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Introduction to Corporate Governance

Intended Learning Outcome

• Understand the concept of governance

• Know the various models of corporate governance
• Categorize the theories affecting corporate governance development
Introduction
The concept of "governance" is not new. However, it means different things to different
people, therefore we must get our focus right. The actual meaning of the concept depends on the
level of governance we are talking about, the goals to be achieved and the approach being followed.
The concept has been around in both political and academic discourse for a long time,
referring in a generic sense to the task of running a government, or any other appropriate entity for
that matter. In this regard the general definition provided by Webster's Third New International
Dictionary (1986:982) is of some assistance, indicating only that governance is a synonym for
government, or "the act or process of governing, specifically authoritative direction and control".
This interpretation specifically focuses on the effectiveness of the executive branch of government.
The working definition used by the British Council, however, emphasizes that
"governance" is a broader notion than government (and for that matter also related concepts like
the state, good government and regime), and goes on to state: "Governance involves interaction
between the formal institutions and those in civil society. Governance refers to a process whereby
elements in society wield power, authority and influence and enact policies and decisions
concerning public life and social upliftment."

Figure 1. Urban Actors

"Governance", therefore, not only encompasses but transcends the collective meaning of
related concepts like the state, government, regime, and good government. Many of the elements
and principles underlying "good government" have become an integral part of the meaning of
"governance". John Healey and Mark Robinson define "good government" as follows: "It implies
a high level of organizational effectiveness in relation to policy-formulation and the policies
actually pursued, especially in the conduct of economic policy and its contribution to growth,
stability and popular welfare. Good government also implies accountability, transparency,
participation, openness, and the rule of law. It does not necessarily presuppose a value judgement,
for example, a healthy respect for civil and political liberties, although good government tends to
be a prerequisite for political legitimacy".
Governance can be used in several contexts such as corporate governance, international
governance, national governance, and local governance. Since governance is the process of
decision making and the process by which decisions are implemented, an analysis of governance
focuses on the formal and informal actors involved in decision-making and implementing the
decisions made and the formal and informal structures that have been set in place to arrive at and
implement the decision.
Government is one of the actors in governance. Other actors involved in governance vary
depending on the level of government that is under discussion. In rural areas, for example, other
actors may include influential landlords, associations of peasant farmers, cooperatives, NGOs,
research institutes, religious leaders, finance institutions political parties, the military etc. The
situation in urban areas is much more complex. Figure 1 provides the interconnections between
actors involved in urban governance. At the national level, in addition to the above actors, media,
lobbyists, international donors, multi-national corporations, etc. may play a role in decision
making or in influencing the decision-making process.
Characteristics of Good Governance
Good governance is responsive to the present and future needs of the organization,
exercises prudence in policy-setting and decision-making, and that the best interests of all
stakeholders are considered. The following are the eight major characteristics of good governance:
1. Rule of Law
Good governance requires fair legal frameworks that are enforced by an impartial
regulatory body, for the full protection of stakeholders.
2. Transparency
Transparency means that information should be provided in easily understandable
forms and media; that it should be freely available and directly accessible to those who will
be affected by governance policies and practices, as well as the outcomes resulting
therefrom; and that any decisions taken and their enforcement are in compliance with
established rules and regulations.
3. Responsiveness
Good governance requires that organizations and their processes are designed to
serve the best interests of stakeholders within a reasonable timeframe.
4. Consensus Oriented
Good governance requires consultation to understand the different interests of
stakeholders to reach a broad consensus of what is in the best interest of the entire
stakeholder group and how this can be achieved in a sustainable and prudent manner.
5. Equity and Inclusiveness
The organization that provides the opportunity for its stakeholders to maintain,
enhance, or generally improve their well-being provides the most compelling message
regarding its reason for existence and value to society.
6. Effectiveness and Efficiency
Good governance means that the processes implemented by the organization to
produce favorable results meet the needs of its stakeholders, while making the best use of
resources – human, technological, financial, natural and environmental – at its disposal.
7. Accountability
Accountability is a key tenet of good governance. Who is accountable for what
should be documented in policy statements? In general, an organization is accountable to
those who will be affected by its decisions or actions as well as the applicable rules of law.
 8. Participation
Participation by both men and women, either directly or through legitimate
representatives, is a key cornerstone of good governance. Participation needs to be
informed and organized, including freedom of expression and assiduous concern for the
best interests of the organization and society in general.
Good governance is an ideal which is difficult to achieve in its totality. Governance
typically involves well-intentioned people who bring their ideas, experiences, preferences and
other human strengths and shortcomings to the policy-making table. Good governance is achieved
through an on-going discourse that attempts to capture all the considerations involved in assuring
that stakeholder interests are addressed and reflected in policy initiatives.
Corporate Governance
From the academic standpoint, corporate governance is seen as one that addresses “the
problems that result from the separation of ownership and control.” Viewed from this perspective,
corporate governance focusses on some structures and mechanisms that would ensure a proper
internal structure and the rules of the board of directors; the creation of independent committees;
the rules for disclosure of information to shareholders and creditors; a transparency of operations
and an impeccable process of decision-making and the control of management.
A recent academic survey of corporate governance defined it as follows: “Corporate
governance deals with the ways in which suppliers of finance to corporations assure themselves of
getting a return for their investment. How do the suppliers of finance get the managers to return
some of the profits to them? How do they make sure that the managers do not steal the capital they
supply or invest it in bad projects? How do suppliers of finance control the managers?”
From this point of view, the corporate governance tends to focus on a simple model:
1. Shareholders elect directors who represent them. – Participation, Equity and
Inclusiveness
2. Directors vote on key matters and adopt the majority decision. - Consensus
3. Decisions are made in a transparent manner so that the shareholders and others can hold
directors accountable. – Transparency and Accountability
4. The company adopts the accounting standards to generate the information necessary for
directors, investors, and other stakeholders to make decisions. – Effectivity and
Efficiency
5. The company’s policies and practices adhere to applicable national, state, and local laws.
– Rule of Law, Resposiveness
A McKinsey & Company Report published in 2001 under the title “Giving New Life to
the Corporate Governance Reform Agenda for Emerging Markets” suggests that by using a two-
version “governance” chain model, we can illustrate the governance practices throughout the
world.
Model 1
In the first version of McKinsey’s model called “The Market Model” governance chain,
there are efficient, well-developed equity markets and dispersed ownership, something common
in the developed industrial nations such as the US, the UK, Canada and Australia. Corporate
governance is basically how companies deal fairly with problems that arise from “separation of
ownership and effective control.” This model illustrates conditions and governance practices that
are better understood and appreciated and as such highly valued by sophisticated global investors.
 Figure 1.2 The “Market Model” governance Chain

