CHAPTER 2
THE THEORY
AND PRACTICE
OF CORPORATE
GOVERNANCE
OBJECTIVES
Over the past three decades, the concept of
corporate governance has gone through a
metamorphosis. Theoretically, from one that
was related to agency cost, it is now
perceived to encompass everyones interests.
This chapter discusses the theoretical basis,
mechanisms and the divergent models of
corporate governance and culminates in the
identification of an ideal corporation.
CHAPTER OUTLINE
The Concept of Corporation
Theoretical Basis of Corporate Governance
Agency Theory
Stewardship Theory
Stakeholder Theory
Corporate Governance Mechanisms
Corporate Governance Systems
Indian Model of Governance
What Is Good Corporate Governance
Obligation to Society at Large
Obligation to Investors
Obligation to Employees
Obligation to Customers
Managerial Obligation
What is a Corporate?
The term corporate refers to an association of
many persons, who contribute money or
moneys worth to a common stock and employ it
in some trade or business, and who share the
profit and loss arising therefrom. The common
stocks so contributed is denoted in money and is
the capital of the company. The persons who
contribute it, or to whom it belongs, are its
members. The proportion of the capital to which
each member is entitled is his share. Shares are
always transferable, although the right to
transfer them is often more or less restricted.
What is Governance?
Governance is the process of decision
making and the process by which decisions
are implemented or not implemented.
Characteristics of a Corporation
o
Incorporated Association
Artificial Legal Existence
Perpetual Existence
Common Seal
Extensive Membership
Separation of Management and Ownership
Limited Liability
Transferability of shares
Theoretical Basis of Corporate
Governance
o
Agency Theory
Problems with the Agency Theory
Stewardship Theory
Shareholder Vs Stakeholder Approaches
Stakeholder Theory
Criticisms of the Stakeholder Theory
Sociological Theory
Behavioural Differences
THEORY
AGENCY
STEWARDSHIP
Managers act as
Agents
Stewards
Governance Approach
Materialistic
Sociological and
Psychological
Behaviour Pattern
o Individualistic
o Opportunistic
o Self-serving
o
o
o
Managers motivated by
Their own
objectives
Principals objectives
Collectivistic
Pro-organisational
Trustworthy
Managers and Principals Differ
Interests
Converge
Management Structures
Monitor and
control
Facilitate and empower
Owners Attitude
Risk Avoidance
Risk taken
Principal Manager
Relationship based on
Control
Trust
Psychological Mechanisms
PSYCHOLOGICAL
RESPONSES
Motivation
AGENCY THEORY
STEWARDSHP
THEORY
o Lower order
o Higher order
needs
o Extrinsic needs
needs
o Intrinsic needs
Social comparison Compatriots
Principal
Attachment
Little attachment
to company
Great attachment to
company
Power
Institutional
Personal
Situational Mechanisms
SITUATIONAL
RESPONSES
AGENCY THEORY
STEWAREDSHIP
THEORY
Management
Philosophy
Control oriented
Involvement
oriented
While dealing with
increasing
Uncertainty and
risk
Greater controls
More supervisions
Training and
empowering people
Risk orientation
Through a system
of control
Through trust
Time frame
Short term based
Long term based
Objective
Cost control
Improving
performance
Making jobs to be
more challenging
and motivating
Cultural differences Individualism
Large power
Collectivism
Small power
Corporate Governance Mechanisms
o The Importance of Corporate Governance
o Contemporary Corporate Governance Situation
o Growing Awareness and Societal Responses
Corporate Governance Systems
o Anglo-American Model
o The German Model
o The Japanese Model
o Indian Model of Corporate
Governance
Fig.1 : The Anglo-American Model
Shareholders
Elect
Appoints &
Supervises
Creditors
Own
Stakeholders
Board of Directors
(Supervisors)
Lien
on
Stake
in
Legal/Regulatory Monitors &
System
Regulates
Officers
(Managers)
Manag
e
Company
Fig.2 : The German Model
Shareholde
rs
Appoint
50%
Appoint
50%
Supervisory Board
Appoints and
Supervises
Management Board
(Including Labour
Relations Officer)
Manage
Employee
s and
Labour
Unions
Company
Fig.3 : The Japanese Model
elect
Shareholde
rs
Provides
Loans
Supervisory Board
(Including President)
Ratifies the
Presidents
Decisions
President
Provides
Managers
Monitors & Acts
in
Emergencies
Consults
Executive Management
(Primarily Board of
Directors)
Manages
Main
Bank
Own
Owns
Provides Loans
Company
Fig.4 : Indian Corporate Governance Model
External Environment
Government Regulations,
Policies, Guidelines etc.
