Fundamental Issue in Corporate Governance

The term Corporate Governance became the subject of significance debate since late 1970s. Now a day, it has become the more burning issue as to the companies. Modern day business needs to set up a changed operating system. The need to establish good governance has become necessary. The growing pressure as to the change of environment in the business sector played a vital role in the growth of Corporate Governance. Economies with efficient economic policies and stable political systems have attraction for the investors. Countries that have good legal systems, providing protection to investors have more attraction for the investor. Scholars and policy makers increasingly look to governance institutions at the level of the firm, to determine their practical economic, social, and political implications. Re-alignments in corporate sector resulted in the growth of economic and political systems. Corporate governance also has diverse international implications. The ability of countries to attract foreign capital is affected by their systems of corporate governance and the degree to which corporate management is compelled to respect the legal rights of lenders, bondholders, and non controlling shareowners. [1]

The gist of this essay is relevant to the discussion that what is the fundamental issue involved in the Corporate Governance of Companies and how it should be addressed? Actually, it is Shareholder VS Stakeholder debate. Scholars, practitioners, policy makers and experts in the areas of corporate law, finance, management and economic policy have devoted their attention to the subject and have focused on pros and cons of their governance model.

This essay will proceeds in three parts. The first will set out the structure of corporate governance. The second will deal with the fundamental issue involved in the Corporate of Governance and its solution. In last, through the analysis of this Article we conclude it.

Corporate Governance:

Definition:

Basic definition of corporate governance is : “The system by which organisations are directed and controlled.” [2] It deals with systems, processes, controls, accountabilities and decision-making of an organisation. [3]

Scholars and practitioners of corporate governance give a wide variety of definitions to the term of corporate governance. Economists and social scientists tend to define it broadly as “the institutions that influence how business corporations allocate resources and returns” [4] and “the organizations and rules that affect expectations about the exercise of control of resources in firms”. [5] In the view of renowned economist, governance is “an institutional framework in which the integrity of the transaction is decided”. [6]

Corporate managers, investors, policy makers and lawyers have tendency towards a more narrow definition. According to them corporate governance is the system of rules and institutions that determine the control and direction of the corporation and that define relations among the corporation’s primary participants. [7] Therefore, the United Kingdom’s 1992 Cadbury Report’s often quoted definition is: “Corporate governance is the system by which businesses are directed and controlled” [8]

Corporate governance is about the mode in which top managers perform their responsibilities and authority and how they account for that authority entrusted to them with assets and resources. It is equally relevant to any organisation, regardless of whether it is in the public or private sector.

“Corporate governance is the outcome of the relationships and interactions between employees, suppliers, customers, the community. An optimal corporate governance structure is the one that would minimize institutional costs resulting from the clash of these diverging interests”. [9] Professor Hart says: “Governance structures can be seen as a mechanism for making decisions that have not been specified by contract” [10] these costs matter, because the performance of the enterprises might be significantly influenced by their size and the identity of their bearer.

The Institutions of Corporate Governance:

Corporate governance is directly relevant to policy makers because its important sources are laws, institutions and regulations. Company law, securities and exchange regulation, prudential regulation of banks, pension funds and insurance companies, accounting and bankruptcy laws have impact on the decisions of corporations and its behavior in the market. There is a wide variety of corporate governance regimes in OECD (Organization for Economic Co-operation and Development) countries. Individual economies developed different capital market mechanisms, legal structures, factor markets and private or public institutions these are the result of institutional, political and social traditions. The principal focus of corporate governance is to define the relationship between the three primary participants in the corporation: shareholders, the board of directors and company management. [11] The institutions of corporate governance include both those that are external and those that are internal to the corporation. The external institutions include government regulatory agencies, stock markets on which corporations list their shares, and the courts that enforce remedies for violations of corporate governance rules. The purpose of any system of governance is to determine how power is allocated and exercised. Within any publicly traded corporation, there are potentially three institutional centres of power: (1) the board of directors or supervisory board; (2)the managers; and (3) the shareholders.