Model 2
In the second version of McKinsey’s model called “The Control Model,” governance chain
is represented by underdeveloped equity markets, concentrated(family) ownership, less
shareholder transparency and inadequate protection of minority and foreign shareholders, a
paradigm more familiar in Asia, Latin America and some east European nations. In such
transitional and developing economies there is a need to build, nurture and grow supporting
institutions such as a strong and efficient capital market regulator and judiciary to enforce contracts
or protect property rights.

Figure 1.3 The “Control Model” Governance Chain

Theories of Corporate Governance

Though the concept of modern corporate governance is of recent origin, it was deeply
rooted in the corporate history from the days the corporate form of business establishments began.
As this form of business passed through several stages of its growth to the present form, corporate
governance also passed through different stages to reach the present form. The subject of corporate
governance is based on strong theoretical foundation derived from several disciplines as finance,
economic, accounting, management, law, organizational behavior, etc. As such it is
multidisciplinary in nature. It can be observed that though legally corporate form of business has
unidimensional characteristics all over the world now, the governance system prevailing in
different countries are multi-dimensional in nature.
Theoretical base upon which the corporate governance has been developed plays a
significant role in the type of corporate governance in a country. Economic system, political
system and governance, path dependency, resource dependency and institutional environment also
play a dominant role in corporate governance.
Table 1.1 Summary of theories affecting corporate governance development

