CORPORATE GOVERNANCE

CHAPTER 1

What is Corporate Governance?

2

Deals with the problems arising from the separation of ownership and control.

Separation of Ownership and Control

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The thousands, or more, investors who own public corporations could not collectively make the daily decisions needed to operate a business. Therefore:
The shareholders are owners of the firm The shareholders elect directors to act as their agents in supervising the firm The directors appoint officers (or executives) to actually run the firm on a day-to-day basis

Separation of Ownership and Control

Ownership
Shareholders

Board

Control

Management

Employees

Focus of Corporate Governance Shareholders elect directors who represent them.

Directors vote on key matters and adopt the majority decisions.
Decisions are made in a transparent manner so that shareholders and others can hold directors accountable. Company adopts accounting standards to generate the information necessary for directors, investors and other stakeholders to make decisions. The company's policies and practices adhere to applicable national, state and local laws.

Principal-Agent Problem
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Principal-agent problem represents the conflict of interest between the principal and the agent. Primary principal-agent problem in corporations: Principal = Shareholders Agent = Officers

If shareholders cannot effectively monitor the officers behavior, then officers may be tempted to use firms assets for their own personal use.

Solutions to Principal-agent problem

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Incentivesaligning executive incentives with shareholder desires. Monitoringsetting up mechanisms for monitoring the behavior of managers.

Can Shareholders Influence Managers?

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Shareholders do not directly hire/fire managers so they cant vote to replace them Shareholders can influence managers indirectly through the board of directors Changing board members can be difficult as management controls the process and some inactive shareholders will go along with whatever management wants. Some active shareholders are large enough to try and influence management or change the board, but they are often met with defeat.

Monitors
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Monitors are called for because managers may not act in the shareholders best interest. Figure 1.1 shows that monitors exist:
Board of directors

inside the corporate structure outside the structure

Auditors, analysts, bankers, credit rating agencies, and attorneys

in government
SECP

Figure 1.1
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Inside monitors-Board of directors

Oversee management and are supposed to represent shareholders interests. Evaluates management and design compensation contracts to tie managements salaries to the firms performance.

Outside monitors
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Interact with the firm and monitor manager activities

Auditors Analysts

Bankers
Credit

agencies Attorneys

Government monitors
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The SECP regulates public firms for the protection of public investors The SECP also makes policy and prosecutes violators in civil courts.

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Governance is more than just Board Processes and Procedures

It involves the full set of Relationship between

a companys management Its Board Its Shareholders Its other stakeholders

One size doesnt fit all. The Board Objectives and Procedures may be the same to all societies but when it comes to applying them to individual countries we have to reckon the peculiar, socio-cultural characteristics, the history of its people, their value systems, their economic system, etc.

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Corporate Governance Guidelines

Most worldwide organizations have strongly promoted good corporate governance by application of the following corporate governance guidelines:
1.

Rights of shareholders 2. Equitable treatment of shareholders 3. Role of stakeholders in corporate governance 4. Disclosure and transparency 5. Responsibilities of the board

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Corporate Governance Guidelines

1. Rights of shareholders
All

shareholders must be given their due rights i.e. They all should have
Secured

ownership of their shares Voting rights Right to full disclosure of information participation on decisions on sale or change in corporate assets or new share issues Capital structure must be disclosed All transactions should be at transparent prices and under fair conditions

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Corporate Governance Guidelines

2.

Equitable treatment of shareholders

All

shareholders should have equal opportunity for redressal of the violation of their rights Insider trading should be prohibited

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Corporate Governance Guidelines

3. Role of stakeholders in corporate governance

Corporate

governance framework apart from the rights of shareholders allow

Employees

representation on BOD Profit sharing Creditors involvement in insolvency proceedings

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Corporate Governance Guidelines

4. Disclosure and transparency

Financial

details, operating results, policies, governance structure should be disclosed Annual audits should be performed by independent auditors

When

in

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Corporate Governance Guidelines

5. Responsibilities of the board

Board

is responsible for

Protecting

the company, its shareholders and other stakeholders Making policies, strategies Monitoring effectiveness

McKinseys Two-Version Governance Chain Models

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Model 1: Market Model In Market Model governance chain, there are efficient, well-developed equity markets and dispersed ownership. Model 2: Control Model

In Control Model governance chain is represented by underdeveloped equity markets, concentrated(family) ownership, less shareholder transparency and inadequate protection of minority and foreign shareholders.

