Literature Review on Good Corporate Governance

This chapter examines the various and diverse definitions, views, theories and models associated with corporate governance concept and it also emphasises on what constitute a good corporate governance structure and finally the relationship between corporate governance and its corporate competitiveness and firm performance.

Overview of Corporate Governance

In this world of constant changes, corporate are in a need to maintain their financial position and increasing their financial performance. A huge degree of emphasis has been laid on continuous learning, research, development and strategic planning. Corporate governance is regarded as a means to ensure that companies are run properly and at the same time, minimising the risk of corporate failure. Coyle (2007) has stated that it is an assessment system that serves as a “signal indicating” mechanism, not only can provide enterprise with a manoeuvrability basis and instruction for furnishing its corporate governance, and provide corporate governance assessment record to the society, but also at the same time, review timely the changes of strategic policy environment and provide a favourable environment for social mutual governance.

Historical Perspective of Corporate governance.

Coyle (2007) related that the main concerns for better practices in corporate governance started in the UK in the late 1980s and early 1990s. Especially in this period a series of reports were drawn which are presented below:

Produced in the wake of the demise of Robert Maxwell and his business empire, the Cadbury Report (1992) is the name for the first Code of Best Practice on good governance practices, as part of the Report of the Committee on the Financial Aspects of Corporate Governance (1992). There was no statutory regulation of the code, but the London Stock Exchange required all listed companies to include a statement of compliance with the code in their annual report.

In 1995, Paul Myners report made various recommendations concerning the relationship between institutional shareholders and company managements, including improving communications. Following this report, various groups of institutional investors have published guidance for their members, and encouraged activism where deemed strategically cost effective. The significance reason of the Myners Report is that it put forward the fact that institutional shareholders to redefine their roles and responsibilities for ensuring good corporate governance of the company they have invested in.

In 2001, Myners Report put forward a voluntary code of practice for the pension funds. The report aimed was on pension trustees and pension advisors. The reason behind this report was that pension trustees are required to be competent for their role and justify the reasonableness of their asset allocation and assumptions about future investment returns.

Following one of the Cadbury’s committee recommendations, a Study Group on Directors’ Remuneration was set up to review corporate governance in UK-Listed companies. The resulting Greenbury Report was published in July 1995, focussing on directors’ contracts and compensation. Greenbury’s recommendations consisted of mainly that remuneration committees should be made up of NEDs to make decisions on senior executive pay, reduction of maximum notice period in a director’s contract from three years to twelve months and bonuses should be linked to satisfactory performance criteria. Hence the overall aim of the report was that there should be clearer window in remuneration packages. These recommendations were accepted by the LSE and were incorporated into the listing rules.

The Hampel Committee chaired by Sir Ronald Hampel was set up in 1995 to build on and to widen the scope of the Cadbury and Greenbury reports and led in due course to the publication in 1998 of the Combined Code on Good Governance. The combined code laid rules mainly concerning conduct of directors, director’s remuneration, relations with shareholders, accountability and audit. In essence, these rules were designed to increase the possibility of companies being run honestly and competently and shareholders being given adequate and reliable information .The combined code was divided into two main parts, namely best practice for companies and best practice for institutional investors.

In April 2002, Derek Higgs was appointed by the UK Chancellor of the Exchequer and the Secretary of State for Trade and Industry to lead to a short independent “Review into the role and effectiveness of non executive directors”. The Higgs’ report envisaged a more demanding and significant role for NEDs and focused on the effectiveness of NEDs in promoting company performance as well as on issues of accountability.

The new combined code was issued in July 2003 and came into force in November 2003. The new combined code is not legally binding, but under the LSE listing rules, listed companies have to describe how they apply the code’s main provisions and supporting principles and they must either “confirm or explain” that is confirm that they have comply with the Code’s provisions and provide an explanation to shareholders.

Definition of Corporate Governance according to Various Writers.

Good governance is not a new concept. It has existed since the early days civilisation. Both eastern and western civilisation recognized and preached the principles of good governance. The philosophy of good governance can be related also to various religious studies like the Hinduism, Islamism, Christianism, Judaism, Buddhism and others. In the modern business world, the concept of governance has been put in the context of business management, thus corporate management and control and to end up with nowadays highly used business word “Corporate Governance”

Corporate Governance is not a new issue. It has an ancient touch, since the formation of companies. The need for corporate governance arises because of the separation of management and ownership in modern Corporation. In practice, the interest of those who have effective control over a firm can differ from those interests of the suppliers of external finance. The ‘principal-agent’ problem is reflected in management pursuing activities which may be detrimental to the interest of the shareholders and this problem can be mitigated through the protections derived from good corporate governance.

