Corporate Governance - Essay Example

Corporate Governance Introduction The Organization of Economic Cooperation and Development (2004, p. 17) have defined governance as “the system by which business cooperation are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as the board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs” Corporate governance as a discipline creates mechanisms and processes that help in alignment of interests among managers and the controlling shareholders. It also ensures that the other interest groups including minority shareholders, financial markets, debt holders, employees, suppliers, customers as well as societies are not harmed in any form. Some of the fundamental characteristics that define good governance are consensus oriented, accountable, transparent, responsive, participatory, following the rules of law, efficient and effective, inclusive and equitable (Foster and Jonker, 2005). While governance is an old concept, its usage, application and underlying meaning have seen dramatic transformation over the years. Present governance system of corporations is highly complex and consists of various levels of audits, monitoring and scrutiny (Mwenja and Lewis, 2009). Although organizations have braced the concept in their goals and value system, it is still a largely avoided category for growth and development of an organization. The objective of the current report is to understand and evaluate the various internal and external factors that impact in the development of effective corporate governance. It is essential to understand the fundamental concept, theories associated and largely accepted and the governance system followed among different organizations in various parts of the world. Organizational case study with respect to the governance strategies and policies will help in evaluating the current trends and practices. Also the above analytical outcomes have been applied to recommend some key areas which can be developed for better governance systems. Governance Theories Several governance theories have been recognized by experts that have been largely followed for organizations and firms across the globe. However, the current report will describe three main theories that have been largely accepted and studied among economists and academics. These are 1. The theory of successful society 2. Governance for growth 3. Theory of social order The first theory that is successful society theory is centred on developing and shaping the governance. Here the focus is give on features as well as characteristics that describe a successful society. It also means that the above theory suggests, emulate and adapt the governance aspects that are largely followed in developed nations. A survey conducted by Bloom, Steven and Weston (2004) suggested that few specific characteristics were possessed by societies and companies that were successful. These are competitiveness, rule-based conducts and strong institutions as well as social capital. Apart from that, successful governances are also characterized by clear institutional and government roles, responsiveness and consistently focusing on the interests of the public (Wanyama, Burton and Helliar, 2013). The second theory reveals a relationship between economic growth and good governance. This means companies that have showcased good overall governance have fared better in terms of economic growth aspects as compared to their counterparts having mediocre or bad corporate governance. However, recent research in developing countries have criticized that second theory suggesting that organizations from developing nations have faced problems, risks and pitfalls while establishing good governance for economic growth (Wanyama, Burton and Helliar, 2013). North, Wallis and Weingast (2008) formulated the third theory known as social order theory. This theory can be regarded as the most robust and creative theory on governance. A research was conducted wherein 200 nations across the globe were divided into two categories. The first category consisted of 175 nations having almost 85 percent of the global population. This category demonstrates a social order which is primitive and has been transformed into various stages, keeping the basics or fundamentals intact. The second category had 25 remaining nations that represented 15 percent of global population and were characterized as an open-access society (North, Wallis and Weingast, 2008). Another model that can be evaluated with respect of nations is the German Model. It is also known as two-beard model and is followed by Germany. Co-determination among employees is the major focus among the management and corporate governance departments across the German organizations. The stock market is concentrated and the shareholdings trends are concentrated. Further, creditor and banks dominate the governance policies of German organizations. Thus, the corporate governance is favouring the financial institutions such as banks rather than orienting towards shareholders. Corporate governance across nations Corporate governance differs greatly across the globe, mainly due to different cultures and different history. A literature review conducted by Hawley and Williams (1996), studied the corporate governance structure of the US and the UK. The major corporate governance followed in these two nations involves shareholders value proposition. Accordingly, four governance model identified among these two nations were stewardship model, stakeholder model, finance model as well as political model. Financial model focussed on