UNIT 1 CORPORATE GOVERNANCE: AN Corporate Governance:

An Overview

OVERVIEW

Objectives

The main objectives of the unit are to:

● Introduce the concept of Corporate Governance and its relevance

● Understand the theories of Corporate Governance
● Describe the models of Corporate Governance
● Explain basic principles of corporate governance and its constituents

Structure

1.1 Introduction
1.2 Corporate Governance
1.3 Corporate Governance Theories
1.4 Models of Corporate Governance
1.5 Principles of Corporate Governance
1.6 Corporate Governance Challenges
1.7 Corporate Governance in Banking Sector
1.8 Effect of Good Corporate Governance
1.9 Summary
1.10 Self-Assessment Questions
1.11 References/ Further Readings

Annexure: The G20/OECD Principles of Corporate Governance

1.1 INTRODUCTION
Business organizations are of different types. Depending on the nature and
size of business and the requirements of the owners there are three broad
forms of business organization - individual, partnership and company.
Individual operates as sole proprietorship. These types of business owned by
an individual like doctors, lawyers or small shop keepers. The owner himself
has a direct control on the management of the company even though there are
managers and employees working under him. No major decisions are taken
for the business without his knowledge. The success and failure of the
business entirely depends on his or her managerial efficiency.

When two or more persons jointly run a business, it is called partnership.

More or less like sole proprietorship but here more than one owner work
together and share profit or loss together. Like sole proprietorship, the
management of the business is directly controlled by the partners. In some
7
Corporate cases, all partners participate in the management whereas in other cases, only C
Governance
a few partners participate in the management. They share their managerial
responsibility. While they are expected to work together for the success of
partnership, there is always a chance that some partners pursue personal
objective, which may not be good for the business. There is a scope for
conflict between partners on some of the decisions taken by the partners and
often many successful running partnerships either collapsed on account of
these conflicts or partners get separated.

As the size of the business increases, additional capital is required. The sole
proprietorship and partnership form of businesses are not suitable for raising
large capital. A company can raise sizable capital from a large number of
owners referred to as shareholders. But the shareholders are not in a position
to exercise effective control on the activities of the organization or company.
Millions of shareholders come together to form a corporation. i.e.large
company by making small investments which collectively becomes a large
capital fund. Another advantage is that the liability of each shareholder is
limited by the amount of shares they have bought. Since the number of
shareholders is large and their contribution is small, it is not possible or
practical for the shareholders to participate in the day-to-day management of
the business. It calls for a separate set of representatives to manage the
company and these professional managers take most of the important
decisions. The success or failure of the business depends on the efficiency of
these managers. In between the owners and business, corporate form of
business introduces a new entity called management. To overcome the
problems of this system and in order to protect the rights and interests of
stakeholders, the need for some mechanism was felt. It was because of this
necessity that the concept of corporate governance emerged and has taken a
prominent place world over for achieving the company’s objectives.

Activity 1

i) Find out the distribution pattern of shareholders of a few BSE 500

companies. Compare the shareholding pattern of Reliance Ltd with ITC
Ltd. Is there any difference and if so, why?

…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

ii) What advantages and problems do you foresee for owners in a company
compared to other forms of business organization?

…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
8
1.2 CORPORATE GOVERNANCE Corporate Governance:
An Overview

“Corporate Governance is the system by which business corporations are

directed and controlled. The Corporate Governance structure specifies the
distribution of rights and responsibilities among different participants in the
corporation, such as, the board, managers, shareholders and other
stakeholders, and spells out the rules and procedures for making decisions on
corporate affairs. By doing this, it also provides the structure through which
the company objectives are set, and the means of attaining those objectives
and monitoring performance”, as defined by OECD (2004). Corporate
Governance postulates set of principles and constructs a framework to assure
that a company is governed through democratic values of fairness,
accountability, responsibility, and transparency.

Wherever there is a governance issue, we can apply these four pillars of

corporate governance to check whether the governance is good or not good.
Governance arises when someone gives us responsibility and our action will
have an impact on those who have given us the responsibility. For those who
are married and having children, as a parent they have to perform good
governance in managing the family. They are assigned with the responsibility
of conducting the family in a way that brings good name to the family and
their children. They are accountable for the activities or decisions that they
take on the behalf of their family. Father and mother are expected to have
transparency between them and so with other family members. They are also
expected to take decision with fairness particularly when they have more than
one child.

Corporate governance attracts a great deal of public interest because of its

importance for economic health of company and the welfare of the society.
The company is expected to take into account the interest of all stakeholders.
Stakeholder includes shareholders, board, management, lenders, consumers,
suppliers, government and society. Each is responsible for their actions. The
Board is responsible to conduct the business in the best interest of
shareholders but also all stakeholders. Similarly, managers are responsible to
the stakeholders for their actions. For instance, they need to consider the
interests of consumers when they develop or manufacture products.
Accountability relates to taking ownership of the actions and their
consequence. Directors are accountable to shareholders for their decisions. If
directors take any wrong decision knowingly, there should be a system to
punish such directors and recover compensation for such decisions.

