CONTEMPORARY CORPORATE GOVERNANCE ISSUES - Essay Example

?CONTEMPORARY CORPORATE GOVERNANCE ISSUES Contents Contents 2 Introduction 3 Corporate Governance 3 Conclusion 11 References 13 Bibliography 15 Appendices 16 Introduction Corporate governance is a new field and its development is influenced by models from varied disciplines such as finance, accounting, economics, management, organizational behaviour and law. Major among these models which have provided a theoretical framework for other models and theories is principal-agent model. However the stakeholder model has drawn significant attention as the organizations are increasingly becoming more aware of the fact that they cannot operate in isolation considering only the shareholders’ interests they also need to have regard to a wider stakeholder community (Mallin, 2007, p.18). The discussed models of corporate governance are deemed incomplete because no single model can be applied to every organization and society around the world. However the models form the theoretical framework for corporate governance based on which many economists have build their research in this field. This project is a critical analysis of the four major models of corporate governance i.e. the principal-agent model, the myopic market model, the abuse of executive power model and the stakeholder model. The approaches in each model have been compared to infer which model has the potential of providing the blueprint for future of corporate governance. The paper by Letza, Sun and Kirkbride (2004) has been taken as a basis for discussion of the four models. Corporate Governance Corporate governance is much talked about issue presently relating to the corporate frauds, social irresponsibility and abuse of managerial power. The main problem perceived is how to address these issues in corporate practice. Oliver Hart (1995) discusses the corporate governance issues and provides that the issues in corporate governance arise when the contracts (between shareholder-manager) are incomplete and there exist the agency problems arguing that the market economy can achieve the efficiency in corporate governance by itself (Hart, 1995, p.688). Corporate governance is about building effective ways and measures to satisfy the current expectations of society and stakeholders (Johnson, 2008, p.164-165). It is an institutional arrangement for various corporate participants having direct or indirect interests in corporation like shareholders, managers/directors, creditors, customers, suppliers, employees, local communities, general public and government (Figure 1). Figure 1: Corporate Governance Relationships Source: (Letza, Sun & Kirkbride, 2004, p.243) The importance of corporate governance in 21st century has been highlight by series of corporate frauds like Enron, WorldCom and Tyco whose managers engaged in illegal reporting leading to loss of shareholder wealth. As shareholders in many countries are absentee owners and managers have the control and power over the organization’s activities, these managers can place their own interest before the interests of shareholders, therefore generating the principal-agent conflict. There are certain views regarding the convergence of corporate governance systems however such possibility is least likely to happen due to difference in corporate culture and ownership structures. In recent years many influential proposals have been made in UK regarding corporate governance such as Higgs 2003, Turnbull Committee 1999, Hampel Committee 1998, Greenbury Committee 1995 etc (Letza, Sun & Kirkbride, 2004, p.242). The legislative strategies place importance to the need of a single governance structure for the corporate world. However no single model of corporate governance has worked at all times. Presently there are four main perspectives on corporate governance that are discussed in the following sections. The Principal-Agent Model Considering a sole-proprietorship organization where the owner-manager is considering sale of a part of his interest to outsiders. As the owner-manager’s share will fall the incentive to generate shareholder wealth will also decline. This is known as agency problem. This problem was first identified by Adam Smith in 1776 noting that the management of a joint stock organization cannot be expected to be as prudent with people’s money as they are with their own (Letza, Sun & Kirkbride, 2004, p.247-248). In the absence of any governance control over the owner-manager’s behaviour post the equity issue, the issued external equity price would fall to reflect the corresponding threat to shareholder wealth. This consequence would fall on the manager and strain the manager-shareholder relationship (Keasey, Thompson & Wright, 2005, p.2). The principal-agent model assumes that the sole purpose of corporation is to maximize its shareholders’ wealth where shareholders cannot exercise enough control and influence managerial actions because they are not involved in the day-to-day operations of the business. Therefore the model argues that regulation over the corporation will increase the power and control of shareholders. The main objective of this theory is to determine an optimal and efficient contract that will govern the principal-agent (shareholder-manager) relationship (Brink, 2011, p.160-161). Although it has been found that despite the agency costs being inherent in the corporate form, the creditors and investors have not been disappointed with the firm growth (Jensen & Meckling, 1976, p.71). This school of thought claims that the corporate governance failure can be best addressed by letting the corporate governance mechanisms operate freely, strengthening the incentive system with bonuses and stock options, providing a voluntary code and appointing independent non-executive directors. Jensen and Meckling (1992) analyzed the relationship between organizational structure, knowledge and control in market systems and private organizations and inferred that the problem of control and rights assignment can be solved by voluntary exchange of alienable decision rights. The alienable decision right is the power