0’Donovan (2003) defines corporate governance as “an internal system encompassing policies, processes and people, which serves the needs of shareholders and other stakeholders, by directing and controlling management activities with good business savvy, objectivity and integrity. Sound corporate governance is reliant on external market place commitment and legislation, plus a healthy board culture which safeguards policies and processes.”

O’Donovan (2003) put forward that “the perceived quality of a company’s corporate governance can influence its share price as well as the cost of raising capital. Quality is determined by the financial markets, legislation and other external market forces plus the international organisational environment; how policies and processes are implemented and how people are led. External forces are, to a large extent, outside the circle of control of any board. The internal environment is quite a different matter, and offers companies the opportunity to differentiate from competitors through their board culture. To date, too much of corporate governance debate has centered on legislative policy, to deter fraudulent activities and transparency policy which misleads executives to treat the symptoms and not the cause.”

Taking a finance point of view, Shleifer and Vishny (1997) define corporate governance as dealing with “the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment”.

Kakabadse, Kakabadse and Kouzmin (2001) put forward that following on a survey which reads “Board Governance and Company Performance: Any Correlations?”, carried out by McKinsey and Company who referred to Agrawal et al., (1996), it was clearly noticed that investors willing to pursue a growth strategy and subsequently invested in low valued or table companies were willing to pay for good governance. These investors assumed that a company with good corporate governance will have a better financial performance over a time lag and/or that good corporate governance can ultimately reduce the risks associated and attract further investments.

Kakabadse, Kakabadse and Kouzmin (2001) further put forward that though there are substantial research that creates the relationship between corporate governance to company performance, there are equally a growing range of results with different interpretations. The wide range of results can be explained because of the variability of different companies concerning their board structures, attitude towards risk, NEDs participation and others. According to Kakabadse, Kakabadse and Kouzmin (2001), there have been studies done by Zahra and Pearce (1989), Jonnegard and Svensson (1995) and Maassen (1999) based on the integrative models of board involvement, incorporating different theoretical perspectives and various board attributes, suggesting that corporate governance has, at least, an indirect effect on company performance.

Taking again a finance point of view, Mathiesen (2002) defines “Corporate Governance is a filed in economics that investigates how to secure or motivate efficient management of corporations by the use of incentive mechanisms such as contracts, organisational designs and legislations. This is often limited to the question of improving financial performance, for example how the corporate owners can secure and motivate corporate managers to deliver a competitive rate of return”.

Taking an integrated approach of the issue, Sir Adrian Cadbury documents that corporate governance is concerned with holding the balance between economic and social goals and between individual and communal goals. The aim is to align as nearly as possible the interests of individuals, corporations and society. It also encompasses the setting up of an appropriate lawful structure, economical and institutional environment that allows companies to thrive as institutions for enhancing corporate competitiveness. Advancing long term shareholder value, and maximising human-centered development while remaining conscious of other responsibilities to stakeholders, the environment and the society in general.

Good Corporate Governance

Good corporate governance entails the pursuit of objectives by the board and management that represent the interests of a company and its shareholders including effective monitoring and efficient use of resources. It is influenced by a number of factors, primarily the nature of the overall institutional and legal framework that has been established by governments to effect such good governance.

Good Corporate Governance is important at different levels. At the company level, well governed companies tend to have better and cheaper access to capital and tend to outperform their poorly governed peers over the long term. Shleifer and Vishny (1997) suggest that good corporate governance increases the efficiency of capital allocation within and across firms. It also reduces the cost of capital for issuers, helps to broaden access to capital, reduces vulnerability to crises, fosters savings provisions, and renders corruption more difficult.

Likely, those companies that insist upon the highest standards of governance are aiming at reducing many of the risks inherent to an investment in an company. Black, Jang, and Kim (2003) supported in their in findings that companies, which actively promote robust corporate governance practices ultimately attract more investors who are willing to provide capital at a lower cost.

More generally, well governed companies are better contributors to the national economy and society. They tend to be healthier companies that add more value to shareholders wealth, workers, communities and countries in contrast to poorly governed countries that may result in job losses, the loss of pensions, and even demoralize confidence in securities market. These good governance practices enable corporations to use their capital efficiently, maintain the confidence of investors and attract more patient long term capital. In accordance with OECD (1999) corporate governance enhances strategic focus, builds market confidence and community support, and is an important source of corporate competitive advantage.

Hence, the state of corporate governance in an economy is likely to be connected with the state of economic and political governance of that given country. Kaufmann (2003) argues that poor governance of financial institutions increases the liabilities of the financial system. They have distorting effect on public institution, deter foreign direct investment and can lead to future financial crisis.