In conducting the affairs of the business, the Board and managers take
several decisions. Most of the decisions are taken without the knowledge of
owners /shareholders. The question is how to ensure that managers have
taken right decisions. If managers are required to provide more details about
the business, it is possible to judge their decisions. For example, if the
management decides to venture into a new product, can shareholders
9
Corporate determine whether such a move is good or bad. Nevertheless, if there is a C
Governance
requirement to show the performance of new product, the shareholders can
assess managerial decision of venturing into the new product. Transparency
and disclosure are critical to assess the accountability.

Fairness implies the company actions and decisions should be free from
biases, prejudice, corruption, and be impartial, accurate, and transparent.
Managers need to be fair among different stakeholders such as shareholders,
lenders, suppliers, consumers and society. There are occasions where there
may be conflict of interests between the stakeholders and managers but they
have to apply fairness in those situations. For example, how managers should
decide whether to invest in a pollution control equipment or to increase
production. Shareholders might feel that this expenditure is unwanted
whereas society would expect the company to improve the quality of
environment. Welfare schemes for the employees are another example where
the conflict arises between different stakeholders. Managers need to apply
fairness and examine how their actions effect each group of stakeholders
before taking decisions.

Thus, corporate governance attracts a good deal of public welfare and it is

related to balancing the relationship among stakeholders, directors, and the
management where the board of directors is responsible for the proper
governance of the firm to achieve the desired objectives within the
jurisdiction of laws and regulations. In other words, it is the process of
direction and control intended to ensure that management acts in the interest
of various stakeholders. e.g. customers, employees, shareholders, government
and society etc.

Activity 2

i) Gandhiji emphasized the need for trusteeship. Briefly state its relevance
in corporate governance.

…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
iii) Compare the Annual Report of a large company and another company
which is·1/5th of its size. Draw your observation on the quality of
transparency.
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
10
1.3 CORPORATE GOVERNANCE THEORIES Corporate Governance:
An Overview

This section aims to explain the different theories of corporate governance

namely, agency theory, stewardship theory, hegemony theory, principal cost
theory, resource dependence theory, social contract theory, legitimacy theory,
stakeholders theory and political theory.

Agency Theory

Agency theory was developed long back by Jensen and Meckling (1976). As
explained above that in corporation type of business form the owners are
separate from managers who are appointed by owners. This type of
relationship is called principal-agent relationship where owners are principals
and Board of Directors are agents. Humans are self-interested and do not
want to sacrifice their personal interests for others’ interests (Daily, Dalton,
& Cannella, 2003). Although agents are expected to take decisions for the
benefit of shareholders/owners but the theory says they indulge in decisions
or activities which are for the benefit of their self-interests. Due to the
separation of management from owners, managers take decisions which may
not maximize the shareholders’ wealth rather benefit the managers
themselves. This situation generates agency conflicts. To reduce the conflicts
between owners and managers, Independent Directors act as an important
monitoring device to reduce the problems generated due to principal-agent
relationship.

If owners are able to identify good directors who are truthful and honest, they
may not resort to activities that are not beneficial to their principal. But the
practical problem is choosing directors and senior managers who are ethical
and capable to run the company. Shareholders have the responsibility to take
every care in the appointment of their agents.

Traditionally, auditing was instituted to resolve the agency conflict. Auditors

are expected to work on behalf of owners and examine the conduct of
business run by the managers and submit the report. However, auditing is
restricted to financial accounting. Auditors would not question managerial
decisions like selection of particular supplier or product mix, which are
purely managerial discretion. Auditing can detect financial frauds but may
not be helpful to assess managerial efficiency. When there were large scale
failures of big companies in the U.S. and Europe, and auditors failed to be
effective, then the need for additional mechanism was felt to resolve the
conflict. That brought to limelight the importance of corporate governance
and gave birth to various corporate governance mechanisms such as emphasis
on independent directors, board committees, and greater disclosures.

Conflict of interest can be managed through stock option given to senior

managers where a part of the salary or incentive is given in the form of equity
shares of the company. Since a large part of the wealth of the senior
managers is then in the form of equity shares of the company, the future
11
Corporate value of their wealth directly depends on their efficiency. This way, the C
Governance
agents become owner reducing the scope for conflict.

Stewardship Theory

In contrast to Agency theory, stewardship theory presents a different model

of management and it advocates that managers are good stewards of the
company who will act in the best interest of the owners (Donaldson & Davis,
1991; Turnbull, 2000). The theory is developed using the fundamentals of
social psychology and focuses on the behaviour of executives. It has been
argued that the steward’s behaviour is pro-organizational and collectivist,
which has higher efficacy than individualistic self-serving behaviour. The
steward’s behaviour will take care of the interest of the organization and
seeks to attain the objectives of the organization (Davis, Schoorman, &
Donaldson, 1997). When organisation achieves success and shareholder
wealth is maximized, the utilities of steward’s are maximized too.

Hegemony Theory

The theory of Hegemony introduced by Italian Marxist Gramsci (1937) is

concerned with dominance of one group over another. It has two variations,
one is known as “Class Hegemony” and other one is “Managerial
Hegemony.” Theory of “Class Hegemony” says that Board of Directors
appoint other directors on boards who match with them in caliber and
similarly for better alignment as they think themselves as an “elite” or
“superior” group. For instance those from a premier engineering institute
would choose other directors with similar background. “Managerial
hegemony” theory explains that members of the corporate management due
to their expertise and knowledge of managing the day to day business
operations dominate the board and other directors lose control to some extent
and sometimes become only the certifying authority to the decisions taken by
the managers and CEO. Therefore, this theory exemplifies how managers due
to their professional knowledge and control on the information and other
resources have a great impact on crucial business decisions and can affect
key decisions in management’s favor (Mendis, 2012).

