CORPORATE

GOVERNANCE
Special Thanks to Dr. Kashif Riaz
Definitions
 “Corporate Governance is the system by which
companies are directed and controlled…”

 “Involves a set or relationships between a

company’s management, its board, its
shareholders, and other stakeholders.
Corporate governance also provides the
structure through which the objectives of the
company are set, and the means of attaining
those objectives and monitoring performance
are determined.”
Definitions
 Good corporate governance consists of a system of
structuring, operating and controlling a company in
order to achieve following objectives:
 Fulfill long-term strategic goals of owners, which after
survival may include building shareholder value, dominant
market share etc
 To consider and care for the interest of the employees past,
present and future (planning future needs, recruitments,
training, working environment, severance and retirement
procedure.
 To take account of the environment and the local community
 To maintain excellent relationships with customers and
suppliers
 To comply with all legal and regulatory requirements
Definitions
 “Corporate governance is the system by which
companies are directed and managed. It
influences how the objectives of the company
are set and achieved, how risk is monitored &
assessed, & how performance is optimized.

 Good corporate governance structures

encourage companies to create value (through
entrepreneurialism, innovation, development &
exploration) and provide accountability & control
systems commensurate with the risks involved”
Definitions

In its broadest sense,

“Corporate governance is concerned with holding the
balance between economic and social goals and
between individual and communal goals”.

The governance framework is there to ‘encourage the

efficient use of resources and equally to require
accountability for the stewardship of those resources’.
The aim is to align as nearly as possible the interests of
individuals, of corporations, and of society. (Cadbury 2004)
Principal actors in Corporate Governance

Shareholders
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Managers Directors
Report to
Process of Corporate Governance

 The process of corporate governance

comprises of four main principal
activities:
Direction Formulating the strategic direction for the future

Executive Action Level of involvement in crucial executive

decisions
Supervision Monitoring and oversight of management
performance
Accountability Recognizing responsibilities
“Why Governance?, Why
now?”
 International deregulation of financial
markets
 Increasing scale and activity of corporations

 Growth of investment institutions

 Effective monitoring necessary for security of

investments
 Recognition that governance matters for

accountability, performance and attracting

capital.
 A general trend in society towards openness,

transparency and disclosure.

 Lifecycle of Corporate Governance

Maturity Governance
challenges
Public Corporation
(Diffuse Shareholders)
• Maintain alertness
• Board assessment
•Advance value
commitments
Developme

Public Corporation
Corporate

(Majority Shareholders) Growth Governance challenges:

•Risk management
•Develop board of
IPO directors.
nt

(Initial Public Offering) • Engage stakeholders.

Private
Company

Founding Launch Governance Challenges:

Entrepreneurs • Raise capital
• Recruit board of directors
• Establish accountability

Time
 DIRECTOR’S DUTIES

To act within the powers conferred;

 to promote the success of the company for the benefit of its
members. Directors must have regard to the long term and
wider factors such as relationships with employees,
suppliers, customers and the impact of the company’s
operations on the community and environment;
 to exercise independent judgment;
 to exercise reasonable care, skill and diligence;
 to avoid conflicts of interest;
 not to accept benefits from third parties;
 to declare an interest in a proposed transaction with the
company.
Director Duties
Classification

1. 2. 3.
The
The duty of The
fiduciary
care and statutory
duties of
skill duties
director
 1.
The duty of
care and
skill
 A director need not exhibit in the
performance of his duties a greater
Director is not bound degree of skills that may reasonably
to bring any special be expected of a person of his
qualifications to his
office. He may knowledge and experience
undertake the  A director is not bound to give
management in
continuous attention to the affairs of
complete ignorance
without incurring the company. He is to attend to all
responsibility for the matters which requires his attention
mistakes. He is not as per circumstances
bound to take part in
the conduct of the  A director is allowed to delegate his
company’s business, duties to officials
but so far as he does
undertake it, he must
use reasonable care
 2.
The
fiduciary
duties of
director
 A duty to act in good faith
 A duty not to act for improper
Fiduciary duties purposes
impose higher
standards of conduct
 A duty not to engage in
on directors than the corporate opportunities
common law duty .
They are the means  A duty not to fetter future
of monitoring
directors’ actions to discretion
ensure that they do
not abuse their
powers.
 A duty to act in good faith
 To act in the best interest of the company
meaning looking after the short-term and
long-term interest of the share holder
 It is not the law that anyone holding the
office as a director of a limited company is
for that reason alone to be released from
what otherwise would be regarded as
fiduciary responsibility owed to those in a
position of shareholders of the same
company
 A duty not to act for improper purposes
 Where directors have acted in breach of their contracted
purposes or in breach of purposes inherent in their duties.
Examples
 Issuance of new shares to additional shareholders to pass a
special resolution.
 Issuance of special shares carrying special voting rights in order
to prevent a takeover bid (decision in good faith)
 Which was ratified through general meeting of the shareholders
 Controversy arise that improper purpose can be legitimized
 The propriety or impropriety of purpose should be determined by
 The interest of the shareholders whether they are a majority or a
minority
 The interest of the company as whole
 In reference to the power allowed to the directors
 A duty not to engage in corporate
opportunities
 Another method of regulating directors’
duties is to impose a requirement whereby
directors should not seize a corporate
opportunity for themselves nor make a
secret profit
 A duty not to fetter future discretion
 Directors must not anticipate in advance as
to how they will vote in the future.
 They must seek company’s consent before
they can seek to fetter their future
discretion
 If they act bona fide and enter into a
contract as to how they will vote at future
board meeting the courts will uphold such a
contract
 3.
The
statutory
duties