The objectives of the corporations:

Fundamental question, which arises as to the every system of corporate governance is that what is objective of the corporation and for whose benefit is it to be run? In the United States and United Kingdom, the formal rules of corporate governance provide that the purpose of the corporation is to bring the profit to its shareholders i.e primacy of shareholders. In the United Kingdom, the objective of the corporation is basically the same as it is in the United States. English law makes it clear that the shareholders are the owners of the company and that a company’s board of directors is required to advance the interests of the shareholders as a whole. [12] This is also known as “shareholder model of corporate governance” because shareholders are the main focus of corporate governance. American Law Institute (ALI) concluded in its Principals of Corporate Governance: “a corporation should have as its objective the conduct of business activities with a view to enhancing corporate profit and shareholder gain.” [13] In other words, the purpose of the corporation under American law is to make profits and the beneficiaries of those profits are the shareholders. Where the objective of the corporations is to advance the interest of other persons, groups other than shareholders are known as stakeholder, and such model of corporate governance is called “stakeholder model” of corporate governance.

The preference for the shareholder as compared to the stakeholder model of corporate governance, based upon the culture and public attitudes of the countries concerned. [14]

Fundamental Issue Involved In The Corporate of Governance:

Fundamental issue involved in the corporate governance is that for whose benefit is it to be run? In other worlds, who will be the prime beneficiary of corporate governance either it will be shareholders or the stakeholders. Infect, it is shareholder vs stakeholder debate. This not debate is not new. It is still not resolved and it is as uncertain today as it was in 1980s. Both models have strong arguments in favour and against. [15]

Supporters of Shareholder model argue that the primary function of the corporation is to make the most of gains to its shareholders and it is the corporation which create the goods and services that society needs. Dealing of managers with social considerations will divert them from their task. They oppose the stakeholder model because it damage the notion of private property, enhance the power of executives by reducing the power of shareholders to control them, and make corporate managers less accountable to shareholders. Professor Milton Friedman, a Nobel laureate in economics, condemned the idea 40 years ago: “few trends would so thoroughly undermine the very foundations of our free society as the acceptance by corporate officials of a social responsibility other than to make as much for their shareholders as possible. This is a fundamentally subversive doctrine”. [16]

According to the supporters of Stakeholder model, the corporation, deriving special benefits and privileges from the community e.g limited liability of shareholders, legal personality, perpetual existence and access to public capital, must take account of community interests in its decisions. [17] American scholars Berle and Means wrote 70 years ago: “It is conceivable–indeed it seems almost essential if the corporate system is to survive–that the “control” [i.e. management] of the great corporations should develop into a purely neutral technocracy, balancing a variety of claims by various groups in the community and assigning to each a portion of the income stream on the basis of public policy rather than private cupidity”. [18] Stakeholder advocates also argued that the stakeholder model facilitates the kind of long-term corporate strategy necessary for the welfare of the firm, rather than the short-term opportunistic corporate actions taken to satisfy shareholders.

Shareholder Theory:

Shareholder theory states that the purpose to the corporation is to bring profit to its shareholders. There will be primacy of shareholder interests. Shareholders are the owners of the company while the board of directors and managers are the employ of the company, and they work for the advancement of the interest of the shareholders. Below is given the viewpoint of a few economists regarding the nature of the firm, taken from their published articles and it can be observed the central relationship in the theories of the firm for all the economists is indeed that of the shareholders and director.