Principal Cost Theory

In contrast to agency theory which focuses only on the agency conflicts and
try minimising the agency costs, principal cost theory of corporate
governance says that a firm’s optimal corporate governance structure
minimises not only the agency costs rather total control costs which comprise
principal costs and agent costs. When owners control the business they tend
to make honest mistakes due to lack of knowledge, information, expertise or
because of conflicts, and due to which firm’s value gets affected. These are
known as principal costs, and when managers do the same these are known as
agent costs. Lack of competence and disloyal conduct of either owners or
managers are the reasons behind occurrence of principal costs and agent
12
costs. Competence costs arise due to lack of competence and conflict costs Corporate Governance:
An Overview
arise due to disloyal conduct.

We can say that there is a trade-off between principal costs and the agent
costs. Any change in the controlling mechanism changes the level of these
two costs. Principal cost theory therefore suggests that as the competence
costs and conflict costs are firm-specific, so the optimal allocation of the
control between owners and managers should also be firm-specific. One-size-
fits-all approach should not be followed while deciding the governance
structures of the firms rather firm can choose from a range of governance
structures depending on their suitability that allows control to owners with
varying degrees (Goshen & Squire, 2017)

Resource Dependency Theory

As per Resource Dependency Theory, boards of directors are used as an

important mechanism to manage the environmental uncertainty that can
affect the firm. The directors bring resources like skills, information,
suppliers, buyers, public policy decision makers, social groups and
legitimacy and all these resources reduce uncertainty (Gales &Kesner, 1994).
This network governance has the power to reduce transaction costs associated
with environmental interdependency (Hillman, Cannella, &Paetzold, 2000).
This theory advocates the appointment of directors to multiple boards so that
they gather information and build network for the benefit of the company
(Hillman et al., 2000).

Social Contract Theory

The social contract theory of corporate governance perceives society as a

string of social contracts between the society and its members (Gray, Owen
& Adams 1996). It has also been pointed out that firm owes a contractual
obligation to the society which is known as social responsibility (Donaldson
1983). Some authors have also developed an integrated social contract theory
which focuses upon ethical decision making in terms of microsocial and
macrosocial contracts (Donaldson and Dunfee, 1999).

Legitimacy Theory

Legitimacy theory too is based on the perception that a social contract exists
between any organisation and the society. Suchman (1995) has defined
legitimacy theory as a generalized presumption that an organisation’s actions
shall be desirable, proper, or appropriate from the point of view of norms,
values, and beliefs prevailing in the society. This gives legitimacy or
acceptance to the company.

Stakeholder theory

Stakeholder theory is an extension over the above mentioned two theories,

which says that stakeholders are valuable to the company and they should be
treated accordingly in the management of company affairs. This theory
13
Corporate disagrees with the shareholders’ primacy approach. According to this theory, C
Governance
the duty of managers in the companies is to create optimal value for all
stakeholders comprising shareholders, creditors, employees, regulators and
government etc. who are affected by a company’s decisions (Keay, 2011).

Political Theory

Political theory argues that political influence may affect the governance
within an organization as well. Laws adopted by a government has a
significant influence on corporate governance of companies of a country. For,
instance it can require a certain proportion of independent directors on the
board , thereby determining the level of board independence. In countries
such as India and China a large number of companies are significantly owned
by government. These companies face more direct political influence such as
fixing the price of the product of the company.

Activity 3

i) Take any five NSE listed companies. What is the remuneration of the
CEO? What percentage is it of profits of the company? What was the
percentage five years back? Is the pay package in the interest of the
shareholders?

…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

ii) List five major corporate scams in the last decade? What was the major
cause of each of these scams? Which theories does this remind you off?

…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

1.4 MODELS OF CORPORATE GOVERNANCE

Different countries have different regulations and corporate governance
models. The model implemented depends on the national socio-economic,
religious, cultural requirements. We can broadly classify the governance
models into the following categories - a) The Anglo-Saxon model, b) The
Continental European Model, c) The Japanese Model and d) Asian Family
Based Model.
14
A) Anglo-Saxon Model Corporate Governance:
An Overview
Under the Anglo-American Model of corporate governance, shareholders
rights are recognized and given importance. They have the right to elect all
members of the Board and the Board directs the management of the
company. Based on the shareholder theory of corporate governance, the
Anglo-Saxon model is widely used in the USA and the U.K and other
commonwealth countries. It is also known in literature like shareholder
model, outsider model, American model, Anglo-American model, equity-
based model, principal-agent model, outsider model and market-centric
model.

The distinctive features of this model is a unitary board model, in which all
directors participate in single board. There is a clear separation of ownership
and management. The Anglo Saxon model thus focuses on the principal-
agent relationship between managers and shareholders. It relies heavily on
independent directors to monitor management.

