Corporate Governance Systems: A Model Based on Shareholder Primacy - Research Paper Example

 Corporate Governance Systems: A Model Based on Shareholder Primacy Abstract Corporate governance systems have become very important in a corporate world that has seen scandals such as that of Enron, WorldCom and many others. It has become mandatory for firm to observe the rules and regulations of accountability and acts such as the Sarbenes Oxley Act. Of equal importance is shareholder primacy and dispersed ownership structure. The paper has examined the statement that there is a convergence of the corporate governance systems towards shareholder primacy and dispersed ownership structure. After a detailed examination of literature and analysis, the paper finds that the statement holds true. There is a convergence of corporate governance systems that is based on the management needs to show profit and thus meet shareholder primacy. This is more so when publicly listed firms with dispersed ownership structures are in place. 1. Introduction Corporate Governance refers to the rules, processes, systems, and laws that govern and direct the operations and policies of organisations. It would also include the relation that a firm has with the stakeholders and the mission of the company. Corporate governance is also about ethical behaviour of a firm and how it behaves with its employees, customers and the manner in which functions such as accounting are conducted. After the recent frauds starting from Enron, WorldCom and the Ponzi schemes run by Madoff, corporate governance has assumed a monitoring role. A firm is expected to abstain from fraudulent bookkeeping and at the same time, refrain from unethical behaviour towards the environment or individuals. Some government schemes such as the Sarbanes - Oxley Act have been implemented to enforce accountability 1. Shareholder Primacy refers to the argument if firms should be run with the main goal of ensuring maximum returns for the stakeholders or if interests of other stakeholders such as employees, customers and even the public should be considered. Dispersed ownership structure occurs when firms go public and are listed on the stock exchanges to raise capital. In such a case, ownership of the firm is dispersed among many shareholders and the owners have the option of retaining 51% shares for majority control. In some cases, owners may even divest their majority holding to raise more money. The shareholders now have a simple objective and that is to obtain maximum returns on their investment. The firm offers dividends, bonus shares and increased share price, to entice more customers and when the share prices rises, it shows the confidence that the market has over the firm 2. With the above understanding, the firm would be obliged to take up only such activities that would increase the value for the shareholders. A conflict can arise when the firm has to take up some activities that would increase shareholder primacy but it would be at dispute with corporate governance. The paper uses this basic understanding to conduct further research to find how corporate governance, shareholder primacy and dispersed ownership are related. 1.1. Research Question The research question that is proposed is “Discussion of the view that the corporate governance systems worldwide are inevitably converging towards a model based on shareholder primacy and dispersed ownership structure”. 1.2. Rationale for the Topic Corporate governance would have a number of stakeholders such as the shareholders, board of directors, management and employees, lending institutional creditors such as banks, customers, regulators and suppliers. Each of these stakeholders has their own needs and requirements and in some instances, the needs of one are in conflict with another. As an example, the management is naturally interested in paying lower wages and obtaining higher productivity. The employees on the other hand want higher wages and lesser working hours so there is a certain conflict 3. The topic assumes significance since corporate governance systems do not operate in isolation but are based in real life situations of employee and shareholder relations. Shareholders add wealth to the firm and when the share market is happy about the performance of a scrip, then the trading is brisk and there are higher returns available for each scrip. For shareholders to be happy, a firm has to adopt a policy of growth. When the ownership of the firm is dispersed as in the case of publicly traded shares, then the shareholders may not be aware of the day to day activities in the share market. All that they want is good returns on their investment. As a result, the firm would take up corporate governance policies that would increase profits and cater more to the shareholder primacy. 2. Corporate Governance Systems Corporate governance deals with certain issues of company laws that says one share - one vote. The vote assumes that all shares have the same weight and because the ownership is dispersed, the common shareholder does not really get to vote and exercise the power. By law, the general assembly of shareholders would elect the administrators who would then elect a President. The elected President would then appoint general managers. The separation between the owners of funds and capital and the managers is legal and it can revoke the second without any limit 4. 2.1. Control Mechanisms used in Corporate Governance Corporate governance controls and mechanisms are made so that there would a decrease in the inefficiency that can arise. Firms typically have an internal corporate governance controls and are also subjected to external controls to monitor the activities of the management and further take suitable actions for accomplishing the organisation goals. Internal Controls used are: monitoring controls initiated by directors; internal auditors; balance of power in important roles and remuneration mechanisms. In addition, there are external corporate governance controls that would control the external stakeholders power over the firm. Some of these are: market competition; debt instruments and covenants; financial statements; government regulations; unions and labour markets; takeovers and acquisitions and media pressures. There is a certain amount of differences between practices that firms adopt in different countries and the corporate governance principles and codes that are adopted. Certain national codes may also be established in different countries and firms would have to observe