History and Principles of Corporate Governance

 

Introduction to literature review:

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 1990s. The reports are as follows:

Report Title and year published

Author name

Report facts, main arguments, recommendations

Cadbury Report (1992)

Sir Adrian Cadbury

The report was part of the Committee on the Financial Aspects of Corporate Governance. There was no statutory obligation of the code, but the London Stock Exchange (LSE) required all listed companies to include a statement of compliance with the code in their annual report.

Myners Report (1995)

Paul Myners

Various recommendations were made concerning the relationship between institutional shareholders and company managements, including communications.

Greenbury Report (1995)

Greenbury

Remuneration committees should be made up Non Executive Directors (NEDs) to make decisions on senior executive pay.

Bonuses for directors should be linked to satisfactory performance criteria.

More transparency in remuneration.

These recommendations were accepted by the LSE and were incorporated into the listing rules.

Hampel Committee (1998)

Sir Ronald Hanpel

The committee was chaired in 1995 and led in due course to the publication in 1998 of the Combined Code on Good Governance. The report laid emphasis on director’s remuneration, relations with shareholders, accountability and audit. The code was divide into two main parts, namely best practices for companies and best practice for institutional investors.

Higgs’ Report (2002)

Derek Higgs

The report envisaged a more demanding and significant role for NEDs and focused on the effectiveness on NEDs in promoting company performance and accountability

An international History of Corporate Governance.

Efforts to improve corporate governance in various countries have resulted in series of reports, legislative measures and codes of conducts. Coyle (2007) mentioned that the need for good corporate governance is a matter of international concern. In developing countries the drive for corporate governance arose out of the need to provide sound governance and institutional practices so as to attract FDI. In develop countries, the impetus was on the quality of reporting and reduce the executive abuses.

The OECD Principles of Corporate Governance

Published in 1999 and subsequently revised in 2004, the OECD principles are to help governments especially those in developing countries to improve their legal, regulatory and institutional frameworks for corporate governance in their respective countries. The six main principles of the OECD are:

• Ensuring the basis for an effective corporate governance framework
• Protecting and facilitating the exercise of shareholder rights
• Ensuring the equitable treatment of all shareholders
• Recognising the rights of shareholders as established by law
• Ensuring timely and accurate disclosure on all material information for the corporation
• Enhancing the mechanism for the board’s accountability to the company and the shareholders while ensuring the effective monitoring of the management by the board

These principles are not compulsory requirements but are intended to provide countries with adequate guidelines in the implementation of good governance practices.

Commonwealth Association for Corporate Governance (CACG)

CACG was established in April 1998 in response to the Edinburgh Declaration of the Commonwealth Heads of Government meeting in 1997 to promote excellence in corporate governance in the Commonwealth. The CACG has two main objectives:

• To promote good standards in corporate governance and business practice throughout commonwealth.
• To facilitate the development of appropriate institutions which will be able to advance, teach and disseminate such standards.

Principles for Corporate Governance: Towards global competiveness and economic accountability (1999) produced various guidelines concerning corporate governance practices.

Corporate Governance in the European Union

In May 2003, the EU commission presented a communication entitled: “Modernising Company Law and Enhancing Corporate Governance in the European Union – A Plan to Move Forward”. The main reasons for this statement were mainly because of recent corporate scandals and to harmonise the rules for creating a Single European Market. The action plan consisted of six headings:

• Corporate Governance
• Capital Maintenance and Health
• Groups and pyramids
• Corporate Restructuring and mobility
• The European Private Company
• Cooperatives and other forms of enterprises.

The King Report (South Africa)

The second King Report on Corporate Governance for South Africa (2002) promotes the concept that companies especially in developing countries should take into account the interests of the communities in which they operate while distinguishing between accountability and responsibility. The report stressed that boards must apply tests of accountability, fairness, transparency and be responsible towards the company’s identified stakeholders. Mervyn King’s approach might be said to meld corporate governance and corporate social responsibility.

The Sarbanes Oxley Act (SOX) 2002 (United States)

The need for greater investor protection especially after various corporate scandals starting with Enron has been one of the main thrusts of “Sarbanes-Oxley”. The official name of SOX is the Public Company Accounting Reform and Investor Protection Act of 2002. The SOX covers issues such as:

• Establishing a public company accounting oversight board
• Auditor Independence
• Corporate Responsibility
• Greater Financial Disclosure

Definition of Corporate Governance according to Various Writers.

“Corporate Governance is the system by which companies are directed and controlled.” Cadbury Report (1992).