the policies and guidelines aiming to construct incentives and effectively align the management with the organisational principle. At the same time, the other three models were found to be mainly ethnocentric (Stevenage Accountant, 2014). In most of the continental Europe including Germany and also in Japan, banks have been playing an influential role wherein the board members are from banks and hold majority of the shares of organisation. The corporate governance models in these nations is majorly inclusive ensures that the workers, suppliers and workers rights are properly represented at the board of director’s meetings. Japan also has many company structures that are more traditional in approach such as cross-shareholdings among companies and financial alliance (Stevenage Accountant, 2014). Countries such as Italy, South America, Spain as well as East Asia parts like Indonesia focus on a corporate governance structure that is run by families. The main reason is a large percentage of these big companies are essentially private and family owned and are controlled and managed by a small group of powerful people (Stevenage Accountant, 2014). Connection between governance and market place context or environment The relationship between and environment is limited to few research and surveys have been conducted across various timelines and different regions across the globe. According to Ienciu (2012), independence of the board, size of the board and the size of the firm significantly and positively influence the environmental practices of the firm. For instance, large organizations and multinational corporations having markets across the globe are more empowered in term of profits, revenues and government access of that particular market and therefore deploy more budget to environmental and CSR (corporate social responsibility) activities, compared to smaller firms which are privately controlled and have lower profits and return (Keane, 2006). A study was performed by Kathyayini, Tilt, and Lester (2012) wherein 100 listed firms from Australia were examined with respect to their corporate governance influence on environmental practices. It was found that factors such as institutional ownership, size of the board, number of female directors and their importance and say in the board decision and the overall independence of the board influenced the environmental practices of that firm. This survey corresponds with the research conducted by Ienciu above (Ienciu, 2012). Challenges and issues which effect governance / decision making Effective governance required a developed and authentic strategy, clearly defined mission, objectives, purpose and aims. Good and effective governance is also related with responsibility, power, transparency, representation and accountability. When power is misused and aforementioned factors are ignored, the quality of governance is compromised. Enron Company is an example of how bad governance and misuse of power can lead to ultimate failure. The company’s recorded profits and assets were highly inflated, wholly fraudulent and even non-existent. By creating fake transactions, losses and debts were converted into offshore entities that were never put in the financial statements of the firm. In 2000, almost 96 percent of the company’s total earnings were made out of fraudulent accounting manipulations (Tonge, Greer and Law­ton, 2003). After the discovery of these practices, the company went bankrupt in 2001, referred as the largest bankruptcy of that time. Also, the accounting firm ‘Arthur Anderson’ that was responsible for proving ratings and conducting audits for Enron was dissolved (Tonge, Greer and Law­ton, 2003). The CEO with many other top management and board members were sentenced. Organizational governance case Study: Merck Pharmaceuticals Company Background Established in 1891, Merck is one of the well-known pharmaceuticals and drugs manufacturers across the globe. It is a US based firm and the headquarters are based in New Jersey. In terms of market capitalization and revenue, it is 7th largest in the world. The drug manufacturer is headed by Kenneth Frazier, who is the present chairmen, CEO and president of Merck. Some of its well known products include Gardasil, Singular, Proscar and Fosamax (Merck, 2014a). The ethics and corporate governance policies and practices of Merck are well-recognized and appreciated by other drug manufacturers as well as government and non-government associations. The company has been recognized for its contribution in accessible and affordable drugs across the globe, especially is emerging and developing nations. Corporate governance of Merck has received numerous accolades. The corporate governance strategies and programs of Merck have reached more than 269 million customers all over the globe (Merck, 2014a). Regulatory framework and corporate governance frameworks Corporate governance frameworks and mechanisms vary across institutional as well as national environments. Critics and academics have however, pointed out towards two major categories of government frameworks being followed across regions. In developed nations such as France, Germany, Spain, shareholder-controlling system is followed largely. At the same time, economies such as US and UK majorly follow market-control mechanisms. Liquid/flowing capital markets dominate the market-controlled system of corporate governance. This market is favourable for market control and takeovers. Here, external and board of directors have critical roles to play and diffused ownership is followed. After careful