Corporate Governance

– The cornerstone

The cornerstone of the modern

market-oriented economy

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What is Corporate Governance?

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 Corporate Governance - Definition
• the system by which business corporations are directed and
controlled
• specifies the distribution of rights and responsibilities among
different participants in the corporation, such as the board,
managers, shareholders and other stakeholders
• spells out the rules and procedures for making decisions on
corporate affairs
• provides the structure through which the company objectives
are set, and the means of attaining those objectives and
monitoring performance
(Source: OECD April 1999)

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 The OECD Principles of
Corporate Governance
1. Ensuring the basis for an effective corporate governance framework
2. The rights of shareholders and key ownership functions
3. The equitable treatment of shareholders
4. The role of stakeholders in corporate governance
5. Disclosure and transparency
6. The responsibilities of the board
- 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.

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 IFC – Russia Corporate
Governance Manual
• Corporate Governance is a system of relationships, defined by
structures and process. [Shareholders – Management]
• These relationships may involve parties with different and sometimes
contrasting interests.
• All parties are involved in the direction and control of the company
• All this is done to properly distribute rights and responsibilities – and
thus increase long term shareholder value.
 Definitions
• “Corporate governance deals with the ways in
which suppliers of finance to corporations
assure themselves of getting a return on their
investment”, The Journal of Finance, Shleifer
and Vishny [1997, page 737].
 Other Definitions
• "Corporate governance is about promoting corporate fairness,
transparency and accountability" J. Wolfensohn, president of the Word
bank, as quoted by an article in Financial Times, June 21, 1999.
• “The directors of companies, being managers of other people's money
than their own, it cannot well be expected that they should watch over
it with the same anxious vigilance with which the partners in a private
co-partnery frequently watch over their own.” Adam Smith, The
Wealth of Nations 1776
Corporate Governance System
Corporate Governance
 Basics of Corporate Governance
• By issuing corporate securities, firms sell claims to control the
companies` resources
– The interests of the various security holders differ
– Separation of ownership and control implies agency relationships.
– Interests of agents (management) are different from those of security
holders, particularly from those of stockholders.
– Monitoring the activities of agents is costly - hence, full monitoring is not
optimal.
– The value forgone due to imperfect optimal monitoring is an explicit
agency cost.
 Four core values of the OECD corporate
governance framework
• Fairness: The corporate governance framework should
protect shareholder rights and ensure the equitable treatment
of all shareholders, including minority and foreign
shareholders.
• Responsibility: The corporate governance framework should
recognize the rights of stakeholders as established by law,
and encourage active co-operation between corporations and
stakeholders in creating wealth, jobs, and the sustainability
of financially sound enterprises.
 OECD Core Values
• Transparency: The corporate governance framework should
ensure that timely and accurate disclosure is made on all
material matters regarding the company, including its
financial situation, performance, ownership, and governance
structure.
• Accountability: 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 shareholders.
 Business Case for Corporate
Governance
• Well governed companies have lower cost of
capital
• Reduction of risks
• Higher valuation of human capital in
companies that are well governed
• Higher share valuation
Business Case
 Corporate Governance
• Promote the efficient use of scarce resources
• Promote the trust of investors
• Good corporate governance has a positive link
to economic development and good corporate
performance
• Funds will flow to entities which are seen to
have internationally accepted standards of
corporate governance

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 Reasons for recent Interest in
Corporate Governance

• Proliferation of financial scandals and crisis

• Loss of trust of investors
• Globalization lead to increasing cross-border
investment opportunities but investors may not
have knowledge about the regulatory
framework of overseas investees