 Directors in discharging their duties, have a statutory duty at all

times to
 act honestly
 use reasonable diligence 
 Secondly, officers and agents of the company cannot make
improper use of any information acquired by virtue of their
position to gain, directly or indirectly,
 an advantage for himself or for any person, or
 to cause detriment to the company. 

 The statutory duties of a director, officer or agent are in addition

to, and not in derogation of, any other written law or rule of law
relating to the duty or liability of directors or officers of a
company. A director’s breach of this statutory duty can be a civil
breach rendering the director liable to the company for any profit
made by him or for any damage suffered by the company.  The
 BOARD DUTIES AND FUNCTIONS

 Reviewing and guiding corporate strategy, major

plans of action, risk policy, annual budgets and
business plans; setting performance objectives,
monitoring and implementation and corporate
performance; and overseeing major capital
expenditure, acquisitions and other divestitures.
 Monitoring the effectiveness of the company’s
governance practices and making changes as
needed.
 Selecting, compensating, monitoring and, when
necessary, replacing key executives and
overseeing succession planning.
 Aligning key executives and board remuneration
with the longer term interests of the company and
 BOARD DUTIES AND FUNCTIONS

 Ensuring a formal and transparent board nomination

and election process.
 Monitoring and managing potential conflicts of
interest of management, board members and
shareholders, including misuse of corporate assets
and abuse of related party transactions.
 Ensuring the integrity of the corporation’s accounting
and financial reporting systems, including the
independent audit and 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.
 Overseeing the process of disclosure and
 Securities markets

Berle
SHAREHOLDERS

and
Institutional
Investors

power
Voting
Means
Board of Directors
Dividends
Supervisory power

Model of Employees
Wages

Labour
Corporation
(management and
Dept capital
Lenders

Owners
physical capital) Interest payments
(market rates)

PUBLIC GOODS
hip and
TAXES
Control Suppliers
Suppliers
National &
Local
Government
Customer
Customers

Adapted from: M. Blair, Ownership and Control (1995)

Shareholding and the governance of
public companies
Shareholding and equity investments

Functions
performed  Private companies
through tends to be used to
shareholding
enjoy various
advantages of legal
It
It provides
provides personality and their
profit
profit
It
It provides
provides without
without shares are used for
control
control unlimited
unlimited control or influence
liability
liability  Public companies tend
to be used to facilitate
Public & Private equity investment and
Companies profit function is more
important
Continued
 Company law treats public and private companies and their
shareholders in more or less the same manner
 The legal structure of a public company has not been designed to
support equity investors however it has many features which suits
the same:
 Limited liability provides share an objective and uniform value carrying a
fixed and quantifiable risk (thus led to development of stock exchange)
 Shares are more attractive as an investment if they are readily sold
 The separation of management from shareholding also increases its
effectiveness for raising capital
 No limit to shareholding therefore small investors can participate in
business whereas large investors can diversify their portfolio
 Side effect of this process is that shareholders are less likely to be active
and vigilant in company’s affairs when their holding is relatively small
 Safeguarding shareholders’ claims on the
profits of public companies
Practical Problems in Governance
• Shareholders face serious difficulties
in acting collectively.
• Because shareholders are diverse
therefore can not readily function as
a decision making organ
Voluntary Contract • If dissatisfied with the company’s
Supply of equity performance the shareholders at
Shareholders
Not really interested in
Company most will sell their holdings and
ownership
invest elsewhere
Return on equity
Dividends, • Due to their inability to exercise their
participation in power and their eagerness to sell the
future issues &
repayment of capital share if dissatisfied with the
Governance company’s performance gave birth
to the theory of “market in
corporate control”
Indirect governance Appoint /
• The theory entails that the
Remove Board of
directors shareholders influence the company
because of their ability to sell the
Direct governance Approval /
shares and thereby affecting the
Rejections of
Resolutions price of the share, thus the risk of
sub-optimal share price, adverse
publicity and increases vulnerability
to a takeover bid.
• The takeover will concentrate the
shareholders’ voting rights into the
 Legal basis of the Shareholder’s Role in
Governance

