Corporate Governance and theories

Corporate Governance and theories

Development of Corporate Government is a global occurrence. Different countries have different Theories in relevance and also depend on the stage of economic condition the country is in, the corporate structure of the country and the ownership groups present. It is also important to understand that not only shareholders but other stake holders are also involved wit a company and therefore emphasis should be given to other interest groups as well like employees, suppliers, customers and local communities (Christine A Mallin 2007).

Theories associated with development of corporate governance

Agency theory

In the theory, there are two parties – principals and agents. Owners are considered Principal and director – agents. According to the theory due to self interest agents may not be working towards principal’s interest. In such cases the result may not be as expected by the principals or owners. A good corporate control is thus required to reduce agency problems and to keep control over director’s actions.

Transaction cost economies

As firms desire to grow overtime, they need capital to expand. Often a firm raises a capital by going public or including other shareholders into the firms. As the owners in the company increase it is possible that the separation of ownership and control (which mostly remains in the hands of directors) may create problems.

Stakeholder theory

As discussed earlier, a firm has a member of stakeholders and is not just accountable to shareholders. If there are other stakeholders that need to be given emphasis then the governance system is developed accordingly. Corporate governance has only recently gained more importance and although agency theory was the main theory that led to its development, stakeholder theory is gaining more importance as it evolves further. It has been observed that good corporate governance have helped business perform better and provided better access to finances.

Corporate Governance in UK

Cadbury and Greenbury reports had a major contribution in UK’s Corporate Governance.

Cadbury Report (1992)

“The Report of the committee on the financial aspects of corporate governance”, also known the Cadbury report, was published in December 1992. After 1980s financial scandals, a committee was formed in may 1991 by the financial reporting councils the London stock exchange and the accountancy profession. The committee worked in the financial aspects of corporate Governance and produced a code of Best Practice, which all UK listed companies related to director remuneration, responsibilities and tenure.

Some of the recommendations were as follows.

• The majority of non-executive directors should be independent of management and free from business or other relationship.

• Non-executive directors should be appointed for the specified terms.

• Executive remuneration should be subject to the recommendation of a remuneration committee made up entirely or mainly of non – executive directors.

Greenbury Report (1995)

The rise of remuneration of directors and absence of necessary incentives for directors to perform better works a rising concern for investors and the public at large especially for listed firms. The Greenbury committee was thus established to address the above-mentioned issue.

The committee submitted its report in 1995 and much of its findings were incorporated into the code of Best Practice on Director’s Remuneration.

The report addressed for major issues “The role addressed for major issues in setting the remuneration package for the CEO and other director.

Service contracts —————————- performance”.

Hampel Report (1998)

After the Greenbury report in 1995, a committee was established in 1996 to review and revise the earlier recommendations of the Cadbury and Greenbury committees. The committee recognized that it was important to understand the situation of each company and the principle of corporate government should be more flexible to be applicable to all companies.

While Cadbury and Greenbury reports addressed the abuse of the discretionary authority entrusted to management, Hampel viewed the same to maximize the shareholder value.

Combined Code (1998)

The combined code was formed from recommendations of Cadbury, Greenbury and Hampel reports put together. It outlined the best practices, which were not mandatory for companies to provide sufficient information to the shareholders about its practices.

Higg’s Report

The report was dedicated towards determining the role, independence and recruitment of non-executive directors. Higgs identified non-executive directors role contributing to corporate strategy, setting remuneration of executive directors, monitoring the performance of executive management et. And recommended that one third board should comprise of non-executive directors.

Corporate Governance in Germany

In Germany, most of the firms are either public or private limited that have shareholders who control the firm and its policies. Like many other European countries, in Germany there are a number of shareholders in a firm. Both financial and non financial investors hold considerable shares in a firm and are the most influential people. It is therefore important to take into consideration these cross-holdings that investors have when analysing the corporate governance in Germany. According to Charkham (1994), banks have considerable investment in large firms and therefore play a central role in determining the corporate policies of the firm. Banks provide long term loans to the firms and develop long term relationship with the firms in the course of time. Due to these facts the corporate governance in Germany can also be called an ‘insider system’ (Charkahm, 1994).

The German corporate governance has a dual board system comprising of a management board and a supervisory board. The management board handles the day to day activities of the firm and is responsible for management of the whole firm. The supervisory board on the other hand is responsible for appointing the directors in the management board, supervising them and deciding their remuneration. The supervisory board also advices the management board on various aspects of business.

According to Charkham (1994),

“ if there were a spectrum with ‘confrontation’ at one end and ‘co-operation’ at the other, we would definitely place German attitudes and behaviour far closer to the co-operation end than, say, those of British or Americans.” (Charkham, 1994)

What Charkham (1994) indicated was how close the shareholders in German firms are to its operations and the interests of different stakeholders are given equal emphasis.