Ronald Coase:

Ronald Coase was one of the first economists who tried to explain the nature of the firm. For him, the firm and the market are alternative methods of co-ordinating business. If the market is used for co-ordinating business than the associated costs of using the price mechanism are endured. [19] One of these costs is related to the negotiation and conclusion of different contracts which the entrepreneur has to enter into for each exchange transaction with the various individuals (factors of production) or with the suppliers in the case of goods. [20] The firm as an alternative provides a mechanism whereby the entrepreneur instead of entering into a series of contracts according to the price mechanism, enters into a single contract with each individual through which they agree to be directed by him within the limits of the contract. [21] For Coase, therefore, a firm ‘consists of a system of relationships which comes into existence when the direction of resources is dependent on an entrepreneur’. An analysis of Coase’s theory reveals that the relationship which is fundamental for him is the entrepreneur – factor of production or in legal terms as he equates it, master-servant or employer-employee [22] and related to this is the theory of the entrepreneur or owner’s authority to direct the employees within the limits of the contract. Practically, it is the directors rather than the shareholders who seem to manage the day-to-day proceedings and exercise authority that Coase finds fundamental to theory of the firm. However, it must be remembered that the authority that directors (employees) exercise is due to the fact that the shareholders (employers) have delegated this authority to them but retain the right to remove them. All major decisions still require the approval of the shareholders. So in essence, the shareholders as employers enter into a contract with each individual director as employee, whereby the director agrees to follow the directions of the shareholders within the limits of his employment contract. The shareholders in turn decide to delegate their authority to the director for the management of the business, This analysis reveals primacy of shareholder.

Armen Alchian & Harold Demsetz

Alchian and Demsetz, while admitting that they are building on Coase’s theory, [23] disagree with his view that the distinguishing feature of the firm is the authority to direct which the employer enjoys over the employee, by commenting that the means available for disciplining an employee in a firm can also be exercised in the market. [24] For them, “long term contracts between employer and employee are not the essence of the organization we call a firm.” [25]

For them, team production, in certain situations, results in greater productivity than an individual working alone. [26] It is also their opinion that a system of rewards results in a given level of productivity rather than the other way round. [27] The problem which they believe arises with team production is calculating the reward for an individual’s contribution to a team, otherwise known as the metering problem, [28] so that he can be adequately rewarded as otherwise the individual would lose the incentive to work efficiently; in other words the shirking problem arises. [29] This problem can only be effectively overcome if there is an individual monitoring the individuals in a team. [30] Similarly, the monitor will only effectively discharge his role if he has incentives to do so. One of the incentives which is provided to him is that he is made the residual claimant of the net earnings of the team. [31] In other words, the more productive the team is, the greater the reward for the monitor.

They explain that in a corporation more capital can be raised “if many contribute small portions to a large investment” [32] and limited liability helps to protect these investors. Since there will be many shareholders, it is more efficient to delegate their authority to a management group (or the directors) so that they can manage the business, while the shareholders retain the authority to revise the membership of the group of managers. [33] Thus, according to Alchian and Demsetz, the shareholders as residual claimants are indeed at the centre of the corporate focus and the director-shareholder relationship is the key relationship.

Michael Jensen and William Meckling

Though Jensen and Meckling acknowledge Coase’s theory, they agree with Alchian and Demsetz in their analysis that the distinguishing mark of the firm is not the authority which the entrepreneur exercises over the employees, as Coase suggests. [34] However, they disagree with the duo on their opinion of the firm as a mechanism for team production, commenting that this is too narrow a view. [35] From their perspective, team production is only one facet of a firm and the agency and monitoring costs, which Alchian and Demsetz associate with team production, is equally relevant to other contracts such as those with suppliers, customers, creditors and so on, since all these contracts are also important.