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 mechanism encompassing processes, policies and people who works for the benefit of stakeholders and shareholders by coordinating sound management practices with integrity and business knowledge which will ultimately lead to a healthy board structure and hence creating a sound corporate structure within the organisation.

O’Donovan (2003) put forward that a firm implementing good corporate governance practices this can influence its share price as well as the amount of cost required in raising capital determined various external market forces, the financial markets, legislations and global environment. External forces are beyond the control of the board and the board find its difficult to handle external pressures and forces. Corporate governance is now being enthralled in various legislations for the sake of transparency from the part of corporate in order to avoid corporate malpractices.

Taking a finance point of view, Shleifer and Vishny (1997) define corporate governance as dealing with the various ways in which finance provider assure themselves of getting an appropriate rate of return on their respective amount of 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) put forwards that corporate governance is an important field in economics that tries to investigate about how to secure a well developed board management and firm management by using incentive internal mechanisms and legislation. This is basically restrained to the issue of improving financial performance, for example how corporate owners can motivate corporate managers to increase the competitiveness of the firm.

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-centred 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 defined when a principal appoints an agent to undertake a specific task. The relationship is recognised under the law of agency. There is an inherent conflict of interest between managers and shareholders. If managers are to act in the best interest of owners, the managers must be monitored and rewarded with appropriate incentives.

Deegan (2000) refers to the agency relationship to the delegation of decision making from the principal to the agent or managers. 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 managers. 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 managers 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 managers are encouraged to share long term performance horizons.

Stakeholding Perspectives

Stakeholder model

Abuse of Executive Power 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 forwarded the idea that the firm operates on a larger environment including the legal and market structure. The main aim of the firm is to create added value wealth for its stakeholders by converting their involvement into final goods and services.

Letza, Kirkbridge, Sun and Smallman (2008) in Freeman (1984) argued that the aim of corporate governance is to maximise wealth creation of the corporation as a whole by taking into account the interests of various groups in the society to which the corporation has an interest either direct or indirect.

The efficiency of this stakeholder approach draws on Japan and Germany as examples of successful industrial societies in which stakeholders are given importance while setting corporate goals so as to maximise the interests of the various groups of stakeholders.

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.

The Abuse of Executive Power Model

Letza, Kirkbridge, Sun and Smallman (2008) referred to Hutton (1995) and mentioned that the current American corporate governance procedures are in the hands of senior management who may abuse it to serve their own interest instead of shareholders and stakeholders. It was put forward that in Keasey et al., (1997) referred by Letza, Kirkbridge, Sun and Smallman (2008) as Incentive Mechanisms such as share options are a means to reduce corporate malpractices. That is to align more closely the interests of the managers and the shareholders through payment to managers partly with cash and share options. This gives the managers a powerful incentive to act in the interests of the company by maximising shareholder value and stakeholding value. However some managers may indulge in some accounting irregularities in order to increase the value of their share potions.

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 managers are inspired by non economic factors and given the needs of managers for responsible, self directed work, organisations may be better served to free managers 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 corporations are well run institutions that have earned the confidence of investors and lenders. Donaldson (2003) found good corporate governance is important for increasing investor confidence and market liquidity. This process prevents corruption and management malpractices, while promoting fundamental values of a free market economy in a democratic society (CIPE, 2002).

However, CC Okeahalam et al (2003) asserted that countries that fail to establish acceptable standards of transparency and governance within bounds of good law will lose their international repute and will find increasingly difficult to attract foreign and institutional investment.

If a company adopts and implement good corporate governance practices, shareholders are retained and new investors are attracted. Institutional investors have indicated willingness to pay a premium for the shares of a well governed company.

Around the world, price earnings ratio are higher among companies with good disclosure. Hence good corporate governance is necessary in order to:

• Create competitive and efficient companies and business enterprises
• Attract both local and foreign investors guarantee them secure investment efficiently managed, within a transparent and accountable purposes.
• Enhance the accountability and performance of those entrusted to mange corporations.

Growth Effect

Growth is likely to be highest when capital is allocated to those financial institutions that use it optimally. A strong system of corporate governance equips investors with the information and confidence necessary for them to lend funds directly to companies. This applies equally to foreigners, who will become more willing to provide their savings to the country in particular to the corporate sector. Likewise, Mervyn King, the governance guru, has observed that foreign capital literally flows to places that “exude a perception of good governance”. As such, investment should increase, thereby boosting productivity and growth across the economy. In these different ways, good corporate governance can lead to higher economic growth.