This is supported by the Works Constitution Act 1972, according to which work council has the right to deal with employee matters and conditions of work. This is done to improve trust of the employees in the organisation by keeping them informed about company’s activities and allowing them to participate in the decisions of the company that may have effects on the workers. However the first corporate governance code, Cromme code, was first published in 2002 as discussed in the next section.

Cromme Code (2002)

A committee chaired by Dr Gerhard Cromme was assigned the task to submit a report on corporate governance. The committee submitted the Cromme Report, also know as the Cromme Code, which was published in 2002 and has a number of sections that provide guidelines about different aspects of corporate governance. Later in 2005 there some amendments made to the code.

Some of the sections that Cromme Code covered are:

1. General Meetings and shareholders

According to this section of the code, it is required by the companies to submit annual reports and other financial statements in the general meeting. The meeting decides how the net income has to be disclosed and whether the decision made by the management and the supervisory boards are appropriate and approved. The code also requires the firms to publish these on their website, with any other agenda for public transparency.

2. Co-operation between the Management Board and the Supervisory Board

The management board being the set of directors who actually run the company operations, and the supervisory board being the one that advises and sets goals for the management board, it is important that the two boards co-operate with each other. The code therefore suggests that the management board should report its activities to the supervisory board so that the company’s strategic approach is rightly followed. The management board can seek guidance of the supervisory board in case of any issue and should look to report these immediately. The supervisory board on the other hand should monitor the progress of the management board and check if the duties assigned to management board are being performed effectively and if there are any changes to be made into them. If there is any deviation from the Cromme Code then it is the duty of the management board and the supervisory board to mention them in the annual report explaining why such deviations had occurred. The company has to keep these details available for public viewing for atleast five years.

3. Management Board

The management board is set up by the supervisory board, and it is required as per the code to report these notes in the accounts. In case of any difference in the interest of the management board and the supervisory board, it should be immediately conveyed to the supervisory board. This is important so that management board can work independently and in the best interests of the company.

The code also mentions that the remuneration of the management board should consist of both fixed salary and variable salary, as in many companies where variable salary is based on performance of the firm.

4. Supervisory Board

The supervisory board has the responsibility to determine the composition of the management board and monitoring of the management board. It is therefore important that the supervisory board has suitable knowledge, experience and ability to make good management board and set good targets. Not only this a good supervisory board can provide good guidance to the management board. The code suggests that the supervisory should be independent and not related to the management board so as to avoid any conflict of interests. The code also forbids the chairman of the management board to become the chairman of the supervisory board. The code also states that the management board directors cannot be in the supervisory board of more than 5 non group listed companies.

The remuneration of the directors in the supervisory board can contain both fixed and performance related pay and needs to be disclosed n the annual report as well. The remuneration can be determined in the general meeting or in the articles of association. The Cromme Code has an important requirement that if supervisory board take part in less than half of the meetings in a fiscal year then it has to be mentioned in the supervisory board report.

5. Transparency

The code requires the management board to disclose any information or fact that might affect the company operations and not known to the public. This is so as to keep all shareholders equally informed about the company’s facts. Disclosure should be made through media which is accessible in time to the public.

6. Reporting and Audit of the Financial Resources

In order to avoid any fabrication of the reports the code requires the supervisory board or the audit committee to obtain a statement from the auditor clarifying that there is no financial or any other relation between the firm and the auditor that can affect auditors independence.

According to the amendments, from 2006 onwards, it is important for the companies to disclose all elements of the directors’ remuneration. However, if 75 percent of the shareholders feel that further disclosure is not required then the firm can chose to do so.

It can be said that the corporate governance code in Germany has provided great emphasis on serving the interests of various stakeholders.

Corporate Governance in India

Government had set new reforms introduced in India after the economic downturn in 1990-91 to open up the economy to depend on market mechanisms instead of the government. With the new reforms the committee Securities and Exchange Board of India (SEBI), which became the regulator of the securities market aimed at transforming the public sector and the banking sector in line with international norms. As the disclosure requirements were introduced to safeguard the interests of shareholders these markets were altered.

After the economic downturn in India during 1990 – 91, Indian government introduced new reforms to open the economy to rely more on the market mechanisms instead of the government. The new reforms were mainly aimed at making the public sector more efficient. There were also reforms in the banking sector to bring India in line with international norms, and in the securities market, with the new committee Securities and Exchange Board of India (SEBI) becoming the regulator of the securities market. The securities market was altered as disclosure requirements were introduced to safeguard shareholder’s interests.

