Theory and Practice of

Corporate Governance
The concept: Corporate
Governance
• The joint stock company known as the
corporation is the nucleus of all business
activities in modern economies. All
corporations do not however enjoy equal
share of power; they also do not have the
same size and degree of operations. In
India as well as countries like US, UK the
major share of the capital is in the hands
of few giant corporations that control the
production and the market for goods.
 Definition
• “The business corporation is an instrument
through which capital is assembled for activities
of producing and distributing goods and services
and making investments. Accordingly, a basic
premise of corporation law is that a business
corporation should have as its objective the
conduct of such activities with a view to
enhancing the corporation’s profit and gains of
the corporation’s owners, that is the share
holders.”
 According to Chief Justice John
Marshall (1801)
• “A corporation is an artificial being, invisible,
intangible, and existing only in the
contemplation of the law. Being the mere creature
of the law, it possesses only those properties which
the charter of its creation confers on
it, either expressly or as
incidental to its very existence.
These acts are supposedly
best calculated to effect the object
for which it was created.
• Among the most important properties are
immortality, and, if the expression be
allowed, individually; which a perpetual
succession of many persons are
considered the same, and may act as a
single individual.”
 What is Corporate?
• In the capitalist economy, capital accumulation takes
place through development and growth of industries,
trade and commerce, infrastructure and agriculture.
The corporation of today has replaced the sole
proprietor of old days and tries to maximize profits and
generate wealth. But it differs on two counts:
1. The life of the corporation is much longer
2. It is more rational in decision making as it is run by a
board of directors and besides they take decisions
based on cost accounting, budget analysis, data
collection and processing, and managerial consulting.
 Characteristics of a corporation
1. Incorporated or registered under the Companies Act of a
country
2. Artificial legal existence- equal to that of a natural person with
its own legal entity
3. Perpetual existence – Law creates a company and only law
can dissolve it
4. Common seal – an artificial person can not sign documents
5. Extensive membership – no limitation on the number of
members
6. Separation of management from ownership
7. Limited liability (owners risk is limited unlike in the case of
partnerships, individual ownerships)
8. Transferability of shares
 Concept of governance
• The concept of governance is as old as human
civilization. Governance stands for decision
making and implementing it. It is used in several
contexts – corporate governance, international
governance, national governance, local
governance. Government is one of the players;
others are companies, associations, NGOs,
Cooperatives, political, parties, police and so on.
All except government and the armed forces are
said to be part of the “civil society”.
 Theoretical basis for corporate
governance
A. Agency Theory
The fundamental theoretical basis of corporate
governance is agency costs. Adam Smith had identified
the agency problem (managerial negligence and
profusion). Shareholders are the owners and the
principals too. The management, the board, chosen by
the shareholders are the agents. Principals may want to
carry out the objectives of the company but the agents
may not quite exactly match the requirements. The cost
of the “dissonance” caused by the agency problem is the
agency cost. There are many a way through which the
management go counter to the objectives of the
shareholders such maximizing shareholder returns.
Ostentatious life styles of directors, empire building etc.
are examples.
• Mechanisms that help reduce agency
costs:
1. Fair and accurate financial disclosures
2. Efficient and independent board of
directors
B. Stewardship Theory
The theory defines situations in which managers are
not motivated by individual goals, but rather they are
stewards whose motives are aligned with the
objectives of their principals.
It assumes that managers are trustworthy and have
high reputations. There fore their behavior will not run
counter to the interests of the company. There is a
significant emphasis on the responsibility of the board
to the shareholders in a corporate governance model
that is emboldened by stewardship and trusteeship.
These concepts of stewardship and trusteeship are
traceable in the scriptures of India and Christendom.
 Basic behavioral differences between Agency &
Stewardship Theories
Agency Stewardship
Managers act as agents Managers act as stewards

Governance approach is materialistic Governance is sociological and

Behavior pattern is individualistic,
opportunistic, and self serving
Managers are motivated by their own
objectives
Interests of the managers and principals
differ
The role of the management is to monitor
and control
Owners’ attitude is to avoid risks
psychological
Behavior pattern is collectivistic, pro-
organizational, and trustworthy
Managers are motivated by the principals’
objectives
Interests of the managers and principals
converge
The role of the management is to facilitate
and empower
Owners’ attitude is to take risks