Market Model Governance Chain

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More common in US, UK, Canada & Australia

Independence & Performance Nonexecutive Majority Boards

Shareholder environment

Institutional Context

Sophisticate d institutional ownership Active equity market

Dispersed ownership

Aligned incentives
High disclosu re

Corporate Context

Active takeover market

Shareholder equality

Capital Market Liquidity

Transparency & Accountability

Control Model Governance Chain

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More common in Asia, Latin America, parts of Europe

Independence & Performance

Shareholder environment

Institutional Context

Concentrate d ownership Reliance on family, bank, public finance Under developed new issue Limited market takeover market

Insider boards

Incentives aligned with core shareholder s Limited disclosu re

Corporate Context

Inadequate minority protection

Capital Market Liquidity

Transparency & Accountability

Corporate Governance Concerns

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1.

2.
3. 4.

5.
6. 7. 8. 9. 10.

Management Accountability Providing Adequate Investments To Management Disciplining & Replacement Of Bad Management Enhancing Corporate Performance Transparency Shareholder activism Enhancing Protection Improving Access To Capital Markets Promoting Long-Term Investment Encouraging Innovation

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Issues in Corporate Governance

Corporate Governance conveys different meanings to different people. But to all, corporate governance is a mean to an end, the end being long-term shareholder value and more importantly stakeholder value. All authorities have identified some governance issues being crucial and critical to achieve these objectives. These are:
1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

Distinguishing the role of Board & Management Composition of Board & related issues Separation of the roles of CEO & chairperson Should the board have committees? Appointments to the board & directors re-election Directors and executives remuneration Disclosure & audit Protection of shareholders rights & their expectations Dialogue with institutional shareholders Should investors have a say in making a company socially responsible corporate citizen

Issues in Corporate Governance 1. Distinguishing the role of Board & Management

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Shareholders

Board
Delegates responsibilities to CEO

Companys Management
Management responsibilities is delegated by CEO to management

Owners who elect BOD

Board of the company has following functions:

Select, decide the remuneration & evaluate on regular basis and when necessary change the CEO. Oversee indirectly the conduct of companys business Review and approve the companys financial objective if necessary Render advice & counsel to the top management Recommending candidates to the shareholders for electing them to BOD Review the adequacy of systems to comply with all laws and regulations All other functions required by law to be performed

Issues in Corporate Governance 2. Composition of Board & related issues

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BOD is a committee elected by shareholders. Sometimes, fulltime functional directors are appointed, each being responsible for some particular branch of the firms work.
Board of Directors

Executive Directors

Non-Executive Directors

Independent Directors

Affiliated Directors (Nominee Directors)

Issues in Corporate Governance 3. Separation of the roles of CEO & chairperson

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Combining the role of chairperson with that of the CEO leads to conflict in decision making and too much concentration of power in one person resulting in unhealthy consequences. The role of CEO is to lead the senior management team in managing the enterprise, while The role of chairperson is to lead the board to evaluate the performance of senior executives including the CEO.

Issues in Corporate Governance 4. Should the board have committees?

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Following committees if made would lessen the burden of the board and enhance its effectiveness:
Nomination

Remuneration
Auditing

Issues in Corporate Governance 5. Appointments to the board & directors re-election

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The board or its specially constituted committee selects and appoints the prospective director and gets the person formally elected by the shareholders at AGM.

Issues in Corporate Governance 6. Directors and executives remuneration

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Shareholders are entitled to a full and clear statement of Directors recent and future benefits and how they have been determined. Remuneration committee must be appointed for this task.

Issues in Corporate Governance

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7. Disclosure & audit 8. Protection of shareholders rights & their expectations 9. Dialogue with institutional shareholders 10. Should investors have a say in making a company socially responsible corporate citizen

Need & Importance for Corporate Governance

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Corporate governance is needed to create a corporate culture of consciousness, transparency and openness. It refers to the combination of laws, rules, regulations, procedures and voluntary practices to enable companies to maximize shareholders long-term value. It should lead to increasing customer satisfaction, shareholder value and wealth

Governance & Corporate Performance

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There is a positive relationship between corporate governance and corporate performance. Improved corporate governance is linked with improved corporate performance either in terms of rise in share price or profitability.

Investors Preference for Good Governance

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Majority of investors (institutional) consider governance practices to be at least as important as financial performance, when they evaluate companies for potential investment. They are prepared to pay a premium for shares in a well-governed company as compared to a poorly governed one exhibiting similar financial performance.

Benefits of Good Corporate to a Corporation

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1. Creation & enhancement of a corporations competitive advantage 2. Enabling a corporation perform efficiently by preventing fraud & malpractices 3. Providing protection to shareholders interest 4. Enhancing the valuation of an enterprise 5. Ensuring compliance of laws and regulations (BCCI)