Kar (2001) mentions how “ foreign portfolio investment was permitted in India since 1992 and foreign institutional investors also began to play an important role in the institutionalization of the market”.

India has a range of business, including the public limited companies listed in the stock exchange, private companies and foreign companies. Main ownership of the companies is difficult to determine as there are very few studies in this area but we can say that after the economy opened up after 1990-91, institutional investors are gaining more shares of the market.

The Confederation of Indian Industries published a ‘Desirable Code of Corporate Governance’ in 1998 and many companies took the recommendation of the committee on board. Still there are many companies that have poor governance practices which has led to the concerns about financial reporting practices, their accountability to losses being suffered by investors and the resultant loss of confidence that this caused. A recent example of Satyam Computers proves this that still there are companies, which are not following the Code of Corporate Governance.

SEBI formally established the Committee on Corporate Governance in May 1999, chaired by Shri Kumar Mangalam Birla. The report of the Kumar Mangalam Birla Committee on Corporate Governance was published in 2000. The report emphasizes the importance of corporate governance for future growth of the economy and the capital market. Three key aspects underlying corporate governance are defined as accountability, transparency, and equality of treatment for all stakeholders in terms of information. The recommendations of the SEBI are split into mandatory requirements, which are essential for effective corporate governance, and non-mandatory requirements.

1. Board of Directors

Board in Indian companies should comprise of the Executive Directors and Non-Executive Directors and Independent Directors. The code recommends not less than 50 percent of the board should be comprised of the Non-Executive Directors, where there is a non-executive chairman, and at least one-third of the board should comprise independent directors, where there is an executive chairman, and finally at least half the board should be independent, the latter being mandatory.

2. Nominee Directors

The Indian system allows nominee directors appointed by the financial or investment institutions to protect their investment in the company. Such directors should have the same responsibility as other directors and be accountable to the shareholders.

3. Chairman of the Board

The roles of the chairman and the chief executive are different, the code identifies the roles as related and may be combined and performed by one person.

4. Audit Committee

The audit committee has many mandatory recommendations, like the committee should comprise at least three members, all of them being the non-executive directors. The audit committee is empowered to seek external advice as appropriate and to seek information from any employee.

5. Remuneration Committee

Remuneration committee is set up to decide on the remuneration of the executive directors. Committee should be comprised of at least three non-executive, chaired by an independent director. All the remuneration package of the directors must be disclosed in the annual report with details on all the elements including the fixed salary and performance based incentives. Another mandatory requirement is that the board of directors must decide on the remuneration package of the non-executive directors.

6. Board Procedures

Board Meetings should be held a minimum of 4 times in a year with a maximum of 4 months between two meetings and that a director must not be involved in more than 10 committees or act as a chairman in more than 5 committees.

7. Management

Management should ensure smooth day – to – day activities of the company. There should be disclosure of the company’s performance, position and other things of interest to shareholders in the annual report.

8. Shareholders

Shareholders are allowed to be able to participate in the annual general meeting, therefore whenever there is a new appointment of a director it must be in the knowledge of the shareholders about the same.

9. Manner of Implementation

Companies must have a separate section on Corporate Governance in its annual report. Non-compliance of any recommendations should be highlighted and explained.

The Indian code is rather complex as compared to UK and Germany as it has a number of mandatory and non-mandatory recommendations in its code. Although India has good recommendations on corporate governance code but still the acceptance of code in many companies is still lagging.

Roles, Duties, Responsibilities and Liabilities of Directors

Functions of Directors

In 1844 an Act in Parliament described directors as ‘ the persons having direction, conduct, management or superintendence’ of a company’s affairs. (Alfred Read) described director as a special kind of agent, whose function is to control the company’s affairs. The directors in a company have certain responsibilities at law, which they must perform efficiently and effectively. In large organisations the major role of the board is to set the context of the strategy and not to formulate the strategy. To accomplish this, the board must keep on reviewing the corporate definition ‘what business are we in’. This can be done by assessing and reviewing strategic proposals and changing them by giving comment and advice on the same, by encouraging managers to work on their strategic aims. The results of these sets the standards of the organisation as well as the standards others have to attain. Another challenge for the directors in an organisation is to balance the powers of managers with accountability to the shareholders. The board of directors act as the internal mechanism for control to overcome the principal agent problem. Directors also help in acquiring critical resources and responding to environmental forces and their impact on the organisation. These were however how the roles were perceived in the 1970s and after a number of highly publicised cases of corporate fraud and failure there has been a strong focus on policy issues. According to the Companies Act 2006, the duties of the directors have been identified seven-folds. These have been formulated to keep the acts of the directors in the interest of the company they serve and their shareholders. It is quite interesting how the roles and duties are slowly being more specifically defined and the need of the directors to comply with these by enforcing these into the Company Act.