B) Continental European Model

Based on stakeholder theory, the Continental European model represents the

broader concept of the corporate governance system. This model is also
called the German Model as it originates from there. The German model is
based on the ideological difference between pure capitalism and moderate
capitalism. The ideological conflict is between owners and workers and the
issue of private ownership and public ownership. It is believed that workers
are one of the key stakeholders of a company and they should have a right to
participate in the management of the company. There has been increasing
pressure for employees to put their nominees in the Board and play an active
role in the management. Many European countries have passed legislations
providing workers' participation in the management of the company.

A two-tier or dual board is adopted in most of the corporations in continental

Europe like in Austria, Germany, Italy, Netherland, and so on. The Dual
board is based on two levels of the board named as Supervisory board and
Management board. The shareholders elect members of Supervisory Board.
Employees also elect their representatives for Supervisory Board but the
number of employees' representatives is generally between 1/3rd and 1/2 of
the Board. This ensures that employees and labourers also enjoy a share in
the governance. The Supervisory board appoints and monitors the
Management Board. The Supervisory Board has the right to dismiss the
Management Board and reconstitute the same. The supervisory board
includes the non-executive directors (shareholders, employees, etc.) who are
responsible for formulations of policies related to remuneration, appointment,
removal, and review, and supervising of members of the management board
and taking other major business decisions. Whereas, the management board
comprised of only executive directors, who supervise the day-to-day
operations of the firms.
15
Corporate C) Japanese Model C
Governance
Japanese companies raise significant part of the capital through banking and
other financial institutions. It is because after the World Wars, the US and
other countries started supporting for the revival of Japan. Banking
institutions have been strengthened and are encouraged to lend money for the
businesses. Since banks and other institutions stakes are very high in
businesses, they also work closely with the management of the company.
These institutional investors exercise direct participation or indirect control
on the Board. The shareholders and main banks together appoint Board of
Directors and the President. Lenders also exert a significant amount of
information from the companies to monitor their activities and also require
approval on important decisions. In India too, many banks have their
nominees in the Board when the lending is high and banks also place several
conditions (called loan covenants) restricting the powers of Board on certain
activities or prior approval of the lenders on certain important decisions. In
the Japanese Model, along with shareholders, the interest of lenders (who are
important stakeholders) is also recognized.

Also known as the Business Network model, managers' accountability shows

up in their dealings with the entire Keiretsu (a network of companies – bank,
loyal suppliers and customers). Keiretsu is a complex pattern of cooperation
and competitive interactions defined by the reduction of opportunism among
the parties involved, the maintenance of long-term corporate partnerships and
to be used as a defensive strategies in hostile takeovers.

D) Asian Family Based Model

Across the globe, family businesses have been a powerful force. Family firm
is a company that is owned and controlled by a particular family. While many
definitions for family businesses have been proposed over the years, the
majority tend to emphasise the importance of the family in transferring
family-centered goals and leveraging family-endowed resources into the
business system, often through the ownership power and legitimate role in
firm governance. More specifically, in a family firm, the founder or
member(s) of his/her family (through either blood or marriage) should
possess at least 26 per cent of controlling stake in the company; besides, the
founder or a member of his/her family should hold an influential position in
the company. Because the majority of listed companies in India are
controlled by business families, firms keep their identity and culture even
after becoming public, owing to the fact that the boards of directors are made
up of family members (Sarkar et al., 2013). Since India's independence in
1947, the country's corporate sector has been dominated by family business
groupings (Balasubramanian, 2010) that are characterised by ownership
concentration. As a result, Indian family enterprises are a unique case to
investigate because they are driven by family values and wealth creation for
the family.
16
Activity 4 Corporate Governance:
An Overview
i) Examine the Board of an Indian Company , an American Company and a
German Company. Which Corporate Governance model do they follow?

…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

ii) Write your views on appropriateness of German Model of corporate

governance for India. Do you think inclusion of employees in the Board
would improve the governance?

…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

iii) Give suitable example of Asian family based model.

…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

1.5 PRINCIPLES OF CORPORATE

GOVERNANCE
The G20/OECD Principles of Corporate Governance are the international
standard for corporate governance. The Principles help policy makers to
evaluate and improve the legal, regulatory and institutional framework for
corporate governance, with a view to support economic efficiency,
sustainable growth and financial stability. First issued in 1999, they were
updated and endorsed by G20 Leaders in 2015.

These principles focus on creation of a corporate governance framework that

● promotes transparent and fair markets

● protects and facilitate the exercise of shareholders’ rights and ensure the
equitable treatment of all shareholders
● provides for stock markets and the intermediaries to function in a way
that contributes to good corporate governance. 17
Corporate ● recognizes the rights of stakeholder and encourages active co-operation C
Governance
between corporations and stakeholders in creating wealth, jobs, and the
sustainability of financially sound enterprises.
● ensures timely and accurate disclosures on all material matters
● ensures board’s accountability to the company and the shareholders,
strategic guidance and effective monitoring of management

A brief summary of the principles is given in the Annexure

Activity 5

i) What are the principles of corporate governance as adopted by Securities

and Exchange Board of India (SEBI). Compare them with OECD
principle of Corporate Governance?

…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

ii) In what ways do these principles help policy makers?

