Study On The Issues Behind Corporate Governance Finance Essay - Free Essay Example

Sample details Pages: 13 Words: 4012 Downloads: 1 Date added: 2017/06/26 Category Business Essay Type Research paper Did you like this example? Furthermore, Each of these frameworks approaches corporate governance in a slightly different way, using different terminology, and views corporate governance from a different perspective, arising from a different discipline for example the agency theory paradigm arise form the finance and economics whereas transaction cost theory arises from economics and organizational theory. Other frameworks, such as stakeholders theory, arises form a more social-oriented perspective on corporate governance  [2]  . However, economist were the first people to offer earliest CG definition as Noble laureate Milton Friedman defined CG the conduct of business in accordance with the shareholders desire therefore maximization of profits for shareholders. Don’t waste time! Our writers will create an original "Study On The Issues Behind Corporate Governance Finance Essay" essay for you Create order Although this definition is outdated now as the stakeholders theory is preoccupation in general CG context. However CG is a set of business techniques, processes, customs, polices, laws and institutions affecting the way an organization runs, directs and administers its business. Therefore CG ensures systems of check and balance to minimize the possible abuse of entrusted powers of members of an organizations along-with the compelling need of openness, integrity and accountability in all decision making process of the said organization.  [3]  Additionally, Boyle Birds  [4]  regard 1992 UK Cadbury Committee Report  [5]  ( In its Report on the Financial Aspects of CG, the Committee concentrated on the tripartite relationship between the board, auditing and the shareholders and was based on the principles of openness, integrity and accountability) as the most authoritative definition of CG that Corporate governance is the system by which business corporations are directe d and controlled. Thus it provides the structure, strategy and effective mechanism through which the company objectives are set, and the means of attaining those objectives and monitoring performance.  [6]  Furthermore, among others, a more wide and compact definition of corporate governance has been put forward by Parkinson (1994). According to him, Corporate Governance is the process of supervision and control intended to ensure that the companys management acts in accordance with the interests of shareholders. This definition has been largely accepted and strongly agreed  [7]  . Dignam et al argued that CG is a multi-faceted subject  [8]  therefore the most important theme of the CG, in my view, is to successfully meet the fundamental goals of an organization by fairly maintaining the relationship among organizations stakeholders. Majority of the codes relates CG to control as stemmed by the Cadbury Report however on the other hand the other theme can be stemmed is supervision of the organization or of management. Furthermore, many definitions relate CG to a legal framework, rules and procedures and private sector conduct. Whereas, on international sphere or codes define CG and encompasses relationships between shareholders, boards and managers. 2.2 The Theories of CG: Economical and Financial Foundations 2.2.1 Historical Perspective According to the Farrer, there are two rival schools of thoughts with respect to the use of history so as to explain the present by reference to the past. One, the traditional view of common lawyers, is to emphasis and perhaps to overemphasize the lessons we can learn from the past. The other, is the radical view of Jeremy Bentham in the early nineteenth century is that it is from the folly not the wisdom of our ancestors that we have so much to learn  [9]  . Hence I am with Jeremy Bentham. However, it became clear centuries ago that, individual entrepreneurs and their families could not provide the finance necessary to undertake developments required to fuel economic and industrial growth. Thus, the sale of company shares in order to raise the necessary capital was an innovation that has proved a cornerstone in the development of economies worldwide  [10]  . Listed companies in their present form originated from the earliest form of corporate entity, namely the sole trader . From the middle Ages, such traders were regaled by merchants guilds, which oversaw a diversity of traders  [11]  . Further, the internationalization of trade, with traders venturing overseas, led gradually to regulate companies arising form the mediaeval guild system. Therefore the members of these early companies could trade their own shares in the company, which led ultimately to the formation of joint stock companies. Therefore, the fist company to combine incorporation, overseas trade and join stock was the East India Company, which was granted a Royal Charter in 1600, for Merchants of London trading into East Indies. The early governance structures of this company were reminiscent of corporate governance structures and mechanisms in todays companies.  [12] The growth of Corporate Governance is, indeed, dependent with the economic development of industrial capitalism as different governance structures evolved with different corporate forms which are designed to pursue new economic opportunities or to resolve new economic problems  [13]  . Consequently the evolutionary expansion of the markets in the nineteenth century along-with technological advances increased the scale and complexity of the business organizations. As a result, the organizations grew in size and shareholders appointed directors or professional managers to succeed and make the business grow, as result, greater productivity, lower cost and higher profits. Consequently, directors or managers controlled the business irrespective of the ownership of the shareholders. Hence, in making decision and running affairs of the organization, the career managers preferred polices that favored the long-term stability and growth of their enterprises rather than those that maximized current profits. 2.2.2 Corporate Ownership Structure Corporate ownership structure has been considered as having the strongest influence on systems of CG although, according to Solomon, many others factors affects CG including legal systems, cultural and religious traditions, political stability and economic events. As all business enterprises need funding in order to grow, and it is the ways in which organizations are financed which determine their ownership structure. 2.2.3 Separation between Ownership and Control The early years of the 20th century saw another significant development when Ownership and Management of the big business organization was separated as result of taking over or replacement of multi-unit-business organizations over the traditional organizations. Shareholders were becoming more numerous and geographically diverse. Their links with the management of their companies were becoming more remote. Therefore using data from companies in the United States, Berle and Means offered the then more influential analysis of the development of corporate governance in the twentieth century  [14]  . They contend that growing concentration of economic power and an increased dispersion of the stock ownership make the corporation in which the separation of ownership and control had taken place central to economic activity in the US. In the preface to the 1932 edition of the work, Berle wrote: The translation of perhaps two-thirds of the industrial wealth from individual ownership t o ownership by large and the divorce of ownership from control and consequent on that process almost necessarily involves a new form of economic organization of society that vitally changes the lives of the property owners, the loves of workers and the methods of property tenure  [15]  . Berle and Means continued in their insistence of the revolutionary impact of the modern organizations upon economics, but through their work was instrumental in the practical policy achievement of Roosevelts New Deal in 1933-1940  [16]  . Whilst Berle and Means go beyond traditional legal and economic theory, to offer a new concept of the modern organizations that might have served as a foundation for a new theory of Corporate Governance. Therefore, among these new economics theory of the firm, agency theory became the dominant force in the theoretical understanding of corporate governance in the last decades of the twentieth century.  [17] 2.2.4 Nexus of contracts theory As Jensen and Mckling in their chapter 4 argued that agency theory mainly rests upon this contractual view of the firm  [18]  . Fama further argued that the firm is just the set of contracts covering the way receipts form outputs are shared among inputs. Therefore in this nexus of contracts perspective, ownership of the firm is an irrelevant concept.  [19]  Similarly some neo-classic economic theorists argued that the organization is not a real thing  [20]  therefore assert that corporations are nothing more than a collection of contracts between different parties primarily shareholders, directors, employees, suppliers, and customers. Proponents of this theory contend that all disputes about the obligations of a particular corporation should be settled by resort to the methods used to interpret contracts, and that courts should not imply the existence of fiduciary duties on behalf of corporate officers and directors.  [21] They further say that the only real actor s are the shareholders, employees, suppliers and so on who cooperate in the organization productive process. The business corporation or the firm is made up of the contracts with these groups. The company or corporation or firm is just an imaginary counterparty to the contracts with each of these groups. The aim of company law and corporate governance is just to minimize the cost of these contracts. Company law and corporate governance are just a type of contract. The question is whether the relationship with the shareholders, employees, suppliers or other contributors to the firms production should be governed by a standard contract or whether it should be regulated through corporate governance mechanisms. Getting the choice right will reduce the firms contracting costs and so make it more profitable. Economic and financial theory further suggests that it is usually appropriate for corporate governance to be used exclusively to govern the relationship with shareholders. The inte rests of the other groups (employees, suppliers etc) can be fully (and more cheaply) be dealt with through express contracts (and possibly by areas of law other than company law). Corporate governance would then concentrate on meeting the needs of shareholders. In particular, it will concentrate on overcoming the agency problem. 