Agency Theory
Agency theory identifies the agency relationship where one party (the principal) delegates
work to another party (the agent). In the context of corporations and issues of corporate control,
agency theory views corporate governance mechanisms, especially the board of directors, as being
an essential monitoring device to try to ensure that any problems that may be brought about by the
principal–agent relationship are minimized. Blair (1996) states:
Managers are supposed to be the ‘agents’ of a corporation’s ‘owners’, but
managers must be monitored, and institutional arrangements must provide
some checks and balances to make sure they do not abuse their power. The
costs resulting from managers misusing their position, as well as the costs
of monitoring and disciplining them to try to prevent abuse, have been
called ‘agency costs’.
Much of agency theory as related to corporations is set in the context of the separation of
ownership and control as described in the work of Berle and Means (1932). In this perspective, the
agents are the managers and the principals are the shareholders, and this is the most cited agency
relationship in the corporate governance context. However, it is useful to be aware that the agency
relationship can also cover various other relationships, including those of company and creditor,
and of employer and employee.
Separation of Ownership and Control
The potential problems of the separation of ownership and control were identified in the
eighteenth century by Smith: ‘the directors of such companies [joint stock companies] however
being the managers rather of other people’s money than of their own, it cannot well be expected
that they should watch over it with the same anxious vigilance [as if it were their own]’. However,
in many countries, especially where there is a code of civil law as opposed to common law, the
protection of minority shareholders is not effective and so there has been less impetus for a broad
shareholder base.
In the last few years, there has been increasing pressure on shareholders, and particularly
on institutional shareholders who own shares on behalf of the ‘man in the street’, to act more as
owners and not just as holders of shares. The drive for more effective shareholders, who act as
owners, has come about because there have been numerous instances of corporate excesses and
abuses, such as perceived overpayment of directors for poor performance, corporate collapses, and
scandals, which have resulted in corporate pension funds being wiped out, and shareholders losing
their investment. The call for improved transparency and disclosure, embodied in corporate
governance codes and in International Accounting Standards (IASs), should improve the
information asymmetry situation so that investors are better informed about the company’s
activities and strategies.
Once shareholders do begin to act like owners again, then they will be able to exercise a
more direct influence on companies and their boards, so that boards will be more accountable for
their actions and, in that sense, the power of ownership will be returned to the owners (the
shareholders). However, that institutional investors will ultimately become accountable to the
millions of ultimate owners who may come to question the policies of the new powers that be.
Then the questions may expand from whether the professional money managers are achieving
maximum private return to whether they are fostering maximum public good. Their demands for
downsizing and single-minded focus on shareholder benefits—whatever the costs—may come to
constitute a new target of ownership challenge (Useem, 1996).
Transaction Cost Economics (TCE)
Unlike the Agency Theory, the transaction cost theory explicitly uses the concept of
corporate governance. This theory states that the company is a relatively efficient hierarchical
structure that serves as framework to run the contractual relationships. The main concern in
transaction cost theory is to explain the transactions conducted in terms of efficiency of governance
structures. This theory was first initiated by Cyert and March (1963) and later it was described and
exposed by Williamson (1996). The Transaction cost theory was interdisciplinary in nature
covering the disciplines of law, economics and organizations. This theory attempts to view the
firm as an organization comprising people with different views and objectives.
TCE views the firm as a governance structure whereas agency theory views the firm as a
nexus of contracts. Essentially, the latter means that there is a connected group or series of
contracts amongst the various players, arising because it is seemingly impossible to have a contract
that perfectly aligns the interests of principal and agent in a corporate control situation.
As firms have grown in size, whether caused by the desire to achieve economies of scale,
by technological advances, or by the fact that natural monopolies have evolved, they have
increasingly required more capital, which has needed to be raised from the capital markets and a
wider shareholder base has been established. The problems of the separation of ownership and
control, and the resultant corporate governance issues have thus arisen.
In other words, there are certain economic benefits to the firm itself to undertake
transactions internally rather than externally. In its turn, a firm becomes larger the more
transactions it undertakes and will expand up to the point where it becomes cheaper or more
efficient for the transaction to be undertaken externally. Coase (1937) therefore posits that firms
may become less efficient the larger they become; equally, he states that ‘all changes which
improve managerial technique will tend to increase the size of the firm’.
Stiles and Taylor (2001) point out that ‘both theories [TCE and agency] are concerned with
managerial discretion, and both assume that managers are given to opportunism (self-interest
seeking) and moral hazard, and that managers operate under bounded rationality . . . [and] both
agency theory and TCE regard the board of directors as an instrument of control’. In this context,
‘bounded rationality’ means that managers will tend to satisfice rather than maximize profit (this,
of course, not being in the best interests of shareholders).
Stakeholder Theory
Stakeholder theory takes account of a wider group of constituents rather than focusing on
shareholders. A consequence of focusing on shareholders is that the maintenance or enhancement
of shareholder value is paramount, whereas when a wider stakeholder group—such as employees,
providers of credit, customers, suppliers, government, and the local community—is taken into
account, the overriding focus on shareholder value becomes less self-evident. Nonetheless, many
companies do strive to maximize shareholder value whilst at the same time trying to take into
account the interests of the wider stakeholder group. One rationale for effectively privileging
shareholders over other stakeholders is that they are the recipients of the residual free cash flow
(being the profits remaining once other stakeholders, such as loan creditors, have been paid). This
means that the shareholders have a vested interest in trying to ensure that resources are used to
maximum effect, which in turn should be to the benefit of society.
The theory is grounded in many normative theoretical perspectives including the ethics of
care, the ethics of fiduciary relationships, social contract theory, theory of property rights, theory
of the stakeholders as investors, communitarian ethics, critical theory, etc. While it is possible to
develop stakeholder analysis from a variety of theoretical perspectives, in practice much of
stakeholder analysis does not firmly or explicitly root itself in a given theoretical tradition, but
rather operates at the level of individual principles and norms for which it provides little formal
justification. Insofar as stakeholder approaches uphold responsibilities to non-shareholder groups,
they tend to be in some tension with the Anglo-American model of corporate governance, which
generally emphasizes the primacy of “fiduciary obligations” owed to shareholders over any
stakeholder claims.
An interesting development is that put forward by Jensen (2001), who states that traditional
stakeholder theory argues that the managers of a firm should take account of the interests of all
stakeholders in a firm but, because the theorists refuse to say how the trade-offs against the interests
of each of these stakeholder groups might be made, there are no defined measurable objectives and
this leaves managers unaccountable for their actions. Jensen therefore advocates enlightened value
maximization, which he says is identical to enlightened stakeholder theory: ‘Enlightened value
maximization utilizes much of the structure of stakeholder theory but accepts maximization of the
long-run value of the firm as the criterion for making the requisite trade-offs among its stakeholders
and therefore solves the problems that arise from multiple objectives that accompany traditional
stakeholder theory’.
Managers accomplish their organizational tasks as efficiently as possible by drawing on
stakeholders as a resource. This is in effect a “contract” between the two, and one that must be
equitable for both parties to benefit.
Stewardship Theory
The Stewardship Theory of corporate governance discounts the possible conflicts between
corporate management and owners and shows a preference for a board of directors made up
primarily of corporate insiders. This theory assumes that managers are basically trustworthy and
attach significant value to their own personal reputations. The market for managers with strong
personal reputations serves as the primary mechanism to control behavior, with more reputable
managers being offered higher compensation packages. Financial reporting, disclosure and
auditing are still important mechanisms, but there is a fundamental presumption that these
mechanisms are needed to confirm managements’ inherent trustworthiness.
This emphasis on the responsibility of the board to shareholders in the Anglo– Saxon model
of corporate governance in terms of stewardship and trusteeship is nowhere better articulated than
in the Canadian guidelines. It is stated therein: “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.” Similar views, though differently told, predominate in corporate governance
guidelines of many countries of the world.
Though the Agency and the Stewardship Theories have something in common, there are
certain basic differences. The tables set out below summarizes the main differences between the
two theories.