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 Reasons for recent Interest in
Corporate Governance
• Governance mechanisms sometimes fail to
adequately monitor and control top-level
managers’ strategic decisions.
• If the behavior of top-level mangers is not
monitored and controlled effectively, this
could mean that the firm will not be
strategically competitive
 Reasons for recent Interest in
Corporate Governance
• Effective corporate governance is also of
interest to nations.
• A country prospers as its firms grow and
provide employment, wealth, and satisfaction
—thus improving standards of living. These
aspirations are met when firms are competitive
internationally in a sustained way.
 Reasons for recent Interest in
Corporate Governance
• Corporate governance reflects the standards of the
company, which collectively reflect societal
standards.
• Thus, in many corporations, shareholders attempt
to hold top-level managers more accountable for
their decisions and the results they generate.
• As with individual firms and their boards, nations
that govern their corporations effectively may
gain a competitive advantage over rival countries.
 Reasons for recent Interest in
Corporate Governance
• to preserve public interest and restore trust and
corporate integrity.
 Reasons for recent Interest in
Corporate Governance
• Becht et al. (2002) identified five reasons why
corporate governance became so prominent in
the past two decades:
• i) the world-wide privatisation wave
• ii) pension fund reform and growth of private
savings
• iii) the takeover wave of the 80s
• iv) deregulation and integration of capital
markets
• v) crises.
 Reasons for recent Interest in
Corporate Governance
• Take-overs are a more important influence on
the corporate governance landscape of the
Anglo-US economies than elsewhere
• Franks and Mayer (1990), for example,
document that in the UK there were
approximately double the number of take-
overs as there are in France or Germany
 Takeovers
• hostile bids are commonplace in the US and UK
• The hostile takeover wave in the US in the 1980s and in
Europe in the 1990s in addition to the recent merger wave (eg
AOL-Time Warner, DaimlerChrysler, or Acelor-Mittal Steel
recently) has influenced the public debate on corporate
governance.
• The 200 billion dollar cross-boarder hostile bid of Vodafone
for Mannesmann in 2000 was the largest ever to take place in
Europe.
• This takeover together with the recent hostile takeovers in
Italy (Olivetti for Telecom Italia) and in France (BNP-Paribas)
have changed the corporate world in Continental Europe.
• Since these events takeover regulations are political agendas
of the European Union (EU)
 Deregulation and capital market
integration
• The greater integration of world capital markets
through the introduction of the Euro and mergers
of stock markets (Euronext and the endless
merger rumours for London Stock Exchange) and
the growth in equity capital throughout the 1990s
increased the interest in corporate governance in
the last few years.
• In addition, increasingly fast growing
corporations in Europe have been raising capital
from different sources by cross listing on multiple
exchanges
 Corporate Scandals
• cases of corporate fraud and scandals around
the world.
Examples include:
• Enron corporation – which engaged mainly in
aggressive and creative accounting
• Cadbury Nigeria (2006) – involving
corruption, lack of transparency leading to the
company’s shares dropping by more than 26%
and a financial loss of $15million in that year
 Examples
• Some of the more prominent and sensational
ones include:
• WorldCom Inc, in which the management
improperly capitalised expenditures instead of
expensing them
• the near collapse and suspension of China
Aviation Oil (CAO, “The Company”) as a
result of the huge debts it incurred in
speculative oil trading
 Examples
• Tyco International, where top executives were
charged for their roles in fraudulent actions
against the company
• the imprisonment of former chief executive of
Accord Customer Care Solutions, Victor Tan,
for bribery and corporate fraud
• revelation of improper business practices and
disclosure standards adopted by Citiraya
 Corporate Scandals
• There has been active interest in the corporate
governance practices of modern corporations,
particularly in relation to accountability since the
high profile collapse of a number of large
corporations during 2001 - 2002 most of which
involved accounting fraud
 Investors’ expectations
• Directors, owners and corporate managers have
started to realize that there are benefits that can
accrue from having a good corporate governance
structure.
• Good corporate governance helps to increase
share price and makes it easier to obtain capital.
• International investors are hesitant to lend money
or buy shares in a corporation that does not
subscribe to good corporate governance principles
 Investors’ expectations
• Transparency, independent directors and a
separate audit committee are especially
important.
• Some international investors will not seriously
consider investing in a company that does not
have these things.
 Corporate Governance
• Investors are not willing to invest in
countries/companies that are corrupt, prone to fraud,
poorly managed and lacking sufficient protection for
investors’ rights
• Securities and company law protection may help, but
not enough
• Corporate Governance supplements the legal
framework

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 Corporate Governance
• Corporate Governance also plays an important
role in maintaining corporate integrity and
managing the risk of corporate fraud,
combating against management misconduct
and corruption

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Recent Corporate Failures

• Enron Corporation
• Worldcom
• Parmalat
• GlobalCrossing
• Aledphia
Even more recent failure related to risk in the
market
• Fannie Mae & Freddie Mac
• BearSterns
• Meryl Lynch
• AIG
• Lehman Brothers
Corporate Governance in practice

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 Board of Directors
• Assume responsibility of leadership and
control of the corporate
• Direct and supervise the corporate’s affairs
• Make decisions in the interests of the
corporate

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 Board of Directors
• Regular meetings
• Active participation
• Freedom to include items in agenda
• Sufficient notice for board meetings
• Access to advice and services of company
secretary and independent professional advice

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 Board of Directors
• Full record of board/committee minutes, and
available for inspection
• Independent non-executive directors should be
present at board meetings to discuss matter
involving conflict of interest
• Abstain from voting if conflict of interest
exists
• Insurance coverage in respect of legal action
against directors

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 Chairman and CEO
• Separation of Chairman and CEO
• Division of responsibilities between Chairman
and CEO clearly laid down in writing

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 Chairman and CEO
• Segregation of the management of the board
and the day-to-day management of the
corporate’s business
• Balance of power at board level to avoid
concentration of power in a single individual

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 Chairman
• Provide leadership for the board
• Ensure the board works effectively and
discharges its responsibilities
• Ensure good corporate governance practices
and procedures are in place
• Ensure all directors are properly briefed on
issues arising at board meeting
• Responsible for ensuring appropriate
information received by directors
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 Chairman
• Encourage full and active contribution to the
board’s affair
• Ensure effective communication between
board and the shareholders
• Hold annual meetings with non-executive
directors
• Ensure constructive relationships between
executive and non-executive directors

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 Board Composition
• Balance of skills and experiences
• Balanced composition of executive and non-
executive directors
• Non-executive directors should be of sufficient
calibre
• Independent non-executive directors should be
expressly identified
• List of directors updated and their respective
role and function identified
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 Appointment, re-election and
removal of directors
• Formal and transparent procedure for
appointment
• Succession plan
• Re-election at regular intervals
• Proper explanation for resignation/removal of
directors

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 Appointment, re-election and
removal of directors
• Specific term for non-executive directors
• All directors subject to retirement by rotation
at regular interval
• Nomination committee formed to make
recommendation on appointment of directors
and succession planning for directors,
chairman and CEO

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 Responsibilities of directors
• Keep abreast of the responsibilities as a director
• Exercise duties of care, skill, integrity and diligence
expected
• Ensure proper understanding of the operation,
business and the regulatory requirement
• Contribute sufficient time and resources to serve the
corporate
• Attend AGMs to share the views of shareholders

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 Non-executive directors
• Active participation in board meetings
• Bring in independent judgment
• Take lead if conflict of interest arise
• Serve on committees
• Monitor the corporate’s performance in
achieving pre-set goals

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Information access by directors
Directors should be provided with accurate
and appropriate information in order to make
informed decision and to discharge their
responsibilities

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 Information access by directors
• Agenda and board papers should be sent in full
in a timely manner to directors
• Information supplied must be complete and
reliable
• Directors should have access to the senior
management for information
• Information supplied should be of form and
quality to facilitate informed decision