review of the aforementioned factors, it can be said that Merck, being established in US, have been followed a similar market-controlled governance system. Both customers and shareholders prefer a corporate governance system that is effective as well as positive perceived among the aforementioned shareholder categories. In order to reach the above objectives, Merck has been rigorously following corporate governance guidelines and policies so that the long-term growth and success of the business is insured. The corporate governance office of Merck was instituted in 1995 and the major objective behind this establishment was supporting the activities of Merck towards corporate responsibility, conduct and accountability (Merck, 2014b). These codes of corporate governance expect every individual associated with Merck to comply with the ethical principles and business practices. The headquarters and other branch offices are managed by both internal officials and external agents, creating a balance between external monitoring and internal control. In 2012, Merck dedicated 2.5 millions in corporate governance budget (Merck, 2014b). The internal governance of Merck is maintained through various strategies and programs. For instance, the company has launched specific channels for employees so that they can get in touch with the head office. Some of these channels include direct telephone lines, emails with specific subject-lines, intranet and AdviceLine for emergency and immediate issues (Merck, 2014b). The corporate governance department also monitors and controls the relationship and behaviour between employees and managers. Establishing and maintenance of an ethical and flexible work environment as well as effective corporate responsibility are two critical tasks of the governance models and regulatory frameworks as laid down by Merck. Apart from the above, the governance models and frameworks also monitor any deviation or violations in the corporate governance standards and guidelines. Merck is a well-known and globally recognized pharmaceutical firm and as a result, has to maintain transparent as well as ethical policies, conducts and corporate governance standards. Any individual who is found to be violating the rules and laws is immediately terminated (Merck, 2014b). The department controlling governance and ethics at Merck is further divided into multiple categories including Public policies and responsibility council, CSR group, board committee as well as executive committee (Merck, 2014c). While the department overlooking CSR depends on the coordination between employees and managers of Merck, public policies department ensures healthy relations are maintained between the organization and external stakeholders and the CSR performance indicators are properly met (Merck, 2014c). Board of directors and Audit Committees Merck has a dedicated group of directors that have been identified and chosen through strategic analysis and after acceptance from the management. After extensive research, various factors have been defined for achieving a sound and effective director’s board and size of the board is an important factor. Yermack (1996) has argued that board size and firm’s market value share an inversely proportional relationship. While the abovementioned claim has not been studied extensively, surveys have revealed that the negative impact of the size of boards is minimized when the decision making aspects and overall intelligence of the board members are better. Board composition can also affect the overall performance and value of the company. In line with the aforementioned points, Merck has taken few important steps to ensure that its board is effective and efficient. Merck appoints 12 directors during shareholder’s annual meetings. The major responsibility of the board is to manage the decision making activities for Merck. Also, they are required to regulate and monitor the associated governance policies of the drug manufacturer. The board’s major objective is to ensure that long-term growth and development strategies of Merck as well as its shareholders are well-protected and properly followed. For this, the company has set strict guidelines for the board such as conducting six board meetings every year and providing strategies directions and specific reviews for the organization such as policy recommendations, expansion and merger proposals and improving the corporate governance reputation of Merck (Merck, 2014d). Audit Committees are formed for regulation of corporate governance and form a major part of the corporate governance strategy. Audit committees are both external and internal. While internal audit committees comprises of internal directors and staffs specializing in governance, regulation and policy making, external audit committees are essentially organizations, rating agencies and firms that specialize in auditing firms and rating them according to the standards and effectiveness of their corporate governance policies, CSR policies and ethical stance (Peters and Pierre, 2006). Merck has launched four specific communities for regulating its corporate governance affairs. These include corporate responsibility committee, committee for benefits and compensation, committee for public policies and general audit committee. These committees ensure that proper monitoring and implementation of the strategies, planning process and corporate governance policies. These audit committees also review the long-term planning process of the firm in business functions such as operations, logistics and supply chain in