Table 1.2 Behavioral Differences

Table 1.3 Phycological Means

 Table 1.4 Situational Mechanism

**Table 1.2 – 1.4 is adapted from “Development of Corporate Governance System: Agency Theory Versus
Stewardship Theory in Welsh Agrarian Cooperative Societies” by, Dr. Alfonso Vargas Sanchez.

Other Corporate Governance Theories

Managerial hegemony and class hegemony theories highlight the potential for a gap
between what boards are expected to do and what they do in practice. Mace (1971)
points out that managers may circumvent control away from the board by various
means, including information asymmetry and elite networks. Huse (2007) made a
significant contribution to the thinking on how research into boards and board
behavior might be carried out by applying lessons from the behavioral theory of the
firm.
Resource dependence theory views the board of directors as ‘the lynch pin between a
company and the resources it needs to achieve its objectives’ (Tricker, 2009, 2012).
Path dependence theory identifies two sources of path dependence: structure driven and
rule driven, pointing out that corporate structures depend on the structures with
which the economy started: ‘Initial ownership structures can affect both the identity
of the rules that would be efficient and the interest group politics that can determine
which rules would actually be chosen’ (Bebchuk and Roe, 1999).
Institutional theory looks at the institutional environment, its influence on societal beliefs
and practices which impact on various ‘actors’ within society (Scott, 1987).
Political theory is identified as having a deep influence on different ownership and
governance structures (Roe, 2003).
Network governance building on the work of Jones et al. (1997), Turnbull advocated the
adoption of network governance as a logical way to extend the science of
cybernetics to organizations. Pirson and Turnbull (2011) argue that companies
should have a structure of network governance and suggest ‘increasing board level
information processing and decision making capabilities by including multiple
boards for different stakeholders to create a division of power and labor’ which
would allow superior risk management.
Module Test
1. What do you understand by the term governance? While explaining the concept of
governance, enumerate and briefly discuss the different characteristics of good governance.
2. Differentiate the market model and control model.
3. Critically discuss the main theories that have influenced the development of corporate
governance.
4. Cite business situation examples with regards to the different theories of corporate
governance.