these codes. If any firm does not follow these codes, then they must explain in writing as to why they do not follow these guidelines. The Disney Decision that was formed in 2005 decides the extent to which firms practice and manage their governance responsibilities. The Model Business Corporation Act that was framed by the American Bar Association prescribe certain rules and guidelines for firms to follow. Another important guideline is the OECD Principles of Corporate Governance that was formed in 1999. Based on the OECD guidelines, some other governance codes have been framed and they are ISAR - Intergovernmental Working Group of Experts on International Standards of Accounting and Reporting formed by the UN. This is an internationally agreed benchmark and has fifty distinct disclosures items placed in five broad categories. They are: auditing; board and management structures and processes; corporate responsibility and information disclosure and the ownership structure and exercise of control rights 5. 2.2. Organisation Performance and Corporate Governance As per a survey done by McKinsey for the Global Investor Opinion Survey where 200 institutional investors were queried about their opinions on whether respondents would pay more money to buy shares in well-governed firms. The survey reported that 80% of the people agreed that they would pay extra for well-governed firms. Well-governed forms are the ones that have outside directors with no management ties and encumbrances. These firms also take formal evaluation of the directors and are interested in complying when investors make a request for information. The main perception behind paying the premium for well-governed firms is that there is a greater assurance that the firm is professionally managed and that their returns are safer. It was also reported in a Fortune magazine that conducted studies for perceptions of quality of firms and the superior share price performance. Five-year cumulative returns were studied and it was seen that the most admired firms had an average return of 125%. The same study also revealed that the least admired firms had returns of 80%. Further, it was found that firms that boards with the best governance had the highest rankings and financial returns. Studies on several cross section of firms that have different corporate governance mechanisms show a trend that support the above studies. It was found that share movement of 63% of firms that showed consistent growth and practice ethical practices in accounting, took environmental protection seriously, showed a much higher stock movement. On the other hands, firms with poor governance and where financial malpractices were reported in the media, quickly saw a downward share price movement. Firm performance has a positive relation with share option pans and these plans in some cases, direct managers efforts. The decisions done are for long term benefits rather that short term performance of the firm. As reported in the wall street journal, there has been severe criticism when mutual fund scandals broke out and this resulted in a dilution of corporate governance 6. 2.3. Corporate Governance Models There are many corporate governance models and these are used depending on the country in which the firm is situated. In case of global firms, the issue becomes more complex since the firms would be operating in different countries and the corporate governance would have to be localised. However, certain minimum conditions and rules are uniformly applied for all units and these ensure ethical behaviour, avoiding exploitation of local employees and local vendors and so on. Anglo American Model or the Liberal model is more commonly used in UK and Europe. This model gives more importance in protecting the interests of the shareholders. Other models are the continental methods and these methods tend to give more importance to employees vendors, customers and the community. However, the zeal with which the continental model is actually applied is often in question and in doubt. When the liberal model of corporate governance is used, it gives importance to cost competition, radical innovation and increasing returns for the firm. This is the original mission of a firm and that is why the firm is set up in the first place. The coordinated model on the other hand shows give importance to meeting the firm’s obligations to its employees and other stakeholders including the community 7. It would thus be seen that the liberal model is more interested in satisfying shareholders requirements while the coordinated model is more interested in being just and ethical. 2.3.1. Increasing Shareholders Primacy Shareholders primacy is identified by the increased in earnings per share, the value of the share today when compared to the purchase price, dividends and bonus paid by the firm and so on. When an investor buys stock of a firm, he would have certain goals and needs. A long time investor would prefer to hold on to the stock for a longer time and then book the profits when there has been a significant rise in the share prices. A short-term investor would look at short gains of a few pounds and then sell the stock in few minutes of buying. The shareholders are thus interested in obtaining quick returns. Firms attempt to increase shareholders primacy by using a number of tactics and methods. Some of them are voluntary while some may be forced by the market forces. The actions taken include internal actions of increasing efficiency and productivity, outsourcing and sub contracting. The external methods include takeovers, mergers, and acquisitions. These are briefly discussed as below 8. Productivity and Efficiency Increase Methods: Firms may bring in new technology and take up work improvement methods that would increase efficiency and productivity. These are technical methods and the results would be evident in improved quality, more production and thus leading to increased sales. Shareholders primacy is increased when the market reacts to the increased productivity. Corporate governance may not be relevant here since these are technical issues. Restructuring methods: Firms may take up restructuring of certain departments, close down loss making units, retrench and lay off people and so on. As a result, the firm becomes much more leaner and would have lesser employees, lower wage bills and thus hopefully show increased profits. Corporate governance is very much active here and issues such as employee benefits, workers rights and ethical behaviour may appear. When a