order to ensure that proper channels are maintained and appropriate standards are followed while deliveries the products to the allocated clients and customers (Merck, 2014e). Some of the critical areas that influence the business and operations of Merck are research and development, marketing, global sales, public environment, political environment, capabilities and resources and international expansion. The stewardship model of leadership claims that when CEO is also the chairman, the leadership is unified and trust is built which stimulated performance motivation among employees and managers (Muth and Donaldson, 1998). Executive remuneration Executive remuneration process of Merck is followed by a four-step process involving growth planning, solving business challenges and creation of unique and differentiated values for shareholders. The foremost strategy is executing Merck’s core business, which includes core branding, development and research process, brand launches as well as market acquisition. The second important strategy is expanding in emerging and growing markets such as Japan. The third strategy is extending the business of Merck to animal health as well as consumer healthcare (Merck, 2014e). The fourth strategy of Merck is continuous investment of time and effort in the strategies adopted by the company for maintaining appropriate cost management structure throughout the organization. It is important to understand the aforementioned strategies as achieving the above strategies, targets and objectives will directly influence the compensation system of executives as well as values of the shareholders (Merck, 2014d). Figure 1 Executive Compensation at Merck (Source: Merck, 2014d) The committee overseeing remunerations also considers the advisory votes of important shareholders during settlement of compensations, remunerations and other benefits for the key executives of Merck. In general, these key executives are CFO, CEO and heads of business functions. The advices from the shareholders form a key influencing ingredient while forming the philosophy and strategy behind compensation and remuneration system. As per the changes in demand among shareholders as well as numerous external and internal environment changes, the above mentioned compensations policies and guidelines are updated. Figure 2: Merck Executive Compensation (Source: Merck, 2014d) Recommendations The current report on corporate governance clearly indicated that good governance has become an extremely critical element among organizations, as they help in coping with the market-place challenges as well as create a strong power base for the organization. However, establishing good governance can be trick and exhausting. Issues related to corporate governance are not confined to the board rooms now. As a result, future corporate governance will have to be more detailed and exhaustive in terms of structures and procedures. Apart from that, management as well as the board shall require disclosing the frequency and outcome of their every meeting and discussion, as shareholders and other internal and external parties expect positive decisions and fruitful outcomes from these meetings (Hurst, 2004). Few of the ways through which the current corporate governance policies can be made more effective and compelling are as follows; 1. Increasing shareholder’s power By increasing the overall shareholder’s power, an organization can gain trust and participation from its stakeholders. A viable example can be proxy voting wherein an organization can give shareholders authority to unseat a board member. This corporate governance is rarely followed among organizations and by following this, an organization can maintain competitive edge with respect to corporate governance reputation and loyalty of shareholders. 2. Disclosing executive compensation Another way of securing shareholder’s loyalty and competitive edge through corporate governance is by fully disclosing the executive compensation policies of the organization. Companies compromise their shareholders and stakeholders value in order to fulfil high monetary demands of the compensation system of executives. When compensation policies are made public, shareholders, investors as well as media will become confident of the organization’s governance policies. This is also helpful in terms of maintaining long-term relationship, loyalty and trust from the stakeholders, thereby making governance an asset for the organization. Conclusion The current report aimed to understand and evaluate the various internal and external factors that influence the development of an effective governance system. For this both qualitative and case study analysis has been used. A study on the governance system across nations revealed that control over the board of directors; diversified board, transparency, shareholder’s control and the overall independence of the board were important factors positively influencing the governance systems. It was also found that governance system varied greatly across continents and nations. For instance, in many of the European nations banks plan an important role in governance. Similarly, in countries such as Italy and Indonesia family-owned businesses are dominant. A case study analysis was conducted on Merck Pharmaceuticals in order to understand the governance system and policies followed by the firm and its effect on the environment. Being a pharmaceutical and drug manufacturer, Merck has extremely strict and transparent governance system. 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