2.2.5 Agency Theory of Corporate Governance Separation between ownership and control indeed brought managerial revolution as result of which agency theory emerged from the seminal papers of Alchian and Demsetz  [22]  in 1972 and then later on Jensen and Meckling in 1976  [23]  . Alchina and Demsetz explained the organization as nexus of contracts among individual factors of production  [24]  . Indeed, an organization is a legal fiction which serves as a nexus of contracting relationships  [25]  but I agree with Alchain and Demsetz who argued that these organizational contracting encompasses not only businesses but entire framework of existence.  [26]  On the other hand Coase  [27]  characterized organization as an authority and further argued that it is not about behaviors or objectives of the firm it is like the behaviors of the market and the outcome of a complex equilibrium process of conflicting objectives of individuals  [28]  . Similarly, Agency theory argued that economics was able to analy sis the workings of the organization by explaining it as a constantly re-negotiated contract, contrived by an aggregation of individual each with the aim of maximizing their own utility  [29]  Shareholders investment is sunk This theory is based on the following observations: Directors are expected to act as agents for owners (shareholders); If they can, have incentives to cheat shareholders The separation of ownership and control common in UK listed companies makes it possible for directors to promote their own interests rather than the interests of shareholders. They need to give assurances to shareholders in advance The more reliable the assurances, the cheaper and easier it will be to finance the company Company law / corporate governance can provide these assurances Many aspects of UK corporate governance can be seen as being, at least in large measure, a response to the agency problem. Some theorists, however now argue that basing corporate governan ce and management exclusively on agency theory is positively harmful  [30]  . 2.2.6 Agency Relationship From this we can infer that there exists and agency relationship between shareholders (principal) and managers (agents)  [31]  . For instance, contract for performance of services on behalf of the principal Involving delegation of decision-making authority in pursuant of which agent should be bound by principals best interest. Therefore agency theory suggests that shareholders are the principal in whose interest the corporation should be run even though they rely on others for the actual running of the organization  [32]  . 2.2.7 Agency Problem Jensen and Mekcling suggest the essence of the agency problem is the separation of management and finance. For instance, mangers raise funds from investors to put them to productive use or to cash out their holdings in the organization. Whereas, investors need the mangers to generate returns on their funds. Furthermore, divergence of interest is also inevitable as agents interest primarily self-serving and opportunistic while Shareholder interest Self-serving and profit motive. As a result aggravated by asymmetry of information and uncertainty about the agent the day-to-day business. Additionally, moral hazard is bound to occur as agent has an incentive to act inappropriately from the view of the principal because the latter cannot costlessly monitor. Similarly, agent has incentives to consume private perquisites rather than invest in present positive value of the firm as a result shirking of responsibilities lack of effort and earnings retention. Therefore the growth of the or ganization and its prestige effects badly. Further, agents/managers favor short-term strategy and decision as an employee and pursue high accounting projects instead of long term projects, such as RD expenditure near CEOs retirement. More importantly, managers and shareholders attitudes to risk is also different, for instance managers are more risk thus try to minimize risky investment decisions. But on the other hand Fama and Jensen contends that separation of decision making and risk bearing functions survives in these organizations in part but an effective common approach to controlling the agency problems caused by separation of decision-making and risk bearing functions.  [33]  Because as a residual claimants shareholders bear the risk of the organization, making profit or loss and also have better interest in the allocation of corporate resources to make the largest residual possible. 2.2.8 Agency Cost problem monitoring costs Monitoring cost is the cost paid by the principal to measure, observe and control an agent. Such as cost of audit, of writing remuneration contracts and most importantly cost of firing. As if manager is fired it is shareholder who hast to suffer a lot according to path dependant theory. Furthermore, in case of breach of agency contract the cost of the of fully enforced agency contracts would be too high while the full contracting regarding managerial action is also not possible. 2.2.9 Solution; Implication for Corporate Governance Culpan and Trussle suggest that Corporate Governance is a set of mechanisms to resolve agency problems For instance finding the best monitor writing better contracts providing incentive mechanisms to align interests, risk-sharing devices to reduce monitoring costs as a result reduction in asymmetry of information  [34]  Furthermore, for agency theorist such as Jensen argued the effect markets are the solution  [35]  . Their main focus of the corporate governance is the elaboration and facilitation of market mechanisms that can mitigate agency problem, for instance, market for corporate,, management labor executive compensation like stoke option and corporate information  [36]  . 