Concern Corporate Social Responsibility Environment-Friendliness Healthy & Safe Environment Competition Trusteeship Accountability Effectiveness & Efficiency Timely Response Corporations Should Uphold The Fair Name Of The Country Obligation To Society At Large

28. Obligation To Investors • Towards Shareholders • Measures Promoting Transparency & Informed Shareholder Participation • Transparency • Financial Reporting & Records

29. Obligation To Employees • Fair Employment Practices • Equal Opportunities Employer • Encouraging Whistle Blowing • Humane Treatment • Participation • Empowerment • Equity & Inclusiveness • Participative & Collaborative Environment

30. Obligation To Customers • Quality Of Products & Services • Products At Affordable Prices • Unwavering Commitment To Customer Satisfaction

31. Managerial Obligations • Protecting Company’s Assets • Behavior Towards Government Agencies • Control • Consensus-Oriented • Gifts & Donations • Role & Responsibilities of Corporate Board & Directors • Direction & Management Must Be Distinguished • Managing & Whole-Time Directors