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 Remuneration of directors and
senior management
• Transparency of directors’ remuneration
policy
• Remuneration should be sufficient but not
excessive
• Each director not to involve in deciding his/her
own remuneration

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 Remuneration Committee
• Remuneration committee to be formed, mainly from
non-executive directors
• Consult Chairman/CEO if needed
• Access to professional advice, market comparable
information
• Make recommendation on policy and structure of
remuneration
• Determine specific remuneration packages of all
executive directors and senior management

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 Remuneration Committee
• Review and approve performance-based
remuneration
• Review and approve compensation
arrangement in connection with loss or
termination of office, dismissal or removal of
directors for misconduct

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 Accountability and Audit
– Financial Reporting
• Management provide explanation and information to
the board to enable them to make informed
assessment of financial and other information
• The board should present comprehensive assessment
of the corporate’s performance, position and
prospects in annual and interim reports, price-
sensitive announcements and other financial
disclosures

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 Accountability and Audit
– Internal Control
• Ensure the maintenance of sound and effective
internal controls to safeguard assets
• Conduct regular reviews of the effectiveness
of the internal control system, covering
financial, operational, compliance and risk
management control functions
• Prevent fraud, corruption, and malpractices

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 Audit Committee
• Have clear terms of reference
• A formal and transparent arrangement to apply
the financial reporting and internal control
principles and maintain appropriate
relationship with external auditors

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 Audit Committee
• Full minutes of audit committee to be kept
• Provided with sufficient resources to discharge
its duties
• Independent from external auditors

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 Audit Committee
• Make recommendation for appointment and
removal of external auditors
• Monitor the effectiveness of the audit process,
ensuring auditor’s independence and
objectivity
• Monitor the integrity of the financial
disclosures
• Oversight of the financial reporting and
internal control procedures

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 The audit committee’s main responsibilities

• To monitor the integrity of the financial statements

• To review the company’s internal financial controls,
internal control and risk management systems.
• To monitor/review the effectiveness of the internal audit
function.
• To make recommendations to the board on the
appointment/removal of the external auditor
 The audit committee’s main responsibilities

• To monitor/review the external auditor’s

independence/objectivity and the effectiveness of the
audit process.
• To develop/implement policy on the engagement of the
external auditor to supply non-audit services
• To review arrangements by which staff may raise
concerns about possible improprieties (‘whistleblowing’)
 Delegation by the Board
• Formal schedule of matters specifically
reserved to the board for decision
• Clear directions to management as to matters
requiring board approval before decision made

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 Delegation by the Board
• Clear directions to the delegation of the
management and administration functions as
well as the powers of management
• Review the arrangement for segregation of
duties between board and management
regularly
• Board Committee to be formed, with specific
terms of reference, as needed

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 Communication with Shareholders
- Effective communication
• Maintain on-going dialogue with shareholders
and make use of annual general meetings or
other general meetings to communicate with
shareholders
• Transparency in corporate governance
practices and business performances through
proper and adequate disclosures
• Encourage shareholders’ participation

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 Communication with Shareholders
- Effective communication
• Separate resolution for each separate issue
• Chairman of the board and chairman of each board
committees be present in general meetings to answer
questions at any general meeting
• Chairman of independent board committee be present
to answer any questions in any general meeting to
approve transaction requiring independent
shareholders’ approval

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 Communication with Shareholders
- Voting by Poll
• Inform shareholders about procedure for
voting by poll
• Ensure proper compliance to regulatory
requirement about voting by poll

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 Functions of the board

Outward Providing Strategy Formulation

looking Accountability

Approve and work

through the CEO

Inward Monitoring and Policy Making and

Looking Supervising Revising

Past and present focused Future Focused

 All Executive Board

Governance

O
O O
O O

O - executive directors
Management
 Majority – executive board

Governance
N

N
N O
O
O O

O - executive directors
N – non executive
Management
directors
 Two – tier board

Governance N N N

N N
N N
N N

O - executive directors
O
N – non executive O O
Management
directors
O O
 Majority – non-executive board

Governance
N
N
N
N
N O

O O

O - executive directors
N – non executive
Management
directors
 The Effective Board
• Clear strategy aligned to capabilities
• Vigorous implementation of strategy
• Key performance drivers monitored
• Effective risk management
• Sharp focus on views of the capital market and
other key stakeholders
• Regular evaluation of board performance
 What does the market look for in a board
member?
• Asks the difficult questions
• Works well with others
• Has industry awareness
• Provides valuable input
• Is available when needed
• Is alert and inquisitive
 What does the market look for in a board
member?
• Has business knowledge
• Contributes to committee work
• Attends meetings
• Speaks out appropriately at board meetings
• Prepares for meetings
• Makes long-range planning contribution
• Provides overall contribution
 The distinction between
Governance and Management
Governance is Different from
Management

Governance

Management
 Governance and Management
• Management runs the business
• the board ensures that the business is well run
and run in the right direction
 GOVERNANCE VS
MANAGEMENT
• "Governance" as represented by the board of
directors involves the strategic task of setting
the organisation's goals, direction, limitations
and accountability frameworks.
• "Management" represented by managers
involves the allocation of resources and
overseeing the day-to-day operations of the
organisation.
 GOVERNANCE VS
MANAGEMENT
One way to think about this is that:
• Governance determines the "What?" - what the
organisation does and what it should become
in the future.
• Management determines the "How?" - how the
organisation will reach those goals and
aspirations.
 GOVERNANCE VS
MANAGEMENT
• The single most important feature of good
governance is a clear segregation of the
responsibilities and accountabilities of the
board from those of the management.
• The board's job is to oversee management, not
to manage
The distinction between governance
and management
• Governance refers to representing the will or
interests of a group of people.
• That group being the owners or shareholders.
• Nonprofits - The citizens, who provide tax
breaks, are one class of owners, but members,
or people who care about the mission of the
organization is another class of owners.
 Governance
• The governance represents those owners and
directs the management to achieve particular
results that are desired by the owners.
• The governance body also oversees the
management to ensure that the organization is
achieving the desired outcomes and to ensure
that the organization is acting prudently,
legally, and ethically.
Organisational Chart