Corporate Culture, Structure,
Characteristics, Influences
Company Acts
SEBI
Stock Exchanges
Depositors, Borrowers,
Internal Environment
Customers and other
External Stakeholders
Company vision; mission, policies, norms
Internal
Stakeholders
Directors
Auditors
Board of
CORPORATE
GOVERNANCE
SYSTEM
Proper governance
Shareholder value
Corporate Governance Outcomes / Benefits to Society
Transparency
Investor protection
Concern for customer
Healthy corporate sector development
What Is Good Corporate
Governance?
o National Interest
Obligation to society at large
o Political Non-alignment
o Legal Compliances
o Rule of Law
o Honest and Ethical Conduct
o Corporate Citizenship
o Ethical Behaviour
o Social Concerns
o Corporate Social Responsibility
Environment-friendliness
Health, Safety and Working Environment
Competition
Trusteeship
Accountability
Effectiveness and Efficiency
Timely Responsiveness
Corporations Should Uphold the Fair Name of the
Country
Obligation to investors
o Towards Shareholders
o Measures Promoting Transparency and Informed
Shareholder Participation
o Transparency
o Financial Reporting and Records
Obligation to customers
o Quality of Products and Services
o Products at Affordable Prices
o Unwavering Commitment to
o Customer Satisfaction
Obligation to employees
o Fair Employment Practices
o Equal-opportunities Employer
o Encouraging Whistle Blowing
o Humane Treatment
Participation
Empowerment
Equity and Inclusiveness
Participative and Collaborative Environment
Managerial obligation
o Protecting Companys Assets
o Behaviour Towards Government Agencies
o Control
o Consensus Oriented
o Gifts and Donations
o Role and Responsibilities of Corporate Board and
Directors
o Direction and Management must be Distinguished
o Managing and Whole-Time Directors
Johnson & Johnsons excellent Credo exemplarily
epitomises what an ideal corporate should
aspire to be.
Our Credo
We believe our first responsibility is to the doctors, nurses
and patients,
to mothers and fathers and all others who use our
products and services.
In meeting their needs everything we do must be of
high quality.
We must constantly strive to reduce our costs
in order to maintain reasonable prices.
Customers' orders must be serviced promptly and
accurately.
Our suppliers and distributors must have an opportunity
to make a fair profit.
We are responsible to our employees,
the men and women who work with us throughout the world.
Everyone must be considered as an individual.
We must respect their dignity and recognize their merit.
They must have a sense of security in their jobs.
Compensation must be fair and adequate,
and working conditions clean, orderly and safe.
We must be mindful of ways to help our employees fulfill their family responsibilities.
Employees must feel free to make suggestions and complaints.
There must be equal opportunity for employment, development
and advancement for those qualified.
We must provide competent management,
and their actions must be just and ethical.
We are responsible to the communities in which we live and work
and to the world community as well.
We must be good citizens support good works and charities
and bear our fair share of taxes.
We must encourage civic improvements and better health and education.
We must maintain in good order
the property we are privileged to use,
protecting the environment and natural resources.
Our final responsibility is to our stockholders.
Business must make a sound profit.
We must experiment with new ideas.
Research must be carried on, innovative programs developed and mistakes paid for.
New equipment must be purchased, new facilities provided and new products launched.
Reserves must be created to provide for adverse times.
When we operate according to these principles,
the stockholders should realize a fair return.
Johnson & Johnson
Corporate Governance in
India
Problems
o Inadequate Sanction and Enforcement.
o No clear demarcation of control mechanisms
between SEBI, DCA and Stock Exchanges.
o Lack of Professionalism of Directors
o Institutional Investors show poor commitment
o Indian boards are not professional
o Unindependent Independent directors
o Whistle Blower Policy not in place
Too many unlisted companies
Accounting gimmicks
Poor Shareholder participation
Obliging auditors
Soft State, lethargic judiciary, inefficient market
regulator, poor enforcement machinery, and a value
system which is indifferent to moral turpitudes.
However things are improving now
o
The market is competition driven
Professional new players are coming in
High growth in market capitalisation
Well-focussed, well-researched portfolio investors
Media influences
Influence of banks and financial institutions
Realisation among Indian companies of the benefits
of corporate governance and
Impending Capital Account Convertibility will exert its
own pressure.