to make decisions and take actions. Therefore if an agent who has the abilities and relevant knowledge and who values the decision rights, will acquire such decision rights. These rights also motivate the decision agents to use their decision rights effectively and efficiently (Jensen & Meckling, 1992, p.28-29). The Myopic Market Model Similar to the principal-agent model this model says that the sole purpose of corporation is to maximize shareholders’ wealth. However the model does not equate the wealth maximization objective with share price maximization because the market does not value properly the long-term capital investment by the firm (Calderini, Garrone & Sobrero, 2003, p.40-42). This short-sightedness of markets deters the managers or agents to focus on long-term value creation of the firm or to take decisions against the threat of hostile takeover and focus more on current share price. This is done at the expense of shareholders interests. That’s why the model criticises the Anglo-American style of CG by saying that the system considers only the short-term market value (Clarke, 2009, p.26). The myopic model provides that reforms related to corporate governance should be focussed on environment where the managers and shareholders are encouraged to contribute to long-term performance prospects such as increasing loyalty and voice of shareholders, encouraging relationship investing by empowering other stakeholder groups to have long-term relationship with the firm. The Abuse of Executive Power Model The abuse of executive power model rejects the previous two models and purports that the purpose of an organization is to serve the corporate interest as a whole. The proponents of this model argue that the present institutional constraints such as improved shareholders’ involvement in decision making, corporate disclosures, independent non-executive directors, the audit process or takeover threat are inadequate to prevent corporate power abuses because the protection from liquid assets market to certain shareholders makes them uninterested in such abuses. This problem is also highlighted by Eugene Fama in his paper ‘Agency Problems & Theory of the Firm’ (Fama, 1980, p.291). The abuse of executive power model assumes that the managers are not just the trustees of shareholders rather to the other stakeholders as well. Therefore the proposed reform under this model is to empower the independent directors in nomination and selection of senior managers and should be provided with the statutory duty of promoting the company’s business as a whole. The appointment of CEO should be made for a fixed term with renewal of contract only once. The Stakeholder Model The stakeholder model proposes that the purpose and objective of the corporation should be more elaborate than just the shareholder wealth maximization. The well-being of employees, customers, suppliers and managers who have stake in the long-term success of the organization should also be considered by the corporation. This model is considered the most elemental challenge to principal-agent model. This model assumes that the stakeholder management is practiced by the corporations then it will be relatively successful. Although there are no clear guidelines for stakeholder management but certain suggestions include trust relationship, interlocking shareholdings, long-term contractual associations, inter-firm co-operations, ownership sharing scheme, ethical code of conduct and employees’ participation in decision-making. The stakeholder model has been seen from three different aspects based on their research approaches- descriptive, instrumental and normative. The model describes the corporation as a constellation of competitive and cooperative interests possessing intrinsic value. The model also establishes a framework to examine the connections between stakeholder management and corporate performance goals. The model has a normative aspect because it involves acceptance of ideas such as stakeholders’ having legitimate interest in procedural and substantive aspects of corporate activity and these interests have intrinsic value (Donaldson & Preston, 1995, p. 66-67). The principal-agent model has roots in market efficiency theory whereas the other three corporate governance models challenge the optimum market assumption and propose hierarchical governance structures and various internal monitoring mechanisms (Zak, 2008, p.304-306). The difference is that the three models take the long-term corporate performance horizons than short-term shared by shareholder and stakeholders. The market efficiency has been recently questioned following the economic crisis which undermines the legitimacy of principal-agent model because the model takes the market valuations as shareholder wealth. The above models do not include all corporate governance theories and control studies and also do not cover all types of firms and societies in the world. However these models represent the theoretical framework of corporate governance and conventional mode of thinking which has been dominating the research and governance practices not just in Anglo-American societies but around the world. The two theories clearly fall into two categories- Shareholder perspective and Stakeholder perspective. The first two models principal-agent model and myopic market model belong to shareholder perspective with common assumption of organization’s objective of shareholder wealth maximization. The other two models abuse of executive power model and stakeholder model commonly hold stakeholder perspective with insistence on stakeholder welfare. Other models and theories are merely based these models and have barely scratched the surface of the governance problems in the organizations. Based on the shareholder camp views a mechanism was designed in company law during the 20th century to check the governance problems- a three-tier structure of shareholders’ general meeting, executive managers and board of directors. The increasing separation of ownership and control in Anglo-American culture the internal monitoring mechanism has become obsolete (Naciri, 