…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

1.6 CORPORATE GOVERNANCE CHALLENGES

Corporate governance must be framed with an economic, political, legal, and
social structure in which firms operate in mind. Thus the challenge of
choosing the most appropriate framework. Different countries thus adopt
different models and have different laws. This creates complexities for large
multinational corporations that operate in many countries.
The issues in corporate governance arise due to the separation of ownership
and control. As defined by Adam Smith (1776) that the directors of a
particular company cannot be expected to direct and control with the same
vigilance as the managers of the company. Bad corporate governance or
weakness in corporate governance structure raises issues in corporate
governance that must be sorted out to stop the outcry of corporate scams and
save the interest of stakeholders.
In many family owned Indian companies in addition to owners and board ,
there is another element called promoter (family member(s)) who own
18
significant shares in the company. The promoters generally dominate the Corporate Governance:
An Overview
management leaving the rest of the board with little say. In that process non-
promoter shareholders interest is affected. This creates a conflict of interest
between majority and minority owners.
Thus, the challenge is to create a strong corporate governance system that is
implemented in law as well as spirit so that the company functions efficiently
creating wealth for all stakeholders.

1.7 CORPORATE GOVERNANCE IN BANKING

SECTOR
The aim of good corporate governance in Indian Banking is to make them
socially and economically responsible for the health of the nation. Basically
banks are expected to make credit and liquidity availability in different
market conditions. The capital need of a bank is typically much higher than
any other manufacturing or servicing company. Since the capital is raised
from several small investors and deposit holders, there is a need for high
standard of governance in banking industry. Banks lend money to several
borrowers and the future of the bank depends on the performance of such
loan portfolio. In a large banking system, managers at different levels enjoy
different loan sanctioning power. It is important that managers exercise their
powers in the best of interest of the banks and investors of the bank. Banks
also deal with several risk products and often sell such products. As a
consequence of selling such risk products, banks take the risk of others and
managing such risk is critical for the future of the bank. There is a need for
proper risk management in a bank. Being a complex high risk business, most
of the governance issues that we discussed earlier would be difficult to
implement in banking industry. For instance, it would be extremely difficult
for financial experts to become board members for the banking industry
particularly when there is a restriction on number of banks in which a person
can be a Director. Most banks have several thousand of branches and it
would be difficult for one auditor to audit all branches. Banks generally
would have local branch level audit using auditors who are located in the city
or town and main auditor will take their audit report for final audit report. It
would require considerable coordination with several audit firms. Though the
governance challenges in banking industry would be much higher than other
industries, governance is also critical for the successful running of the
banking business. A bank failure would create an economy wide negative
impact and hence it is all the more important for the regulating agencies to
demand higher level of good governance standards.

1.8 EFFECT OF GOOD CORPORATE

GOVERNANCE
Good governance is important in every sphere of the environment whether it
be the corporate environment or general society or political environment.
19
Corporate Good governance levels can improve public faith and confidence in the C
Governance
business and political environment. When the resources are too limited to
meet the minimum expectations of the people, it is the good governance level
that can help to promote the welfare of the society. The way forward, to
achieve the desired level of corporate governance in Indian scenario, is to
promote the social thinking in a positive perspective along with the perfect
monitoring mechanism of regulatory framework.

Good governance practices entail active participation of shareholders in the

direct and indirect management of a corporation through the board of
directors and an arrangement of productive checks and balance among
shareholders. Sound corporate decision-making has emerged as the direct and
positive outcome of good corporate governance system.

Corporate governance is the system by which companies are directed and

controlled. Boards of Directors are responsible for the governance of their
companies. The shareholders role in governance is to appoint the directors
and auditors and to satisfy themselves that an appropriate governance
structure is in place. The responsibilities of the board include setting the
company’s aims, providing the leadership, supervising the management of
the business and reporting to shareholders on their stewardship. The Board’s
actions are subject to laws, regulations and the shareholders in general
meetings. There are many players in the system of corporate governance.
Were the government and other regulatory agencies provide the platform
through legislations and rules, on the other side, the board of directors,
auditors, shareholders, financial institution’s, accounting professional,
company secretaries and employee play their individual roles for the proper
governance. However, on the wake of changes in the economy, their
traditional roles need some fine tuning.

The Board of Directors has a pivotal position in the structure of corporate

governance. A company according to legal parlance is equal to a natural
person and has a legal being of its own. Though a company is itself a person,
it is an artificial legal person created by law, and can, therefore, a necessity,
act only through the agency of natural persons. It is on account of the
peculiar character of a company that the needs for directors arise. The
directors are not only the agents of a company but they are also its trustees.

1.9 SUMMARY
Separation of ownership and management creates governance problems in
large companies with several thousands of shareholders owning the company
but managed by a small team of directors. The function of governance is not
only to reduce the conflict of interest between shareholders and management
as described in the agency theory but to balance the interest of all
stakeholders as advocated by the stakeholder theory. Each theory, helps us to
understand different governance issues.
20
There are several alternative governance models suggested for corporate Corporate Governance:
An Overview
form of business. The Anglo-Saxon model requires the shareholders to elect
the board members who are expected to represent the shareholders interest
while performing the governance. The German model requires representation
for the employees in the Board and expects that the board takes into account
the interest of both shareholders' and employees. The Japanese model
provides important role for lenders in governance structure and their interest
is also considered while taking managerial decisions.