SHAREHOLDERS

BOARD OF
DIRECTORS /
Governing Body

MANAGEMENT
 Management
• Management makes operational decisions and
policies
• keeps the board educated and informed
• brings to the board well-documented
recommendations and information to
support its policy-making, decision making
and oversight responsibilities.
 Functions of Governance
Strategic direction
• Exercising effective leadership that optimizes
1. the use of the financial, human, social, and
technological resources of the organisation.
2. Establishing a vision or a mission for the
organisation
3. Reviewing and approving strategic documents
4. Establishing operational policies and guidelines.
5. Continually monitoring the effectiveness of the
organisation’s governance arrangements and
making changes as needed.
 Management oversight
• Monitoring managerial performance and
implementation of policies, appointing key personnel,
approving annual budgets and business plans, and
overseeing major capital expenditures.
• Promoting high performance and efficient processes
by establishing an appropriate balance between
control by the governing body and entrepreneurship
by the management body.
• Monitoring compliance with all applicable state laws
and regulations, and with the regulations and
procedures of stakeholder organizations, as the case
may be
 Stakeholder participation
• Establishing policies for inclusion of
stakeholders in the organisation’s activities.
• Ensuring adequate consultation,
communication, transparency, and disclosure
in relation to stakeholders that are not
represented on the governing body
 Risk management
• Establishing a policy for managing risks
and monitoring the implementation of the
policy.
• Ensuring that the volume of financial
resources is commensurate with the
organisation’s needs and that the sources of
finance are adequately diversified to mitigate
financial shocks
 Conflict management
• Monitoring and managing the potential
conflicts of interest of members of the
governing body and staff of the management
team.
• Monitoring and managing conflicting interests
among the organisation’s stakeholders
especially those that arise during the process
of implementation of various organisation’s
activities / projects.
 Audit and evaluation
• Ensuring the integrity of the organisation’s
accounting and financial reporting systems,
including independent audits.
• Setting evaluation policy, commissioning
evaluations in a timely way, and overseeing
management uptake and implementation of
accepted recommendations.
• Ensuring that evaluations lead to learning and
continued development of the organisation.
INGREDIENTS FOR
GOOD CORPORATE
GOVERNANCE
 Basic elements of Good Governance
• Accountability – being answerable for decisions and having
meaningful mechanisms in place to ensure that all applicable
standards are adhered to
• Transparency/openness – having clear roles and
responsibilities and clear procedures for making decisions and
exercising power
• Integrity – acting impartially, ethically and in the interests of
the organisation, and not misusing information acquired
through a position of trust
• Stewardship –(the careful and responsible management of
something entrusted to one's care) - using every opportunity to
enhance the value of the organisation’s assets and institutions
that have been entrusted to one’s care
• Efficiency – ensuring the best use of resources to further the
aims of the organisation
• Leadership – achieving an organisation-wide commitment to
good governance through leadership from the top.
 Corporate Governance

Corporate Governance is a dynamic process and is continually evolving

AND

It has no boundaries or limits!

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MODELS

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 Models of corporate governance
Five broad systems of corporate governance:
 The American rule-based mode
 The United Kingdom/Commonwealth principles-
based model
 The Continental European two-tier model,
 The Japanese stakeholder-orientated network
model
 The Asian family-based model
The American rule-based model

 companies incorporated by states

 Investor protection federal by Securities Exchange
Commission(SEC)-the US
 company law based on common law
 governance regulated by law and mandatory rules,
which are inherently inflexible
 high levels of litigation
 generally accepted accounting principles rule-based
 unitary boards with executive and non-executive
directors
 roles of board chairman and CEO often combined
 Anglo-Saxon Model
• US, UK, Canada, Australia, New Zealand
• Shareholder value maximization
• “outsider” model – arms length investor
• Internal governance mechanisms
– board of directors
– employee compensation
• External mechanisms
– market for corporate control
– monitoring by financial institutions
– competition in product and input market
• Reliance on legal mechanisms to protect shareholder rights
• Short term financial performance key
 The UK/Commonwealth
principles-based model
 companies incorporated at country level
 company law based on common law
 governance is principles-based
 corporate governance codes - follow or explain
why not
 international accounting standards
 unitary boards with executive and non-executive
directors
 roles of board chairman and CEO separated
The Continental European two-
tier model
 companies incorporated at country level
 company law based on rule-based civil law
 governance rooted in the law
 international accounting standards
 supervisory board - all non-executive
 executive board - all executive
 no common membership between the two boards
 co-determination with employee and shareholder
appointed directors on supervisory board
 Japanese Model
• Formal role of large and almost entirely executive boards – single tier
board
• Historical roots of the Keiretsu network interlocking business
relationships
• Existence of significant cross holdings and interlocking-directorships,
• Lifetime employment system plays in corporate policy
• Role of banks
• Market share maximization over shareholder value maximization
• Long term perspective
 The Japanese business network
Model
– Keiretsu networks of companies connected through cross-holdings,
interlocking directorships and extensive inter-trading
– classical model of the keiretsu reflects the social cohesion within
Japanese society
• unity throughout the organization
• non-adversarial relationships
• lifetime employment(life-long learning perspective)
• enterprise unions
• personnel policies encouraging commitment
• decision-making by consensus
• promotion based on loyalty and social compatibility as
well as performance
This model is currently under pressure to change but survives
 Continue ……..
The Japanese business network model
– boards of directors tend to be large
– all executive - the top layers of the management
pyramid
– 'promotion to the board‘
– independent outside directors not acceptable
• how can they understand the company?
• how can they appreciate the corporate culture?
• potential to disrupt the harmony
– Meetings of the whole board formal, ceremonial
– governance power lies with chairman and senior
directors/executives
 The Asian family-based model
Overseas Chinese firms are:
 family centric with close family control
 controlled through an equity stake kept within the family
 entrepreneurial often with a dominant entrepreneur
 decision making centralised
 close personal links emphasizing trust and control
 paternalistic in management style
 social fabric dependent on relationships and social harmony,
 strategically intuitive with business seen as more of a succession of
contracts or ventures, rather than strategic plans, brand-creation or
quantitative analysis
 German (Continental) Model
• Co-determination - partnership between capital and labor
• Social cooperation
• The two-tier board structure that consists of a supervisory board and
executive board – greater efficiency in separation of supervision and
management
• Cross–shareholding in financial – industrial groups
• Role of banks as major shareholders
• Primary sources of capital – retained earnings and loans
THEORIES