2008, p.242). Then the financial economists proposed market governance as an effective mechanism as the takeover and capital markets pressure could discipline the managers. But this mechanism had a serious flaw of taking only short-term perspective of shareholder wealth (Lane, 2008, p.14). This flaw was highlighted by the myopic market model indicating that the market for corporate control cannot be an efficient mechanism. This model’s flaw was it turned towards the internal mechanisms stressing on long-term economic relationships and corporate performance. The abuse of executive power model appeal for statutory changes in governance mechanism requiring a fixed term for CEO of an organization, independent nomination and more powers of non-executive directors. However the major challenge to the shareholder perspective models comes from the stakeholder model. This model takes the concept of a business organization as a social or natural entity neglecting that the business is bound with profit-making and economic functions for society’s development and survival (Foster et al, 2009, p.218). The stakeholder model also ignores the complexity of incorporation asserting that all the stakeholders are external to an organization and influential but the organization is a constituent of its members without which it cannot exist. Jones and Wicks (1999) have provided a new form of stakeholder theory which is based on Donaldson and Preston’s (1995) stakeholder model- Convergent stakeholder theory. This theory consists of both the normative and instrumental basis described by Donaldson and Preston saying that such a convergent theory, in which the corporate managers behave morally without endangering the viability of the firm and their relationship with it, is challenging but not impossible (Jones & Wicks, 1999, p.218). Both the shareholder and stakeholder perspectives present the organization as an entity either individual or social which may not remain so over time. The two perspective require the hierarchical form of governance mechanism but practically the governing forms vary especially in non-Anglo societies such as Asian where the network forms of governance is prevalent which is based on mutual trust, shared ideology, reputation, friendship and reciprocity. However it has been seen that both the models have become mutually attractive in the last few years, where Germany and Japan traditionally followed stakeholder based model have now changed to the shareholder-oriented and market based model due to worldwide competition and globalization. In US the investors face the risk of takeover to discipline managers. However the varying degrees of corporate governance structures have called for individual suitable governing mechanism which would repair their specific problems (Macey & Miller, 1995, p.111-112). Therefore it can be implied that the priority and superiority is not universal rather contextual. Conclusion The field of corporate governance is relatively new to the theory of organization. Although the issues of corporate frauds, social irresponsibility and abuse of managerial power that have led to corporate governance mechanisms are not new to the corporate world. The corporate fraud case of Enron, WorldCom and Barings bank has made the investors realize the governance issues of ownership and control. However the theories which form the theoretical framework of corporate governance have not been fully developed to provide a uniform solution to address agency problems. Based on the review paper by Letza, Sun and Kirkbride on corporate governance this project has been an attempt to critically analyze the models of corporate governance which have been categorized into two perspectives- Shareholder and Stakeholder. These models have been the much debated due their different approach towards the governing mechanisms and the changing relationship of management and shareholders and/or stakeholders. The principal-agent model has been the theoretical basis of the other three models however due to widely accepted flaw of equating wealth maximization with share price maximization has led economists to look beyond the shareholder wealth maximization objective. The myopic market model is similar to principal-agent model but is oriented more towards the internal mechanisms built on long-term relationship and corporate performance. The stakeholder perspective models i.e. the abuse of executive power and stakeholder model reject the principal-agent model and take the organization as a social entity are more oriented towards stakeholder management. However these models neglect the profit making and economic function of the organization. This clearly shows that none of the model can be universally adopted and the applicability is contextual depending upon the type of society and organizational culture. References Brink, A. (2011). Corporate Governance and Business Ethics. Springer. Calderini, M. Garrone, P. & Sobrero, M. (2003). Corporate governance, market structure, and innovation. Edward Elgar Publishing. Clarke, T. (2009). European corporate governance: readings and perspectives. Taylor & Francis. Donaldson, T. & Preston, L.E. (1995). The Stakeholder Theory of the Corporation: Concepts, Evidence, and Implications; the Academy of Management Review, Vol. 20, No. 1 (Jan., 1995), pp. 65-91. [Pdf]. Available at: http://zonecours.hec.ca/documents/A2010-1-2410481.stakeholdertheoryofthecorporation,concepts,....pdf. [Accessed on December 17, 2011]. Fama, E.F. (1980). Agency Problems and the Theory of the Firm: The Journal of Political Economy, Vol. 88, No. 2. (Apr., 1980), pp. 288-307. [Pdf]. 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The Principal-Agent-Theory Within the Context of Economic Sciences: Summary. BoD – Books on Demand. Phililips, R. (2011). Stakeholder Theory. Edward Elgar Publishing. Solomon, J. (2007). Corporate governance and accountability 2nd ed. John Wiley and Sons. Spira, L.F. (2002). The audit committee: performing corporate governance. Springer. Appendices Appendix 1: Summary of Corporate Governance Models Source: (Letza, Sun & Kirkbride, 2004, p.246) Read More