2.2.10 Tackling the agency problem Thus, company law in the form of directors duties, especially the duty of good faith and reporting and auditing requirements. Corporate governance, for instance the appointment of non-executive directors and fostering participation by institutional shareholders and market-based mechanisms such as the market for corporate control and the inclusion of performance-related elements in directors pay packages are all inspired by the need to create a system of sanctions and incentives that align directors interests with those of shareholders. Hence, the problem can be tackled in this way. 2.2.11 Critique of agency theory O Sullivan and Ghoshal and Moran criticize the agency theory on the following points: Reductionist understanding of human behaviour Reductionist understanding of the nature of a business enterprise Consequence is use of high-powered incentives that harm the business  [37] 2.3 Different Models of Corporate Governance its Debate. 2.3.1 Shareholder exclusive Protection Model of Corporate Governance (Anglo-American Model) Shareholder value is the concept that company law and corporate governance is to be seen as involving (in the last analysis) exclusively the interests of shareholders. According to this theory shareholders are the principal (agency theory) of the managers or directors therefore argue shareholders as the object of CG as shareholder input as capital providers therefore organization must to be run in their interest. Furthermore the main objective of CG should be to protect shareholders interest and primarily emphasis on directors/managers discipline. Moreover, shareholders as the best placed monitor and similarly hopes and expects for shareholder activism. Hence, organizations main founder are its shareholder who provide finance and capital to run the affairs of an organization  [38]  . In essence, this view suggests that the shareholders should be the exclusive beneficiaries of the governance protection. Directors who serve for the shareholders for their interests are regarded as the agent of shareholders  [39] Williamson also suggests that it is only shareholders who need corporate governance as the contractual mechanism to protect their investment therefore ccorporate governance (and company law) exist to protect the interests of shareholder  [40]  . This view suggests that there is no such thing as the firm: nexus of contracts. Hence the purpose of corporate governance is to reduce the costs associated with being and the shareholder and the separation of ownership and control is the main source of these costs. In this respect the purpose of corporate law is to anticipate what shareholders would have asked for in private bargaining. Therefore the only purpose of the firm is to make a profit as there is no mandatory terms in company law therefore no place for stakeholders in company law / corporate governance because in essence corporate governance (and company law) exist to protect the interests of shareholders However in the UK, the duty of g ood faith is understood to be a duty to run the company in the medium and long-run interests of shareholders. It can be contrasted with stakeholder theory which argues that other stakeholders (employees, suppliers, the community, the environment etc) are just as interested in the companys success and just as entitled to be looked after by its governance mechanisms. In the run-up to the Companies Act 2006, the Steering Group that advised the Government rejected a move to stakeholder theory. Instead, they adopted a pluralist or enlightened shareholder value approach. That is, the duty of good faith is still understood in shareholder value terms. Directors are reminded, however, that directors need to look after stakeholders responsibly if they are to promote shareholder value in a sustainable way. 2.3.2 The Stakeholder Protection Model of Corporate Governance Model (European Model) The broad view encompasses the stakeholder theory are argues that the organization exists in a network of relationships therefore argues that there are many inputs to the business which are also equally important. Additionally this view suggests that the purpose of business is more than shareholder profit and emphasized that the CG is a mechanism to balance all interests and thus eensure healthy business and a healthy contribution to society. Stakeholder theory was not adopted by the UK although the new Companies Act as well as the Combined Code acknowledge that directors have to cultivate good relationships with relevant stakeholders. One of the reasons for the rejection of an outright move to stakeholder theory is that it would make the agency problems worse. Directors would be able to use their powers to further their own interests but hide behind stakeholder theory (arguing that although they are not acting in the best interests of shareholders they are promoting the good of other stakeholders), Some would reply that directors have been able to use agency theory and shareholder value to promote their own interests (especially in the area of executive pay). 