103
 Contract Theory of Corporate Governance

• Contract are arranged between principles (owners) and

agent (managers)
• Contracts are also made between the firm and providers of
capital
• Problems with contracts:
– Moral Hazard
– Incomplete contracts
– Adverse selection bias
• Coase 1937, Jensen & Meckling 1976, Fama and Jensen
1983
 Agency Theory
• Berle and Means (1932) – separation of
ownership and control through modern
corporation structures
• Agency Problem
 Agency Problem
• Managerial discretion - Business judgement
• Managerial opportunism – self dealing
• Duty of loyalty of management to firm
 Agency Problem
• Separation of Ownership and Control
• Contract between financiers and management
• Managerial discretion - Business judgement
• Managerial opportunism – self dealing
 Agency Problem
• Duty of loyalty of management to firm
• Incentive contracts that align management
interests with investors
• Agency costs – monitoring and compliance
• Shareholder actions- shareholder democracy,
proxy fights, access to the proxy ballot,
derivative lawsuits
 Agency Problem Duty of loyalty
of management to firm
• Incentive contracts that align management
interests with investors
• Agency costs – monitoring and compliance
• Shareholder actions- shareholder democracy,
proxy fights, access to the proxy ballot,
derivative lawsuits
 Theoretical Challenges to Agency Theory

• Stewardship theory, the alternative

perspective, takes an altogether broader frame
of reference, being based on the original and
legal view of the corporation in which
directors have a fiduciary duty to their
shareholders to be stewards for their interests.
 Agency Theory
An agency relationship exists when:
Agency Relationship
Shareholders Risk Bearing Specialist
(Principals) (Principal)

Hire Managerial Decision-Making

Firm Owners Specialist
(Agent)

Managers
(Agents)
which creates
Decision
Makers
 Agency relationship

112
 Agency Theory

The Agency problem occurs when:

- The desires or goals of the principal and agent conflict
and it is difficult or expensive for the principal to
verify that the agent has behaved appropriately
Example: Over diversification because increased product
diversification leads to lower employment risk
for managers and greater compensation
Solution: Principals engage in incentive-based performance
contracts, monitoring mechanisms such as the
board of directors and enforcement mechanisms
such as the managerial labor market to mitigate
the agency problem
 Agency Theory

Principals may engage in monitoring behavior to assess

the activities and decisions of managers
- However, dispersed shareholding makes it difficult and
and inefficient to monitor management’s behavior

For example: Boards of Directors have a fiduciary

duty to shareholders to monitor
management
- However, Boards of Directors are often accused of
being lax in performing this function
From Owner Entrepreneur to double Agency
Dilemma
OWNER

Owner Entrepreneur
PRIVATE
COMPANY

SHAREHOLDERS

PUBLIC
COMPANY

Shareholders Delegate Power to the Board of Directors

Double Agency Dilemma
BOARD OF DIRECTORS

Board Delegates Power to Management

MANAGEMENT

Source: Adapted from Blake (1999).

 Double Agency Dilemma

COMPANY SHAREHOLDERS

Shareholders Delegate Power to the Board of Directors

BOARD OF
DIRECTORS
Board Delegates Power to Management

MANAGEMENT

Source: Adapted from Blake (1999)