The principles of corporate governance provide the basis for countries to

develop their corporate governance laws and regulations in a way that best
suits their cultural and political setup. If every stakeholder follows good
governance of responsibility, accountability, transparency and fairness the
company will create value for all. Therefore, we have to realize that corporate
Governance is not only the process of fixing eligibility criteria for the
appointment of directors but also toning up the value system and
organizational culture.

1.10 SELF-ASSESSMENT QUESTIONS

1) What is corporate governance? Why is it important for companies to
have good governance?

2) Compare the Agency theory and Stewardship Theory. Which theory

would support giving more autonomy to directors?

3) Describe the principal cost theory. How is it different from other

theories?

4) Discuss the basic principles of governance. How such principles improve

harmony between different stakeholders?

5) “The role of corporate governance is well recognized but the challenge is

implementation”. What are the challenges for implementing good
corporate governance? Discuss.

1.11 REFERENCES / FURTHER READINGS

Balasubramanian, N., (2010). Corporate Governance and Stewardship:
Emerging role and responsibilities of corporate boards and directors.New
Delhi, Tata McGraw Hill Education.

Daily, C. M., Dalton, D. R., & Cannella, A. A. (2003). Corporate

governance: Decades of dialogue and data. Academy of Management Review,
28(3), 371–382. https://doi.org/10.5465/AMR.2003.10196703

Davis, J. H., Schoorman, F. D., & Donaldson, L. (1997). Toward a

Stewardship Theory of Management. Academy of Management Review,
22(1), 20–47. https://doi.org/10.4324/9781315261102-29
21
Corporate Donaldson, L., & Davis, J. H. (1991). Stewardship Theory or Agency C
Governance
Theory: CEO Governance and Shareholder Returns. Australian Journal of
Management, 16(1), 49–64. https://doi.org/10.1177/031289629101600103

Gales, L. M., &Kesner, I. F. (1994).An analysis of board of director size and

composition in bankrupt organizations.Journal of Business Research, 30(3),
271–282. https://doi.org/10.1016/0148-2963(94)90057-4

Goshen, Z., & Squire, R. (2017). Principal costs: A new theory for corporate
law and governance. Columbia Law Review, 117(3), 767–830. https://doi.org/
10.2139/ssrn.2571739

Harvard Business Review on Corporate Governance, Harvard Business

Press, 2000.

Hillman, A. J., Cannella, A. A., &Paetzold, R. L. (2000). The resource

dependence role of corporate directors: Strategic adaptation of board
composition in response to environmental change. Journal of Management
Studies, 37(2), 235–256. https://doi.org/10.1111/1467-6486.00179

Jensen, M. C., &Meckling, W. H. (1976). Theory of the firm: Managerial

behavior, agency costs and ownership structure. Journal of Financial
Economics, 3(4), 305–360. https://doi.org/10.1016/0304-405X(76)90026-X

Jr. Colley, L. John, Doyle L. Jacqueline, Logan W. George, Stettinius

Wallace, What is Corporate Governance, McGraw Hill, New Delhi, 2005.

Keay, A. R. (2011). Stakeholder Theory in Corporate Law: Has It Got What

It Takes? SSRN Electronic Journal, (January), 1–52. https://doi.org/10.2139/
ssrn.1531065

Madhani, P. M. (2017). Diverse Roles of Corporate Board: Review of

Various Corporate Governance Theories. The IUP Journal of Corporate
Governance, 16(2), 7–28. Retrieved from https://ssrn.com/abstract=2981605

Mendis, T. (2012).Analysis of corporate governance theories and their

implications for Sri Lankan companies.Journal of the Faculty of Graduate
Studies, 1(1), 29–46.

Monks A.G. Rober and Minow Neil, Corporate Governance, Wiley

Blackwell, 2002.

Pound, J. (1988). Proxy contests and the efficiency of shareholder

oversight.Journal of Financial Economics, 20(C), 237–265. https://doi.org/
10.1016/0304-405X(88)90046-3

Sarkar, J., Sarkar, S. & Sen, K., (2013). Insider control, Group affiliation and
earnings management in emmerging economies: Evidences from India.
Volume Available at: http://ssrn.com/abstract=2197713.

22
Suchman, M. C. (1995). Managing Legitimacy Strategic and Institutional Corporate Governance:
An Overview
Approaches. Academy of Management Review, 20(3), 571–610. https://doi.
org/ 10.5465/amr.1995.9508080331

Turnbull, S. (2000). Corporate Governance: Theories, Challenges and

Paradigms. Gouvernance: Revue Internationale, 1(1), 11–43. https://doi.org/
10.2139/ssrn.2213

Annexure : G20/OECD Principles of Corporate Governance , 2015

I) Ensuring the basis for an effective corporate governance

Framework.

The corporate governance framework should promote transparent and fair

markets, and the efficient allocation of resources. It should be consistent with
the rule of law and support effective supervision and enforcement.

A) The corporate governance framework should be developed with a view

to its impact on overall economic performance, market integrity and the
incentives it creates for market participants and the promotion of
transparent and well-functioning markets.

B) The legal and regulatory requirements that affect corporate governance

practices should be consistent with the rule of law, transparent and
enforceable.

C) The division of responsibilities among different authorities should be

clearly articulated and designed to serve the public interest.

D) Stock market regulation should support effective corporate governance.