2.3.3 State Oriented Model of Corporate Governance The main trait of this corporate governance system model is a important role of a small number of founding families and the persistent character of the state on the other. The founding families and their allies usually exercise control over an extensive network of listed and non-listed companies. They are often shielded from risk by directly holding only a limited number of shares. Most of the rest is held by other corporations in the group or other friendly agents. Often, a minority is floated on the local exchange. The families that control the Korean chaebols own an average of less than 15% in group companies, the rest of the controlling blocks being held by other affiliates in a complex web of cross shareholdings. A common characteristic of such systems is that the concept of limited liability, i.e. the separation between the shareholders and the corporation (which has its own decision-making mechanism and assets/liabilities), is weak. In Greece, it was standard practice for the banks to ask for guarantees by the individual family shareholders for the granting of loans. In Korea, one of the most important hidden liabilities within chaebols was the cross-guarantees for bank loans between chaebol affiliates. All decisions related to the strategy of different affiliates within the group, including the ones that are publicly quoted, are taken by a small group of family-related individuals in an informal way i.e. outside the governing instances of the corporations (board and general meetings). Sweden is an example of a traditionally family-dominated ownership system USA 2.3.4 Anglo-American Modal Vs. European Modal 1. Management dominated Controlling shareholder dominated 2. Shareholder focused Stakeholder focused 3. Wide public share ownership less wide public share ownership 4. Strong shareholder rights less strong shareholder rights 5. Unitary board structure Two-level board structure 6. Single powerful leader consensus or divided leadership 7. Shareholder litigation culture Less strong litigation  [41] Chapter 3: Corporate Governance is todays issue; Its Debate and Implication. Lipton and Rosenblum argued that Corporate Governance is a means, not an end. Before we can speak intelligently about corporate governance, we must define its goals.  [42]  Drawing the control separate form the ownership is inevitable for the 21th centurys organizations to survive or to foster. Although there arises potential opportunities for the managers to utilized the owner assets to chase their own benefits and it is where the agency cost or agency problem occurred. Therefore, to discipline the directors or managers activities and to reduce the agency cost ensuring managers accountability to the shareholders and the protection form hostile takeover are crucial functions for the CG. Lipton and Rosenblum hold it as Managerial discipline Model  [43]  although they disagree with this purpose of CG but rather argue that the ultimate goal of corporate governance is the creation of a healthy economy through the development of business operations that operate for the long t erm and compete successfully in the world economy. They further suggest that corporate governance is a means of ordering the relationships and interests of the corporations constituents: stock- holders, management, employees, customers, suppliers, other stakeholders and the public. However, I agree with the Lipton and Rosenblum to the effect that what is needed is system that will lead managers and stockholders to work cooperatively towards the corporations long- term business success.  [44] CG debate is a reaction of the corporate scandals so as to search a good corporate governance system as investor presumes and relates profit is imperative if the good CG is in place. Additionally, it is a strong perception of correlation between good corporate governance and overall economic success. Stephen Griffin says that these debates, discussion and government intervention into issues of corporate governance are the natural consequence of the economic and social impact which organizat ions affect in the generation and maintenance of personal and national wealth and prosperity.  [45]  Furthermore, this interference is driven by both an economic and political desire to rid the corporate infrastructure of systems and practices which may give rise to potentials for like or future failures and scandals. More importantly, in seeking to clear up a corporate mess a governments objective will be to calm and reassure investors, corporate players and markets, thereby protecting economics stability and the general public interest. 3.1 Mutually Agreed Principals of CG Honesty, trust and integrity, openness, performance orientation, responsibility and accountability, mutual respect, and commitment to the organization are the general key principals of the CG. However commonly accepted principle CG are as under Respect the Rights of the shareholder and coordination with respect to exercise of those rights and equitable treatment of shareholders Recognition of the Interests of other stakeholders Fulfillment of the responsibilities of the board: Integrity and ethical behavior: Disclosure and transparency  [46]  : 3.2 Issues involving corporate governance principles include: internal controls and internal auditors the independence of the entitys external auditors and the quality of their audits oversight and management of risk oversight of the preparation of the entitys financial statements