 Stewardship Theory
• States that if managers are left on their own, will act as
responsibly as stewards of the organisational
resources/assets they are given to have control over.
• The stewardship theory assumes that managers are good &
trustworthy. They are appointed mainly due to their good
reputation. This is done with the intention to cut
bureaucracy & increase motivation, which will help the
managers take quick decisions.
• Stewardship theory it suggests that executives tend to be more
motivated to act in the best interests of the corporation than in their
own self-interests. Stewardship theory focuses on the higher-order
needs, such as achievement and self-actualization.
• The theory argues that senior executives over time tend to view the
corporation as an extension of themselves.
 Stewardship Theory
• It’s an alternative approach to corporate governance,
in the agency theory (by Donaldson and Davis)
• “Stewardship theory stresses the beneficial
consequences on shareholder returns if facilitative
authority structures which unify command by having
roles of CEO and chair held by the same person.” -
Donaldson and Davis
• So, stewardship theory does not put manager under
control of owners, it empowers managers to take
autonomous executive action
 Resource dependence theory
(RDT)
• Views that organizational external resources
affect the organizational behavior.
• The procurement of external resources is
critical for both the strategic and tactical
management of businesses.
 Basic argument of RDT
• Organizations depend on resources[Resource-Based View-
RBV].
• Resources originate from an organization's
environment[Internal/External].
• The external environment contains other organizations.
• The resources may be in the hands of other organizations.
• Resources are a basis of organisational power.
• Legally independent organizations can be interdependent.
• A direct link between power and resource dependence:
– Organization A's power over organization B is equal to
organization B's dependence on organization A's resources.
Power is thus relational, situational and potentially mutual.
 Managerial and Class Hegemony
• Hegemony refers to leadership or dominance
• Suggests that senior management selects cronies(close friends) and
colleagues who will not stop their actions.
• They are willing to be passive participants in the process of CG
• They are dependent on the management of the coy for information.
• It’s a symbolic approach-meeting the regulatory requirements (mere
compliance)
• There is no substance-its not a tool to effect organisational change-
but to keep status quo.
• There is no commitment to provide direction.
• Board does not act as an independent body that monitors
management(that happens with Agency Theory)
• From a hegemony perspective the functions of the board are limited to ratifying
(making officially valid-rubberstamping) management’s actions.
• Board of Directors represents the interests of corporate managers to the exclusion
of other stakeholders.
• Class Hegemony is an extension of managerial hegemony
• This when the dominance goes beyond company boundaries-the influence goes to
other organisations.
• The hegemonic board is detrimental to shareholders because there will be no
monitoring
• It impairs the stewardship function.
• Promotes entrenchment of management(gate keeping)- they want to show that
change is difficult and costly to the firm.
• The CEOs stock the firm with sympathetic outsiders
• The Audit Committee will be under the influence of management.
• The AC becomes an ally to management leading to collusion problems.
• The AC becomes a toothless “paper tiger”
What the corporate governance problem becomes
– When managers control the firm
Owners Principal

Board Customers
Agent

Top Management Middle Management

Employees

Suppliers
Organizational Behavior
Henry Tosi
Prof. Henry Tosi - University of Florida
Psychological and organizational perspectives
 Stakeholder Theory
• In agency theory, maintenance or enhancement of
shareholder value is paramount
• Stakeholder theory-argues that the corporation
should include the interests of other stakeholders and
not shareholders only.
• Here, in the stakeholder theory we take into account
a wider group of people:
•shareholders, employees, providers of credit, customers, suppliers,
government, local community
– Should we favor shareholders over other stakeholders?
 Stakeholder model of
Corporate Governance

( Freeman, (1984),
ed Crane, A et al, 2008 P114)

Stakeholders theory, is based upon the premise that organisations should be responsible to a
wider range of stakeholders, than the narrow interests of one group. (Cornforth, 2007)
 Continue ………..
• Stakeholders will make firm-specific investments in the
corporation.
• Taking the interests of stakeholders into account will
generate more wealth for the organisation.
• CRITICISM
• Managers are told to serve two masters(equity holders
and the community).
• Profit maximisation faces challenges thus corporate
wealth is reduced.
• It becomes very complicated to balance the interests of
all stakeholders.
 Basic Points of Transaction Cost Perspective
• Organisations: series of transactions, some
within the Org, some across the Org’s boundaries
 Transaction: exchange of goods and services among
groups within the Org. or across organisational
boundaries
 Transaction Costs: explicit fees or costs associated
with a transaction; implicit costs of monitoring and
controlling a transaction
 Goal: to determine the most efficient arrangement of transactions
— whether transactions should take place inside the Org or across
Organisational boundaries; seek lowest transaction costs.
 Transaction Cost as Problem to Remedy
Organisational economists use the term “cost”
to refer to a wide range of problems that
owners must remedy in order to create an
organization that allows for wealth
maximization
Types of Transaction Costs
 Bounded Rationality  Asset specificity
 Opportunism  Small Numbers
 Information Asymmetry
1- Bounded Rationality
Owners and managers unable to process all of
the available information, and face uncertainty
in transactions or contract relationships

Employees, suppliers, and contractors may be

in a position to take advantage of the owner

Therefore, costs are incurred by the owner

in gathering and processing information in
order to reduce these costs
 2- Transaction Cost Economics
Theory
How to maximize efficiency of transactions by
determining the proper boundaries of the
Org.
What should be done internally versus
what should be contracted for on the
outside?
2- Opportunism

Principals and agents often have different

goals and will seek their own self-interest
Agents will not always fulfill their
obligations because they prefer leisure to
work and are subject to shirking
Moral hazard: workers will not supply
the agreed-upon effort
Adverse selection: agents will misrepresent
themselves
3- Information Asymmetry

Information related to exchanges or

transactions is not evenly distributed

Agents have certain information about their own

behaviour and shortcomings that is not available
to the principal

Costs are incurred in gathering

additional information and using
various governance mechanisms
4- Asset Specificity

Assets that are very specific and fixed can

reduce the flexibility
Investment decisions in specific
assets have implications on how the
organisation governs its relationship
with employees and other firms
5- Small Numbers

An organisation with only a small number

of potential trading partners (an oligopoly)
has a problem

The organisation can more easily be

exploited by a trading partner
 THEORY Assumptions Board member Main board Key issues
role function
Principal-Agent theory Owners’ interests may Supervisor Conformance: Emphasis on control may
differ from managers’ (Chosen to - Safeguard stifle innovation and risk
interests represent owners owners resources taking, and reduce staff
interests, and be and interests motivation
independent of - Supervise
management) management/staff

Stewardship theory Owners and managers have Partner Improving Management proposals and
similar interests (Chosen for Performance: systems may not be given
expertise) - add value to top adequate scrutiny.
decisions/strategy
- partner
management
Stakeholder theory Different stakeholder have ‘Represent’ Political: Board members may promote
legitimate but different different - represent and stakeholder interests rather
interests in the balance different than the organisation’s. May
stakeholder
organisation. stakeholder be difficult to agree
views interests objectives.
- make policy
- control executive
Resource dependency theory Organisational survival Supporter External influence: External focus of board
depends on maintaining (Chosen for - secure resources members may mean internal
coalition of support to influence or - improve supervision is neglected.
obtain resources and resources they stakeholder Board members may lack
legitimacy may bring.) relations expertise.
- bring external
perspective