Shareholders
Governance
Directors

• Directors owe their power to appoint by others are liable to removal

from office and are to exercise their power for the benefit of other.
• Directors’ are entitled to exercise the powers vested in them in their
own right, in effect acting as a company itself.
• The constraints on directors powers originate from both the company’s
constitution and external sources like companies act, rules of stock
exchange and fiduciary duties and disabilities.
• Directors are allowed to vary and reject some of the rules mentioned
based on the circumstances however there are others which must be
followed irrespective of their impact on the shareholders.
• A governance structure having discretionary powers gives rise to two
problems.
 the constraints requires enforcement in the event of breach.
 there may need to be another decision maker to approve actions
Missing organ in the present system of
governance

 Previously stated problems are difficult to resolve as the

directors could not resolve these problems without
contradicting the very point of constraint and the
shareholders are not an active decision making organ
 In law the constraints on the directors’ discretion are legal,
this may be suitable for dealing with breaches of duty by an
individual but not suitable where the collective performance
of the board is an issue.
 A breach of duty can only be evaluated if a new board is
appointed like in the case of takeover or when the company
goes into liquidation
 The shareholders ability to hold directors accountable for
their actions is impaired by their shortcoming as an effective
decision making organ.
continued
 Shareholder are unlikely to enforce constraints on the
directors except through “market in corporate control”
theory
 Directors can seek to legitimize their constraints by
seeking approval in a general meeting but that to has
to be weighed in terms of cost and effectiveness
 Therefore where possible shareholders may allow a
wider discretion to the management and accept the
greater risk of abuse and seek compensation through
a lower share price. This perhaps explains that
regulations rather than shareholders pressure are the
main source of restriction on directors’ powers.
Managerial discretion and the public
interest in governance

 The discretionary power of corporate management is

a matter of public concern because it is difficult to
reconcile with the traditional economic theory which
states how the self-interested behavior of the
individual also serves the public good.
 Individuals and firms are assumed to be motivated by
profit maximization therefore resources are deployed
where they generate most value.
 A company will only optimize resources if there
managers are motivated or compelled to maximize
return to the shareholders if not there own interest of
increasing their remuneration does not ensure most
efficient use of resources
Continued

 The separation of ownership and control in public companies is a

variant of general economic problem associated with agents.
 There are many instances where an agent can perform the task better
because of superior skills, expertise, information or opportunities.
 Agency function requires an agent to have some discretion which
provides an opportunity for the agent to serve their own interest
 In public company the agency problem is intensified because
shareholders are unlikely to act as owner and their incentives are
anyway different because of limited liability
 On way of resolving this issue is to plead to the shareholders into
behaving more like owners of a private property. Regulations
may be enforced to ensure active participation by the
shareholders specially in the matters as (1) the issuance of
shares, (2) directors’ service contract and (3) transactions
involving a likely conflict of interest
The role of ‘Exit’ & ‘Voice’ in
Corporate Governance
The Objective of corporate governance

 Controlling agency costs

 Agency cost is the loss incurred by the
shareholders as a result of management
behavior which deviates from maximization
of shareholders wealth plus the cost of the
mechanism employed to control such
behavior
 Agency cost = loss due to change of interest +
cost of control
 An efficient governance system attempts to
minimize the sum of these two costs
 Market for Badly managed company
corporate control
 Is subject to certain Decline in share prices