E) Supervisory, regulatory and enforcement authorities should have the

authority, integrity and resources to fulfil their duties in a professional
and objective manner. Moreover, their rulings should be timely,
transparent and fully explained.

F) Cross-border co-operation should be enhanced, including through

bilateral and multilateral arrangements for exchange of information.

II) The rights and equitable treatment of shareholders and key

ownership functions

The corporate governance framework should protect and facilitate the

exercise of shareholders’ rights and ensure the equitable treatment of all
shareholders, including minority and foreign shareholders. All shareholders
should have the opportunity to obtain effective redress for violation of their
rights.

A. A. Basic shareholder rights should include the right to: 1) secure

methods of ownership registration; 2) convey or transfer shares; 3)
obtain relevant and material information on the corporation on a timely
23
Corporate and regular basis; 4) participate and vote in general shareholder C
Governance
meetings; 5) elect and remove members of the board; and 6) share in the
profits of the corporation.

B. Shareholders should be sufficiently informed about, and have the right to

approve or participate in, decisions concerning fundamental corporate
changes such as: 1) amendments to the statutes, or articles of
incorporation or similar governing documents of the company; 2) the
authorisation of additional shares; and 3) extraordinary transactions,
including the transfer of all or substantially all assets, that in effect result
in the sale of the company.

C. Shareholders should have the opportunity to participate effectively and

vote in general shareholder meetings and should be informed of the
rules, including voting procedures, that govern general shareholder
meetings:

1) Shareholders should be furnished with sufficient and timely

information concerning the date, location and agenda of general
meetings, as well as full and timely information regarding the issues
to be decided at the meeting.
2) Processes and procedures for general shareholder meetings should
allow for equitable treatment of all shareholders. Company
procedures should not make it unduly difficult or expensive to cast
votes.
3) Shareholders should have the opportunity to ask questions to the
board, including questions relating to the annual external audit, to
place items on the agenda of general meetings, and to propose
resolutions, subject to reasonable limitations.
4) Effective shareholder participation in key corporate governance
decisions, such as the nomination and election of board members,
should be facilitated. Shareholders should be able to make their
views known, including through votes at shareholder meetings, on
the remuneration of board members and/or key executives, as
applicable. The equity component of compensation schemes for
board members and employees should be subject to shareholder
approval.
5) Shareholders should be able to vote in person or in absentia, and
equal effect should be given to votes whether cast in person or in
absentia.

D. Impediments to cross border voting should be eliminated.

E. Shareholders, including institutional shareholders, should be allowed to

consult with each other on issues concerning their basic shareholder
rights as defined in the Principles, subject to exceptions to prevent abuse.
24
F. All shareholders of the same series of a class should be treated equally. Corporate Governance:
An Overview
Capital structures and arrangements that enable certain shareholders to
obtain a degree of influence or control disproportionate to their equity
ownership should be disclosed.

1) Within any series of a class, all shares should carry the same rights.
All investors should be able to obtain information about the rights
attached to all series and classes of shares before they purchase. Any
changes in economic or voting rights should be subject to approval
by those classes of shares which are negatively affected.
2) The disclosure of capital structures and control arrangements should
be required.

G. Related-party transactions should be approved and conducted in a

manner that ensures proper management of conflict of interest and
protects the interest of the company and its shareholders.

1) Conflicts of interest inherent in related-party transactions should be

addressed.
2) Members of the board and key executives should be required to
disclose to the board whether they, directly, indirectly or on behalf
of third parties, have a material interest in any transaction or matter
directly affecting the corporation.

H. Minority shareholders should be protected from abusive actions by, or in

the interest of, controlling shareholders acting either directly or
indirectly, and should have effective means of redress. Abusive self-
dealing should be prohibited.

I. Markets for corporate control should be allowed to function in an

efficient and transparent manner.

1) The rules and procedures governing the acquisition of corporate

control in the capital markets, and extraordinary transactions such as
mergers, and sales of substantial portions of corporate assets, should
be clearly articulated and disclosed so that investors understand their
rights and recourse. Transactions should occur at transparent prices
and under fair conditions that protect the rights of all shareholders
according to their class.
2) Anti-take-over devices should not be used to shield management and
the board from accountability.

III) Institutional investors, stock markets, and other intermediaries

The corporate governance framework should provide sound incentives

throughout the investment chain and provide for stock markets to function in
a way that contributes to good corporate governance.

25
Corporate A. Institutional investors acting in a fiduciary capacity should disclose their C
Governance
corporate governance and voting policies with respect to their
investments, including the procedures that they have in place for
deciding on the use of their voting rights.

B. Votes should be cast by custodians or nominees in line with the

directions of the beneficial owner of the shares.

C. Institutional investors acting in a fiduciary capacity should disclose how

they manage material conflicts of interest that may affect the exercise of
key ownership rights regarding their investments.

D. The corporate governance framework should require that proxy advisors,

analysts, brokers, rating agencies and others that provide analysis or
advice relevant to decisions by investors, disclose and minimise conflicts
of interest that might compromise the integrity of their analysis or
advice.

E. Insider trading and market manipulation should be prohibited and the

applicable rules enforced.

F. For companies who are listed in a jurisdiction other than their

jurisdiction of incorporation, the applicable corporate governance laws
and regulations should be clearly disclosed. In the case of cross listings,
the criteria and procedure for recognising the listing requirements of the
primary listing should be transparent and documented.