Managerial hegemony theory Owners and managers have Symbolic Legitimacy: Management may pursue own
different interests, but -ratify decisions interests at expense of
managers control main -support ‘owners’, managers gain little
levers of power. management of value from board.
-give legitimacy
Theoretical Perspectives: CG and Board Role

AGENCY TRANSACTION MANAGERIAL CLASS

COSTS STEWARDSHIP RESOURCE STAKEHOLDER HEGEMONY HEGEMONY
ECONOMICS DEPENDENCY
CORPORATE GOVERNANCE AND BOARD ROLE
Self- Focus on Ensure the Reduce Defines firms The board as Perpetuate
interested governance Stewardship uncertainty; as inclusive a ‘legal elite & class
utility needs of of corporate boundary multilateral fiction’; power;
maximizing exchange assets spanning; agreements Managerial Corporations
motivation relations highlights the between the control as
of No inherent Interdependence enterprise exploitative
individual conflict of of firms rather and multiple Need to vehicle for
Interest understand Accumulation
actors than viewing Stakeholders
between the
Managers/ them simply in of wealth and
Concerned relationship
Ensure
with owners, and terms of Between
power
match that optimum management These relation-
mechanisms owners,
Between governance ships constrain
which intentions Managers
managers structures and create the
reduce costs and
(‘agents’) allow strategic
associated Connecting firm The board of
and coordination possibilities of
with with external Directors
shareholders. of the the company.
contractual resources help
(‘principals’) enterprise to
hazards to reduce
be achieved Uncertainty

Source: Adapted from Corbet and Mayer (1991); Charkham 1992; Ebster-Grusz and Pugh 1992; and Nunnenkamp (1995)
 Theoretical Perspectives: Origin, Analysis, Focus

AGENCY TRANSACTION RESOURCE MANAGERIAL CLASS

COSTS STEWARDSHIP DEPENDENCY STAKEHOLDER HEGEMONY HEGEMONY
ECONOMICS
ORIGIN

Economics Economics Organization Organization Politics, Law, Management Sociology &

and Finance and Studies Studies & management Organizational Politics
Finance organization Studies
studies
ANALYSIS

Individual Transaction Coordination Resources Stakeholders Management Corporations

FOCUS

Agency costs Asset Stewardship Interdependence Relationships Control Exploitation

Specificity

Source: Adapted from Corbet and Mayer (1991); Charkham 1992; Ebster-Grusz and Pugh 1992; and Nunnenkamp (1995) Stiles and Taylor 2002
 Theoretical Perspectives: Origin

AGENCY TRANSACTION RESOURCE MANAGERIAL CLASS

COSTS STEWARDSHIP DEPENDENCY STAKEHOLDER HEGEMONY HEGEMONY
ECONOMICS
THEORETICAL ORIGIN

Self- Focus on Ensure the Reduce Defines firms The board Perpetuate
interested governance Stewardship uncertainty; as inclusive as elite and
utility needs of of corporate boundary multilateral a ‘legal class
maximizing exchange assets spanning; agreements fiction’; power;
motivation relations highlights the between the Managerial Corporations
of No inherent Interdependence enterprise control as
individual conflict of of firms and multiple exploitative
Interest rather than Need to vehicle for
actors Stakeholders
between understand Accumulation
Managers/
viewing them
Concerned the of wealth
Ensure
with owners, and simply in term
match relationship and
mechanisms that optimum terms of These relation-
Between
Between governance management ships constrain power
which owners,
managers structures and create the
(‘agents’)
reduce costs intentions Managers
associated allow strategic
and and
with coordination possibilities of
shareholders. Connecting firm The board of
contractual of the the company.
(‘principals’) with external Directors
hazards enterprise to
resources help
be achieved
to reduce
uncertainty

Source: Adapted from Corbet and Mayer (1991); Charkham 1992; Ebster-Grusz and Pugh 1992; and Nunnenkamp (1995)
 Shareholder Theory
• Argues for the primacy of shareholders
• Argues that the duty of corporate director is to
maximize shareholder value
• Shareholders (unlike other stakeholders) have
the greatest incentive to ensure profit
maximisation.
• This goal will benefit the whole organisation
and other stakeholders.
 Continue ……………
• Balancing other stakeholders’ interests could
be costly o the corporate

• Arguments against Shareholder Primacy:

• Reduction in aggregate social welfare-focus on
profit maximisation.
• Disregarding ethical considerations for profit
maximization.
 Continue ………..
• Shareholders may end up over-investing in
‘harzadous industries’ to get more profits.
• Focus on short-term earnings
• Shareholders’ wealth may be increased by
merely transferring wealth to shareholders
from other stakeholders who are not protected
by fiduciary duty of directors.
 Enlightened Shareholder Theory.