Principal-manager relationship is based on Principal-manager relationship is based on

control trust
Issues in Shareholder Versus
Stakeholder
• Shareholder approaches fundamentally mean that
corporations have limited responsibilities namely that of
obeying laws and maximizing shareholder wealth. That is
to say, shareholder interests will automatically maximize
societal utility. But this argument presupposes that there
will be perfect competition which is rather suspect in
many situations.
• Stakeholder approaches dwell upon the theme that
corporate managements have responsibilities toward
other stakeholders. In other words responsibilities of the
companies in terms of maximizing profits toward the
shareholders should be subject to obligations toward
others.
 Stakeholder theory
• Dating back to 1930s, this theory represents a synthesis
of a fair bit of economics, behavioral science, business
ethics, and stakeholder concept. It deals with the
common interests of employees, customers, dealers,
government, and the society at large and draws all of
them into corporate-mix. It is often criticized as “wooly
minded liberalism” because it is not applicable in practice
by companies. But the defense is that managers can act
efficiently only by drawing upon the resources of the
stakeholders and as such there is a “contract” between
the company and the stakeholders.
• But then who are all genuine stakeholders? Some might
make bizarre choices like terrorists, dogs, trees and to
the least questionable like employees and customers!
Corporate Governance
Mechanisms
• The joint-stock, limited liability company is
becoming the most preferred organization for
running any business.
• It has been successful in providing employment,
generating wealth, and contributing to economic
and social development.
• In the limited liability company, the business is
incorporated as an independent legal entity
separate from its owners.
• Shareholders’ liability for debts is limited to the
amount of capital they have agreed to subscribe
for.
• The company as a legal person has the rights to
sell, buy, to own assets, to incur debts, to
employ, to contract, and to sue and be sued
upon.
• Company has a long life span different from
those of its innumerable shareholders.
• Companies need to be governed as well
as managed. The board of directors is
central and its structure and processes are
fundamental; so are the board’s
relationships with its shareholders,
regulators, auditors, top management, and
other legitimate stakeholders.
• These days companies’ shareholders are
of diverse nature – private individuals,
institutional investors such as banks and
pension funds, insurance companies, and
other companies who might have business
relationship with the company. This make
it a very complex situation.
• There has been a growing awareness of
corporate governance around the world. A
number of studies and official reports have
followed as a result of the growing
awareness and societal responses. These
provided a code of best practices for the
governance.
• Many a major company today operate through
group structures of wholly-owned subsidiary
companies, partly owned subsidiaries in which
other external parties have a minority equity
interest and associated companies in which the
holding company has a significant but not
dominant holding. In an era of globalization,
major companies are getting engaged in a
variety of joint ventures and strategic alliances.
Corporate governance systems
• The role of the management (which mostly appears in
the organizational chart and not the board) is to run the
business while the board oversees that it is run well and
in the right direction. Management operates as a
hierarchy. There is an ordering of responsibility,
authority, delegation downwards through the firm and
accountability upwards to the top brass.

• By contrast, the board members need to work together

as equals reaching agreement by consensus or if
necessary by voting. Each director bears the same
duties and responsibilities.
• Corporate governance systems vary
around the world:
1.The Anglo-American Model
2.The German Model
3.The Japanese Models
The Anglo-American Model

Shareholders Elect Board of directors

(Supervisors) Stakeholders

Appoints &
supervises

Officers
(Managers)

Manage
Monitors &
regulates Regulatory
Creditors Lien on Legal System
Own Company Stake in
 Features of Anglo-American Model
1. Ownership equally divided among individual and institutional shareholders
2. Directors are rarely independent of management
3. Companies run by professional managers with negligible ownership stakes
– clear separation of ownership and management
4. Institutional investors are reluctant activists – if not satisfied with the
company, they just sell shares and pack off
5. Disclosure norms are comprehensive – rules against insider trading,
penalties for price manipulation, protection for small investors, discourage
large investors from taking active role in corporate governance
 The German Model

Appoint 50% Appoint 50%

Supervisory Board

Appoints &
Supervises

Employees & Management Board (incl.