G. Stock markets should provide fair and efficient price discovery as a

means to help promote effective corporate governance.

IV) The role of stakeholders in corporate governance

The corporate governance framework should recognise the rights of

stakeholders established by law or through mutual agreements and encourage
active co-operation between corporations and stakeholders in creating wealth,
jobs, and the sustainability of financially sound enterprises.

A. The rights of stakeholders that are established by law or through mutual

agreements are to be respected.
B. Where stakeholder interests are protected by law, stakeholders should
have the opportunity to obtain effective redress for violation of their
rights.
C. Mechanisms for employee participation should be permitted to develop.
D. Where stakeholders participate in the corporate governance process, they
should have access to relevant, sufficient and reliable information on a
timely and regular basis.
E. Stakeholders, including individual employees and their representative
bodies, should be able to freely communicate their concerns about illegal
26
 or unethical practices to the board and to the competent public Corporate Governance:
An Overview
authorities and their rights should not be compromised for doing this.
F. The corporate governance framework should be complemented by an
effective, efficient insolvency framework and by effective enforcement
of creditor rights.

V) Disclosure and transparency

The corporate governance framework should ensure that timely and accurate
disclosure is made on all material matters regarding the corporation,
including the financial situation, performance, ownership, and governance of
the company.

A. Disclosure should include, but not be limited to, material information on:

1) The financial and operating results of the company.

2) Company objectives and non-financial information.
3) Major share ownership, including beneficial owners, and voting
rights.
4) Remuneration of members of the board and key executives.
5) Information about board members, including their qualifications, the
selection process, other company directorships and whether they are
regarded as independent by the board.
6) Related party transactions.
7) Foreseeable risk factors.
8) Issues regarding employees and other stakeholders.
9) Governance structures and policies, including the content of any
corporate governance code or policy and the process by which it is
implemented.

B. Information should be prepared and disclosed in accordance with high

quality standards of accounting and financial and non-financial
reporting.

C. An annual audit should be conducted by an independent, competent and

qualified, auditor in accordance with high-quality auditing standards in
order to provide an external and objective assurance to the board and
shareholders that the financial statements fairly represent the financial
position and performance of the company in all material respects.

D. External auditors should be accountable to the shareholders and owe a

duty to the company to exercise due professional care in the conduct of
the audit.

E. Channels for disseminating information should provide for equal, timely

and cost-efficient access to relevant information by users.
27
Corporate VI) The responsibilities of the board C
Governance
The corporate governance framework should ensure the strategic guidance of
the company, the effective monitoring of management by the board, and the
board’s accountability to the company and the shareholders.

A. Board members should act on a fully informed basis, in good faith, with
due diligence and care, and in the best interest of the company and the
shareholders.

B. Where board decisions may affect different shareholder groups

differently, the board should treat all shareholders fairly.

C. The board should apply high ethical standards. It should take into
account the interests of stakeholders.

D. The board should fulfil certain key functions, including:

1) Reviewing and guiding corporate strategy, major plans of action,

risk management policies and procedures, annual budgets and
business plans; setting performance objectives; monitoring
implementation and corporate performance; and overseeing major
capital expenditures, acquisitions and divestitures.
2) Monitoring the effectiveness of the company’s governance practices
and making changes as needed.
3) Selecting, compensating, monitoring and, when necessary, replacing
key executives and overseeing succession planning.
4) Aligning key executive and board remuneration with the longer term
interests of the company and its shareholders.
5) Ensuring a formal and transparent board nomination and election
process.
6) Monitoring and managing potential conflicts of interest of
management, board members and shareholders, including misuse of
corporate assets and abuse in related party transactions.
7) Ensuring the integrity of the corporation’s accounting and financial
reporting systems, including the independent audit, and that
appropriate systems of control are in place, in particular, systems for
risk management, financial and operational control, and compliance
with the law and relevant standards.
8) Overseeing the process of disclosure and communications.

E) The board should be able to exercise objective independent judgement

on corporate affairs.

1) Boards should consider assigning a sufficient number of non-

executive board members capable of exercising independent
judgement to tasks where there is a potential for conflict of interest.
28
 Examples of such key responsibilities are ensuring the integrity of Corporate Governance:
An Overview
financial and non-financial reporting, the review of related party
transactions, nomination of board members and key executives, and
board remuneration.
2) Boards should consider setting up specialised committees to support
the full board in performing its functions, particularly in respect to
audit, and, depending upon the company’s size and risk profile, also
in respect to risk management and remuneration. When committees
of the board are established, their mandate, composition and
working procedures should be well defined and disclosed by the
board.
3) Board members should be able to commit themselves effectively to
their responsibilities.
4) Boards should regularly carry out evaluations to appraise their
performance and assess whether they possess the right mix of
background and competences.

F. In order to fulfil their responsibilities, board members should have

access to accurate, relevant and timely information.

G. When employee representation on the board is mandated, mechanisms

should be developed to facilitate access to information and training for
employee representatives, so that this representation is exercised
effectively and best contributes to the enhancement of board skills,
information and independence.
Source:Adopted from G20/OECD Principles of Corporate Governance available at
https://www.oecd.org/corporate/principles-corporate-governance/accessed March 26,
2022

29