• Attempts to strike the balance between the

certainty of shareholder primacy and the
sensitivity to external impacts of shareholder
theory.
• It understood as a limit on the maximisation
of shareholder value
 The Governance of Corporate
risk
• “Risk comes from not knowing what you are
doing” Warren Buffet
• 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, corporations and society.
( Sir Adrian Cadbury, UK, Commission Report:
Corporate Governance 1992)
 What is Risk?
 GRC – Governance, Risk and Compliance
 Definition of Risk traces its origin historically to
Greek mythology -“ to run into danger”
 Incidentally the word “governance” also traces its origin to
Greek word “kubernao” and passed on to Latin – to steer.
 Time immemorial enterprising people dared to venture and
conquer. No venture will succeed unless there is an overlay of
risk.
 But essential element of business is not only to make profits
but also steer clear of danger.
• A risk is a potential problem – it might happen and it might
not
• Conceptual definition of risk
– Risk concerns future happenings
– Risk involves change in mind, opinion, actions, places, etc.
– Risk involves choice and the uncertainty that choice entails
• Two characteristics of risk
– Uncertainty – the risk may or may not happen, that is,
there are no 100% risks (those, instead, are called
constraints)
– Loss – the risk becomes a reality and unwanted
consequences or losses occur

Prentice Hall, Inc. ©2012 2-146

Risk Categorization – Approach
#1
• Project risks
– They threaten the project plan
– If they become real, it is likely that the project schedule will slip and that
costs will increase
• Technical risks
– They threaten the quality and timeliness of the software to be produced
– If they become real, implementation may become difficult or impossible
• Business risks
– They threaten the viability of the software to be built
– If they become real, they jeopardize the project or the product

(More on next slide)

147
Risk Categorization – Approach
#1 (continued)
• Sub-categories of Business risks
– Market risk – building an excellent product or system that no one really
wants
– Strategic risk – building a product that no longer fits into the overall
business strategy for the company
– Sales risk – building a product that the sales force doesn't understand how
to sell
– Management risk – losing the support of senior management due to a
change in focus or a change in people
– Budget risk – losing budgetary or personnel commitment

148
Risk Categorization – Approach
#2
• Known risks
– Those risks that can be uncovered after careful evaluation of the project plan,
the business and technical environment in which the project is being
developed, and other reliable information sources (e.g., unrealistic delivery
date)
• Predictable risks
– Those risks that are extrapolated from past project experience (e.g., past
turnover)
• Unpredictable risks
– Those risks that can and do occur, but are extremely difficult to identify in
advance

149
 What is Risk Management?
Risk - The possibility of financial loss
Management - The business function used to plan,
organize, and control all available resources to reach
company goals
Risk Management - The systematic process of
managing an organization’s risk exposure to achieve
objectives in a manner consistent with public interest,
human safety, environmental factors, and the law.
Risk Management Cycle
 What is Risk Analysis?
• The process of identifying, assessing, and
reducing risks to an acceptable level
– Defines and controls threats and vulnerabilities
– Implements risk reduction measures
• An analytic discipline with three parts:
– Risk assessment: determine what the risks are
– Risk management: evaluating alternatives for
mitigating the risk
– Risk communication: presenting this material in an
understandable way to decision makers and/or the
public

Slide #152
 Benefits of Risk Analysis
• Assurance that greatest risks have been
identified and addressed
• Increased understanding of risks
• Mechanism for reaching consensus
• Support for needed controls
• Means for communicating results

Slide #153
 Basic Risk Analysis Structure
• Evaluate
– Value of computing and information assets
– Vulnerabilities of the system
– Threats from inside and outside
– Risk priorities
• Examine
– Availability of security countermeasures
– Effectiveness of countermeasures
– Costs (installation, operation, etc.) of countermeasures
• Implement and Monitor
Slide #154
 Identify Assets
• Asset – Anything of value
• Physical Assets
– Buildings, computers
• Logical Assets
– Intellectual property, reputation

Slide #155
 Example Critical Assets
• People and skills
• Goodwill
• Hardware/Software
• Data
• Documentation
• Supplies
• Physical plant
• Money
Slide #156
 Threats
• An expression of intention to inflict evil
injury or damage
• Attacks against key security services
– Confidentiality, integrity, availability

Slide #157
 Types of Risk Analysis
• Quantitative
– Assigns real numbers to costs of safeguards and damage
– Annual loss exposure (ALE)
– Probability of event occurring
– Can be unreliable/inaccurate
• Qualitative
– Judges an organization’s risk to threats
– Based on judgment, intuition, and experience
– Ranks the seriousness of the threats for the sensitivity of the
asserts
– Subjective, lacks hard numbers to justify return on investment

Slide #158
Ways to Handle Business Risks

There are 4 principle ways to handle risks

–Risk Prevention and Control

(Loss Prevention)
–Risk Transfer
–Risk Acceptance
–Risk Avoidance
Risk Prevention and Control
– Screening and Training Employees
– Providing Safe Conditions
– Providing Safety Instruction
– Preventing External Theft
– Deterring Employee Theft
– This is often called “Loss Prevention” in the business world
Risk Transfer
3 Common
Risk Transfers
– insurance
– product/service
warranties
– transference through
business ownership
 Insurance
– Insurance policy - contract that covers a business with
a specific type of insurance reducing risks
– Business liability - insurance protects a business
against damages for which it may be held legally liable,
usually up to only $1 million.
– Personal liability - covers damages by customer and/or
employees
– Product liability - protects from personal injury
caused by product manufactured or sold by the business
Product/Service Warranties
• Warranties are simply
promises made by the
seller or manufacturer
with respect to the
performance and quality
of a product and
protection against loss
 Transference Through
Ownership
• The total amount of risk the business must
handle depends in part on the type of business
ownership
– For example, a entrepreneur who owns a sole-
proprietorship assumes all the risk as where a
stockholder in a corporation assumes only his
percentage of the risk.
 Risk Acceptance
• When the business assumes the loss
responsibility into the upkeep of the company
• Most companies pull out a certain percentage
of their revenue for damages, loss to theft, and
unsold items.
 Risk Avoidance
• Risks can be avoided by advance anticipation
• Following market research can assist a business in
making the decision on whether or not to invest in a
product.
• To determine whether the product is a low risk you
must weigh the potential benefits against the potential
risks
 Risk Management Plan
• Develop an overall Risk Management Plan for
the business
• Develop a specific Risk Management Plan for
specific events that occur within the business
• Revisit the plan regularly to update
Thank you!

168