Theories relevant to corporate governance

The theories of corporate governance comprise of:

Shareholding Perspectives

Stakeholding Perspectives

Stewardship theory

Shareholding Perspectives

There are two main theories that explain the shareholder approach governance:

The Separation of ownership and control- origin of the Agency theory

The myopic market model

The Separation of ownership and control- origin of the Agency theory

Berle & Means (1932) described a fundamental agency problem in modern firms where there is a separation of ownership and control. Jensen & Meckling (1976) further define agency relationship and identify agency costs. Agency relationship is a contract under which “One or more persons (principal) engage another person (agent) to perform some service on their behalf, which involves delegating some decision making authority to the agent”.

Deegan (2000) refers to the agency relationship to the delegation of decision making from the principal to the agent or mangers. The conflict of interests between managers or controlling shareholder, outside or minority shareholder refer to the tendency that the former may extract “perquisites” (or perks) out of a firm’s resources and be less interested to pursue new profitable ventures that will increase shareholders wealth. This leads to potential loss in efficiency of generating profits as mangers. Act in their self interests.

Therefore, the share price that shareholders (principal) pay often reflects such agency costs. To increase firm value, one must therefore reduce agency costs. This is one way to view the linkage between corporate governance and corporate competitiveness therefore reduce agency costs. This is one way to view the linkage between corporate governance and corporate competitiveness by improving corporate financial and overall performance.

Letza, Kirkbride, Sun and Smallman (2008) mentioned that two problem occurring out of the agency theory are that it is very difficult to monitor what the agent is doing and the second problem is that the principal and the agent may share different actions because of the different attitudes to risk horizons.

Myopic Market Model

Letza, Kirkbride, Sun and Smallman (2008) made reference to the work of Hayes and Abernathy (1980), which shared a common view with the principal agent model and that corporations should serve the shareholders’ interests only, but criticises that the Anglo-American model of corporate governance because of “competitive myopia” and its consequent pre occupation with short term gains in return, profit and stock price. The Myopic model argues that what is wrong with corporate governance is that the system encourages mangers to focus on short term performance by sacrificing long term value and corporate competitiveness of the corporation.

Financial markets often force managers to behave in a divergent way from the maximisation of long term wealth for shareholders. It was further argued that the myopic market model contends that corporate governance reform should provide an environment in which shareholders and mangers are encouraged to share long term performance horizons.

Stakeholding Perspectives

Stakeholder model

Stakeholder Model

The firm is not a standalone entity. It has stakeholders to which it is accountable and which in turn work towards its prosperity. The interdependence between a firm and its strategic shareholders is recognized by Clarkson (1994), who states that “The firm is a system of stakeholders operating within the larger system of the host society that provides the necessary legal and market infrastructure for the firm’s activities. The purpose of the firm is to create wealth or value for its stakeholders by converting their stakes into goods and services”.

The main components proponents of the stakeholder theory for the provision of ‘voice’ and ‘ownership-like incentives’ to strategic stakeholders that are intended to share the control of the firm between investors and stakeholders through a compound board so as to reduce conflicts of interest and agency costs.

Stewardship Theory

The stakeholder theory was put forward by Donalsdon (1990), a management scholar. In this model, “managers are good stewards of the corporations and diligently work to attain high levels of corporate profit and shareholders returns” (Donaldson & Davis, 1994). The authors argue that mangers are inspired by non economic factors and given the needs of managers for responsible, self directed work, organisations may be better served to free mangers from subservience to NED dominated board.

However, supporters of the stewardship model are basically those individuals who contribute their own funds and other resources to non profit organisations to become a director. It is interesting to note that both agency theory and the stewardship theories are contradictory theories, in the sense that the former views the manager as the self seeking agent whereas the latter views the manager as the god steward.

Why has Corporate Governance become so prominent today?

The East Asian Crisis of 1997 severely affected foreign capital after property assets collapsed The second event was in 2001-2002which saw the collapse of two big corporations namely Enron and WorldCom and the ensuing scandals and collapses like Arthur Andersen, Global Crossing and Tyco.

Becht et al. (2002) documents that the world wide wave of privatization of the past two decades, the pension reform and the growth of private savings, the takeover wave of the 1980s, the deregulation and integration of capital markets and recent corporate scandals have lead to corporate governance gaining momentum.

Yoshikawa & Phan (2001) note intensifying global competition and rapid technological changes force firms to focus on maximising asset efficiency and shareholder value if they want to access funds to fuel growth opportunities. These technological advances reduce transaction costs and information research costs rendering capital markets more accessible to investors. This has fuelled global competition between capital markets and evolution of corporate governance around the world.

Benefits of good corporate governance

Earnings confidence of shareholders

Firstly when good corporate governance is fully implemented, it ensures that large