Given the technical nature of their theory, Jensen and Meckling, deal directly with the agency problems between shareholders and managers and debt-holders and managers. They recognize that debts cannot adequately provide for all the capital required for the firm [36] and it is the shareholder-manager relationship which is more important. It has been observed that since they focus on issues with respect to the relationship between shareholders and managers, they are frequently cited in support of understandings of the firm and of corporate governance emphasising the relationship between director and shareholder. [37]

Oliver Hart

Hart agrees with the criticism pointed out by Alchian and Demsetz regarding Coase’s theory. [38] However, he criticizes their theory on the basis that it does not justify why the process of joint production and monitoring needs to be carried through the mechanism of a firm rather than using the market. [39] He analyzes the theory presented by Jensen and Meckling and states that though their theory holds some validity, all it does is to shift the focus from the basic question, which is what the firm actually is. [40] The focus of Hart’s theory is that the firm should be viewed as a “set of property rights”, [41] an approach which he considers to be aligned with Coases’s view among others. He believes that since the owners of the firm own all the non-human assets of the firm, they will have residual rights of control. In essence the owner of the assets of the firm decides who gets to use those assets and this provides an incentive to the employees to work satisfactorily as otherwise they will be replaced, thus this authority of the owners explains the advantage that the firm has over the market.

Hart admits that the property rights approach doesn’t adequately deal with the modern corporation in which there is separation of ownership and control. [42] He goes on to explain that shareholders as owners of the assets of the firm retain the authority to remove a director if his performance is unsatisfactory but since many of the day-to-day authority has been delegated to the board of directors, they have the control of the firm rather than the owners of the property rights (shareholders).

Stakeholder Theory:

The term ‘stakeholder’ can be traced back to the early 1960s and finds a resonance, for example, in a series of reports in the UK during the 1970s. Its is the work of R. Edward Freeman which gave impetus to the concept. However, over the years several other academics and businessmen namely Cassidy, Donaldson and Preston and Thompson and Driver have presented their views related to the concept.

Dennis Cassidy’s views:

Dennis Cassidy is a businessman rather than an academic and has loads of practical experience. For him, corporate governance is the creation and implementation of processes adopted by a properly authorized and constituted board seeking to optimize the return to shareholders whilst satisfying the legitimate expectations of stakeholders who include employees, suppliers and customers as well as members of those communities with whom their business activities interface. In this the board should make its forward plans and actions as visible as is consistent with commercial sensitivity and in doing so enable stakeholder communities to express their views. He considers the pleas that shareholder should intervene in the management of the business to be in conflict with the concept of empowering boards to act decisively, whilst being more transparent in their actions. This was the thrust of the Cadbury Report and its successors. He is critical of the current position and refers to it as box-ticking mode. He concludes by giving examples of Marks & Spencers, Marconi, Railtrack, Tomkins and Equitable Life, where these companies fulfil the box -ticking criteria of corporate governance but are struggling because their corporate governance doesn’t take account of the stakeholder concept.

Donaldson and Preston’s views:

Donaldson and Preston are of the opinion that the stakeholder theory is gaining loads of momentum as lots of authors are focusing on it. The primary focus of their theory is on three aspect of the stakeholder theory – descriptive/empirical, instrumental and normative – and they clarify, justify and explain that these aspects despite being different are mutually supportive and the normative base serves as the critical underpinning for the theory in all its forms. They view the stakeholder theory to be different to other theories because it is intended to both explain and to guide the structure and operation of the established corporation. The theory is used to describe and sometimes explain specific corporate characteristics and behaviour. Stakeholder theory has been used to describe the nature of the firm (Brenner and Cochran 1991), the way managers think (Brenner and Molander, 1977) etc. According to them there is ample descriptive evidence. Raymond Baumharts survey revealed that 80 % of upper-level managers regarded it as unethical management behaviour to focus solely in the interest of shareowners and not in the interest of employees and customers. According to them however, this descriptive element does not provide justification for adopting the stakeholder approach, it just provides the managers with relief that they are conforming to the latest trend and practice. The stakeholder theory is also used to identify the connections, or lack of connections between stakeholder management and the achievement of traditional corporate objectives. The authors explain that it was used by Cochran & Wood 1984 etc and O’Toole 1985 in this manner, though their methods of reaching the implications were different. Whatever their methodologies, these studies have tended to generate “implications” suggesting that adherence to a stakeholder principle and practices achieve conventional corporate performance objectives as well or better than rival approaches. The authors believe that even without empirical verification, the stakeholder management might be linked to conventional concepts of organizational success through analytical argument. In this regard they analyze the approach of Hill & Jones and Freeman & Evan and come to the conclusion that despite their efforts the stakeholder theory is ultimately justified on normative principles. They try to justify their theory on the basis of the theory of property. According to them the ultimate managerial implication of the stakeholder theory is that mangers should acknowledge the validity of diverse stakeholder interests and should attempt to respond to them within a mutually supportive framework, because that is a moral requirement for the legitimacy of the management function.