The Company Director His Functions, Powers and Duties by Alfred Read, Jordan & Sons Limited, London, 1971

Safeguarding the Shareholders

An important function of the board is to ensure that the interests of the members are properly safeguarded. If saving and investment are to play their proper part in the future, the investor must be assured of fair treatment and an adequate return, and it is for the directors to ensure that, so far as is consistent with the circumstances, he is not disappointed.

Take Over Bids

The function of the board in safeguarding the interests of shareholders is of particular importance in take-over situations. The general rule regarding the exercise of directors’ powers applies that the interests of their company must be their paramount consideration. It follows that the directors of a company, when advising their shareholders whether to accept or reject an offer for their shares, must disregard the effect he take-over will have on their own personal positions.

Ensuring Progress

Another function is that of ensuring that the operations of the company are kept under constant review so that changes which are necessary are made without delay when changes take place in public taste or in political and economic conditions.

Checking Up on Progress

A board must check up on results in order to ensure that the policy that has been laid down is being carried out and that the results expected from it have been obtained. Proper statements should be presented to the directors at regular intervals to keep them informed of what is happening.

Powers of Directors

The duty of the board is to see that the business is carried in accordance with the memorandum and articles of association. While some powers may be reserved for shareholders, some powers can only be exercised by the board of directors.

Often the directors are given power to declare and pay interim dividends during the year if in their opinion the profits of the company justify them. It is also usual for the fixed dividends on preference shares to be authorized by the board. Other powers usually vested in the board are the allotment of shares, the making of calls, the forfeiture of shares for non-payment o calls, the appointment of the chairman and of agents, officers and servants of the company and all matters of policy and management which are of special importance. Also the directors may delegate any of their powers to committees consisting of such members of their body as they think fit; any committee so formed shall in the exercise of the powers so delegated conform to any regulations that may be imposed on it by the directors.

Remuneration of Directors

Salary has traditionally been described as a word that represents as monthly income of an individual. Directors Remuneration has been a major concern for investors for long. It is observed that director’s remuneration has some or most elements of the following:

1. Basic Salary

2. Benefits in Kind

3. Annual Bonus

4. Share Options

5. Pension Rights

Basic Salary

Basic Salary is a fixed part of the salary that directors get. The basic is generally in the range that similar jobs are offered. Individual experience, skills, and commitment also form an important factor of determining the basic salary. It is also important for the company to analyze skills, and job security related to the individual while setting the basic pay.

Benefits in Kind

Certain companies provide the directors with some benefits in kind. For example provision of goods, travel and luxury items are some kinds of benefits given to the directors of the company. It is however important that the remuneration committee keeps a close check on such benefits and reviews them periodically, annually provided to improve executive performance.

Annual Bonuses

Annual bonuses are given based on the performance of company or division. It is mostly a variable form of remuneration and is generally a percentage of basic pay. Annual bonuses can act as motivation for directors’ to improve their performance. It is therefore important that the remuneration committee sets the good performance targets for the directors.

Long Term Incentive Schemes (Share Options)

Executive share option is a long-term incentive scheme that has been used by companies for long. Share Options are provided at a lower price than that in the market or at some future date at current prices. This is a factor used to align directors and shareholders interests. The directors thus would want the share prices to go up so as to benefit from the returns from their holdings.

However, the directors may sell off their shares and loose interest in share prices thereafter. In UK a provision in the code C6, limits directors to exercise their share options, for at least three years. This is done to keep directors interest in the share prices high for at least that period. A benefit for share options is that it is not taxed until the shares are sold and thus provide the directors a non-taxed form of investment for a specified period.

Pension Rights

“Pension Entitlements are a key element in the total Remuneration, with important longer term implications for the individual and the company” (Greenbury, 1995). The pension provision is carefully considered by the remuneration committees, and is measured in terms of the value of pension entitlements earned during the year.

(As written in proposal needs more changes but not sure of the books from where it was written)

Remuneration can be defined as the aim to reward people fairly, consistently and equitably in accordance to their value to the organization. The impact of executive remuneration on the efficiency of the company can be explained with many different theories. Other policies and theories on effective remuneration, like theory of Human Motivation, are based on the need for stability and sustained staff commitment. Also there are surveyed and comparable pay market for different grades and specialists. Remuneration also depends on the pay structure practice in comparable organizations. Members of board of directors who are not the employees or major shareholders are paid for their services as directors of the company. In the past directors compensation was relatively dependent on the number of hours they devoted to the company but according to the new federal law a new sense of public outrage has appeared and a new fear of shareholder litigation has caused directors to work even harder as before and hence many of the determinants have changed since then.