Shareholders
Labor Unions labor relations officer)

Manage

Own
Company
 Features of German Model
1. Governance is exercised through two-tier
board – upper board supervises the executive
board on behalf of shareholders
2. The shareholders own the company but do not
entirely dictate governance mechanism –
shareholders and labor unions on a 50-50
basis appoint the supervisory board
3. Supervisory board appoints and monitors the
management board
The Japanese Model Provides managers .
monitors, acts in
emergencies
Appoint Supervisory Board
(including the President)
Provides
managers
Ratifies the President’s
decisions

President

Shareholders Consults Main Bank

Executive Management
(Primarily Board of Directors)

Manages

Provides loans
Own Company
Owns
 Features of Japanese Model
1. The financial institution has accrual role
in governance – shareholders and main
bank together appoint the Board of
Directors and the President
2. The President who consults the
supervisory board and the executive
management is included
3. Importance of the lending bank is
highlighted
 Indian Corporate Governance Model

Government regulations, External Environment Corporate culture,

policies, guidelines , etc structure, characteristics,
Influences

Internal Environment
Company vision, mission, policies, norms Depositors, borrowers,
Company Act customers and other
SEBI, Stock external stakeholders
Exchange Internal Auditors Board of
stakeholders Corporate Directors
Governance
System
Proper Shareholder value
governance

Corporate governance outcomes/Benefits to society

Transparency

Investor protection Concern for customer

Healthy corporate sector development

 Features of Indian Model
1. Indian companies are governed by the
Company’s Act of 1956
2. Follows more or less the UK model
3. Private companies are closely held or
dominated by a founder, his family, and
associates
4. In the wake of economic liberalization, India
has adopted the key tenets of the Anglo-
American external and internal control
mechanism
 What is good Corporate
Governance?
• Bad governance is being recognized as the major root
cause for corrupt societies
• Investors and institutions provide loans and aid stressing
that the reforms that ensure good governance are adopted
by the companies
• Good corporates are not born, rather they are the result of
the combined efforts and contributions of all stakeholders,
board of directors, government, and the society at large
• There are obligations to society at large, investors,
employees, and customers
• Managerial obligations too are important
Values, Concerns , Duties, Responsibilities
Society expects from Corporates
• If a corporate has to survive, grow, and
wants to be counted, its vision should
focus on the ways and means of
becoming a responsible and responsive
corporate citizen.
 Our Credo
We believe that our first responsibility is to the doctors ,
nurses, and patients, to mothers and fathers and all
others who use our products and services. In meeting
their needs everything we do must be of high quality. We
must consistently strive to reduce costs in order to
maintain reasonable prices. Customers’ orders must be
serviced promptly and accurately. Our suppliers and
distributors must have an opportunity to
make a fair profit.
 We are responsible to our employees, the men and
women who work with us throughout the world. Everyone
must be considered as an individual. We must respect
their dignity and recognize their merit. They must have a
sense of security on their jobs. Compensation must be
fair and adequate, and working conditions clean, orderly,
and safe. We must be mindful of ways to help our
employees fulfill their family responsibilities. Employees
must feel free to make suggestions and complaints.
There must be equal opportunity for employment,
development and advancement for those qualified. We
must provide competent management, and their actions
must be just and ethical.
 We are responsible to the communities in which we live
and work and to the world community as well. We must
be good citizens – support good works and charities and
bear out fair share of taxes. We must encourage civic
improvements and better health and education. We must
maintain in good order the property we are privileged to
use, protecting the environment and natural resources.
 Our final responsibility is to our stockholders. Business
must make a sound profit. We must experiment with new
ideas. Research must be carried on, innovative program
developed and mistakes paid for. New equipment must
be purchased, new facilities provided, and new products
launched. Reserves must be created to provide for
adverse times. When we operate according to these
principles, the stockholders should realize a fair return.