Driver and Thompson’s views:

According to Driver and Thompson the prevalent form of corporate governance focuses on strengthening shareholder power over that of other interest and stakeholders. They are of the opinion that it has been forgotten that the firm is not just a commercial organization but also a public institution with certain public responsibilities. In their view as well as the stakeholder idea being considered in the context of its performance outcome for the profitability of the firm and its potentially wider economic efficiency effects-the traditional emphasis-the democratization of the firm could be considered an objective in its own right. In their opinion those that feel liberty would be threatened by economic democracy see this threat coming by way of greater equality. Their concept of liberty is private ownership of property. The authors also use the legal model of a company to explain that legal rights in respect to company law are always highly specific and what they impart to different agents are differential capacities and capabilities to undertake actions and engage in litigation. Legal rights do not exclusively or unconditionally guarantee access to ownership or anything else but only impart possibilities for taking action or undertaking litigation.

Redress:

They also believe that statute and common law can advance this goal. The Companies Act 2006 Section 172 imposes on the directors of a company to act according to the ‘enlightened shareholder value’ formulation. The directors should consider the interest of the stakeholders while making decisions but, it retains the primacy of the shareholders while also compelling directors to consider the company’s stakeholders.

An analysis of these theories leads the present author to the conclusion that these theories have their merit. The corporation has become more than a simple entity for doing business; it has a role to play in the society as a whole. It cannot exist in isolation for the sole purpose of making profits, it has do so in a responsible manner which requires something more than what the basic regulatory regimes of different systems require.

Agency Costs definition :

The incremental costs of having an agent make decisions for a principal.

An agency cost is an economic concept that relates to the cost incurred by an entity (such as organizations) associated with problems such as divergent management-shareholder objectives and information asymmetry. The costs consist of two main sources:

The costs inherently associated with using an agent (e.g., the risk that agents will use organizational resource for their own benefit) and

The costs of techniques used to mitigate the problems associated with using an agent (e.g., the costs of producing financial statements or the use of stock options to align executive interests to shareholder interests).

Though effects of agency cost are present in any agency relationship, the term is most used in business contexts.

Contents

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1 Agency costs in corporate finance

1.1 Management

1.2 Bondholders

1.3 Board of directors

1.4 Labour

1.5 Other stakeholders

2 Agency costs in

A type of internal cost that arises from, or must be paid to, an agent acting on behalf of a principal. Agency costs arise because of core problems such as conflicts of interest between shareholders and management. Shareholders wish for management to run the company in a way that increases shareholder value. But management may wish to grow the company in ways that maximize their personal power and wealth that may not be in the best interests of shareholders.

Investopedia Says:

Some common examples of the principal-agent relationship include: management (agent) and shareholders (principal), or politicians (agent) and voters (principal).

Agency costs are inevitable within an organization whenever the principals are not completely in charge; the costs can usually be best spent on providing proper material incentives (such as performance bonuses and stock options) and moral incentives for agents to properly execute their duties, thereby aligning the interests of principals (owners) and agents.

R

Agency Costs

Costs of preventing agents (e.g. managers) persuing their own interests at the expense of their principals (e.g. shareholders).

Examples include contracting costs and costs of monitoring. In addition there is the agency cost of the loss of wealth caused by the extent to which pre