Stability effect

In addition to the growth effect, strong corporate governance can reduce the likelihood of a domestic financial crisis, in which investors lose confidence in the assets which they own. On a broader view, recent research has found a relationship between the state of corporate governance in an economy and the severity of the crises that it suffers. Meesook et al., (2001).

Nonetheless, this link should not be over emphasizes. Some countries with good corporate governance have had crises. Other countries with poor corporate governance have avoided them. In his recent excellent survey of the state of corporate governance in India, Omkar Goswani argues that a transparent and well governed company makes good business sense.

Economic development effect

Corporate Governance has implications for economic development especially in helping to increase the flow of financial capital to firms in developing firms. Without efficient companies or business enterprise, a country will not create wealth or employment. Consequently, without investment, companies will stagnate and collapse. If business enterprises do not prosper, there will be no economic development; no employment, no taxes paid and invariably the country will not develop. As such, developing countries in particular, need well governed and managed business enterprises that can attract investments, create jobs and wealth and remain viable, sustainable and competitive in the global market place.

Moreover, results from an extensive study of corporate governance in emerging markets by CSLA Global Emerging Markets, released in April 2001 suggest good integrity and responsiveness to shareholders, competitive advantage and performance. Good corporate governance therefore becomes a prerequisite for national economic development and to operate competitively in a globalised world.

Determinants of good corporate governance

Discipline in modern corporations in induced by both internal and external factors.

The Internal Drivers

Internally, effective governance systems are reflected in a set of relationships among the key players in a corporation. Typically, these would be reflected in the companies act, auditing regulations of the company, securities laws and listing requirements of the Stock Exchanges. Internal arrangements differ accordingly to the ownership structure of the company. For a publicly owned company with dispersed ownership, the manner of selection board members is important.

The Role of the Board of directors

In simpler terms, a board is the link between shareholders and the company. As such, all companies should be headed by an effective board which can lead and control the company. A company’s board of directors prepares financial statements reflecting a true and fair view of the operations of the company during the financial year and takes steps to safeguard assets of the company to prevent and detect fraud.

Fama & Jensen (1983) view the board as the apex of internal decision control systems of organisations.

Functions of boards

The act of providing counsel and advice to management is a key element of the board’s function. Chatterjee and Harrison (2002) found that board of directors in and of itself can be a valuable resource to the firm. Similarly the Report on Corporate Governance for Mauritius (2003) stipulates that it is the board responsibility to provide effective corporate governance, performance and control affairs of the company.

Size of the Board of Directors

The board should have an appropriate balance of executives, non executives and independent directors. It is essential for the protection of shareholders’ interest that the board has some directors who are independent from the company and from any dominant shareholder. Having independent directors on the board will normally increase the level of corporate governance as shareholders will have more confidence on the board. Botha (2001) documents independent director presents a broad spectrum of stakeholders and appears to contribute to the success of well performing boards.

Regarding the size of the board, it may vary from industry to industry and corporation to corporation as in determining board size, directors should take into account the nature, size and complexity of the company as well as its stage of development. Large corporate usually have eight to sixteen members on their boards.

Mak and Yuanto (2003) echo the above findings in firms listed in Singapore and Malaysia when they found that firm valuation is highest when board has five directors, a number considered relatively small in those markets.

However, Faleye (2003) presents an interesting proposition. He argues that no “one hat fits al” and board leadership structure depends entirely on individual firm characteristics such as organisational complexity, availability of other controls over CEO authority, CEO reputation, and power.

External Auditors

Most listed companies sustain their own internal audit department but to check whether accounts have been prepared in a fair view, they appoint external auditors. The main objective of the external audit is to report on the financial statements prepared by the managers. The detection of fraud and errors are incidental to this main objective. The regulators’ reliance on external auditors is premised on the belief that the auditors are public spirited and will act on behalf of either the public or the state, and that they are independent of the management. To engender public confidence in the integrity of the external auditor, he must be skilful, careful, diligent, faithful and honest. Such an auditor bolsters the perception of corporate governance.

Internal Control and Risk Management

An internal control system comprises of control procedures and policies. Internal controls are devices that ensure, as far as possible the orderly and efficient conduct of business. Internal controls and risk management are closely linked because a company’s system of internal control has a key role in management of risks that are significant to the fulfilment of its business objectives. Sound internal practices ensure risks are managed and avoided through control mechanism which identify risk, monitor and mitigate them.

Communication and disclosure

Transparency is believed to be the keystone of good governance. Access to information provides the basis of accountability, performance assessment and attainment of strategic objectives. Information should be prepared and disclosed in accordance with high quality standards of accoutring and fi