limitation and Signal to rivals that its assets are under

therefore its utilized

effectiveness is Raises interest of taking control of the

questionable company

Offers a price greater than its prevailing

market value

Gives control to the purchaser and

ineffective management is thrown out
The market and social responsibility

 Profit reducing social expenditure can provoke shareholders to ‘exit’ which may
lead to reduction in share prices and making the company a potential target for
takeover; therefore prevents managers from engaging into any social activities
that have a damaging effect on the company’s profit
 Market in control therefore will curtail social expenditure by the company
assuming that shareholder decision to buy or sell shares are purely influenced
by financial returns
 The role of some shareholders specially ethical investment bodies may be
affected by other factors apart from financial returns for example shareholders
with ethical sense may say no to share of companies involved in making and
selling arms and ammunitions or tobacco companies promoting their products in
third world countries no matter how profitable there shares are.
 Therefore for ethical investors the market in control will bring the managers
decision in line with the social aspiration of the investors or might provide some
latitude to the managers to respect ethical consideration however it does not
seem that these effects will be very significant in practice as one will always find
investors who are more than willing to buy shares irrespective of ethical
concerns and solely driven on profit maximization
 Therefore in reality market in control
mechanism of control that aligns
management conduct with shareholders
preferences and in the absence of an
implausible, widespread transformation
in shareholders’ attitude; its effect will
be to suppress social initiatives that do
not promise to have at least a neutral
impact on profits
Voice: The German System
 The role of voice has increased
German
Companies in the German system.
32% debt  In order to ensure safe
financed
recovery of debt banks
Banks hold about
5% shares
participates in governance
through their equity holding
Banks holds  Although banks are required to
bearer shares as
deposits of seek instructions from their
clients clients against the bearer
Taking bearers shares as to how they should
shares into vote BUT this is rarely
account banks
hold about 34%
exercised therefore gives more
of the voting power to the bank
rights German
The 3 largest
 It must also be pointed out that companies are major shareholders
in each other and account for almost 42% of the voting rights
 Investment by companies which are often reciprocal are not
purely for investment but may also have a strategic purpose like:
 Reinforce trading relationship or connectedly
 To protect the company from takeovers
 Corporate shareholders differs from institutional shareholders in
two ways:
 Because of their large holding and their long-term characteristics they
are more eager in governance and therefore act in a more owner like
way
 Because of strategic nature of their stakes they are more interested in
stability and growth of the company and are less interested in the
dividends received
 The banks are active in governance as well because their
participation in general meetings and in providing and servicing
companies’ supervisory board enables them to protect their
interest as a major creditors: therefore banks can stop a
company from engaging in risky projects or making excessive
dividends payments to shareholders
 The German banks are not themselves subject to the same
governance system as in many cases their shares are widely
dispersed therefore question arises that instead of solving the
governance issue we have simply shifted it from companies on to
the banks
 Counter argument is that banks cannot afford to make mistakes
because any indication of instability in the banking system would
prove a rapid regulatory response and would threaten bank
autonomy.
Governance and corporate efficiency:
Voice versus Exit

Voice (Advantages) Exit (Disadvantages)

 A supervisory board is  Information is
capable of having earlier received late and may
access to more
not be complete
complete information
about performance and
future plans
 Information can be
made available to  Information received
supervisory board as
insiders therefore is free usually comes with
from commercial commercial
confidentiality confidentiality
 Supervisory director  Market participants
can actively seek out are passive recipient
information of information
 Supervisory board will  Market will take
respond more quickly sometime in
to managerial failure responding to the
managerial failure
 It is cheaper to
 It is costlier to remove
unsatisfactory
remove
management through
unsatisfactory
takeover
management
 Voice Exit (Advantages)
(Disadvantages)  Ruthlessly
 Reluctant to removes
remove management
management  There is no
 Collegiality due to respect or
reciprocal consideration
shareholdings given in
might result in dismissing the
mutual protection management
of management
  The supervisory board fails in  The market in control theory
dealing with ex ante failure fails in dealing with ex post
 An ex ante failure occurs when failure
there is difference in  An ex post failure exists when
expectations between in absolute terms or relative
investors and managers about
to other firms corporate
how company’s assets can
performance has been weak.
most profitably used for the
future
 They are less conducive to  They are more conducive to
dynamic efficiency as they dynamic efficiency and will
will not change the change the management if
management until and unless they think that the assets
a positive evidence of are being utilized below
managerial weakness is their maximum output
found
Takeovers jeopardize non economic values like loyalty, community and cultural
community, the unusual scope and rapidity of changes results in cost cutting and
other defensive mechanisms. The market in control may promote dynamic
efficiency but as a society we may prefer less efficiency in order to gain greater
Governance and social responsibility

 It is more inherent that governance system that

relies on voice to control agency cost and
function provides management room to depart
from exclusive pursuit of shareholders interests
that cannot be done under market in control
mechanism
 Governance through voice will more readily allow
the interest of non shareholders to be taken into
account during the decision making process
 VOICE mechanisms enables the company to
resist demand for short term profit maximization
and thus facilitate mutually beneficial
accommodations of interests. The absence of
Increasing the role of voice
 One obvious source of increased voice is more active
monitoring of company’s affairs by institutional investors.
 The cost and benefits of the institutional interventions entails
that they are more likely to intervene in structural changes or
in times of crises rather than being involved in continuous
monitoring of the company’s performance
 A theory is given that institutions might form an agency to
recruit and nominate monitoring directors to particular
companies. Since appointments would be taken out of the
hands of the management therefore it will enable
genuinely independent directors to hold office.
 Through this approach the question of who will monitor the
monitors can be answered and this task can be performed by
the institutional appointed agency
 The theory further entails that independent non executive
directors can not only be appointed by institutions rather