firm ignores all but the most severe violations of workers rights and goes ahead with the restructuring to preserve shareholder primacy. Outsourcing: This method is used when firms decide to subcontract their product manufacturing work or services to other firms. The firm to which work is outsourced can very well be a local firm or it can be from overseas, from countries such as China and India. Many automotive, helpdesk service firms, BPO, software development and other firms have managed to outsource work to Asian countries. The benefits offered are lower wages; lower manufacturing rates and acceptable skill levels. Firms in countries from where work has been outsourced often retrench and lay off the workers. Corporate governance often comes into play here, the whole exercise is done to increase profits by reducing costs, and this leads to increased shareholder primacy. Takeovers and acquisitions: The corporate actions of friendly or hostile takeovers can severely disrupt the existing corporate governance measures. If a larger and more efficient company takes a smaller firm, then the shareholder primacy is increased. If the takeover is hostile and the raider is not very good at corporate governance, then the shareholder primacy would be reduced. Corporate governance is up to the new owners and they can either adopt a liberal method or the continental method. The market would adopt a wait and watch attitude, giving the new owners sufficient time to redirect the firm 9. 2.4. Summary The chapter has examined some important aspects of corporate governance, shareholder primacy and how these two factors are related. Some control mechanisms may be used to ensure corporate governance is indeed uniformly applied. Several national codes and rules attempt to ensure corporate governance is being applied by firms to ensure transparency and ethical behaviour. There are two models of corporate governance, the liberal and the continental. The liberal model attempts to focus on increasing shareholder primacy while the continental methods tries to increase requirements of customers, employees and community are met. Therefore, the liberal method is more focussed on profits while the continental method tries to focus on social welfare also. 3. Convergence of Corporate Governance Systems Convergence refers to a merging of different processes and practices so that two or more practices become integrated. In the previous chapter, various issues and concepts of corporate governance have been studied. Issues such as control mechanisms for corporate governance, organisation performance and corporate governance and different models. Method used by firms to increase shareholder primacy have been discussed. In this chapter, the issue of convergence of corporate governance to either the market or group based systems are discussed. It would be shown that corporate governance practices are indeed converging in practice to a theoretical convergence model where the shareholder primacy acquires importance. Convergence of corporate governance systems would originate from two sources. One is the convergence of corporate rules and the other is for business practices. In corporate rules convergence, it has been argues that the structure of a corporate would depend on the original objects that were present when the economy was started. These corporate structures again would depend on certain corporate rules that may be path dependant. It is also observed that in industrial clusters, there would be certain common rules of corporate governance that are accepted by members of the community. In such cases, there is a convergence of corporate governance, organisational behaviour towards certain commonly held values and beliefs. Such instances of convergence can be seen in Asian countries such as India, China and Vietnam 10. 3.1 Market and Group Based Systems It would be observed that the strongest market economies are either the market of the group based governance systems. These have their own regulatory systems and mechanisms and which have their own corporate controls. These can also be related to the liberal and the coordinated model that was discussed in ‘Section 2.3. Corporate Governance models’. There are some slight differences in the regulatory mechanisms used but these concepts remain the same. In the market-based system, a guiding driving force is played by the market forces. Te government does not attempt to interfere in the market and thus there is a strong competitive force. Firms operate under pressure with managers are under pressure to deliver results. The understanding is that the survival of the fittest would ensure that only the competent firms remain afloat. When it means that the government is not interfering, it implies that the government would be more lenient when there are minor infractions of the corporate governance rules. While fraud and unethical behaviour are not tolerated, acts such as closures, restructuring outsourcing and other acts are allowed to be carried out by firms 11. Group Based Systems are practices in Japan and some countries of Europe. The communist China and Russia were great followers to this system. In this system, the government is involved largely in guiding the economy. A series and system of planning and benign industrial policies are followed. There is more of government help and firms may start to look at them for support. Some types of government help that can be obtained include subsidised power, lowering of tariffs, taxes, and so on. The government would try to force the market towards achieving national objectives. While competition is intense, the market would not be very efficient and would look forward to the state for support. All along these years, it has been seen that both types of systems managed to be successful and allowed both types of firms in the economies to survive and grow. The case however is different in the current adverse market condition. With recession, tightening of credit and available credit becoming more expensive, the corporate governance systems would tend to fail if they do not force a system of accountability on the firms 12. Firms have to become more competitive and they should not look at the government for support. In other words, the market is becoming oriented to a market driven system. This further means that shareholder primacy assumes more importance and firms attempt to meet their obligations for stakeholders first by regulating themselves to show more profit. 3.2. Corporate Governance and Share Holder Primacy in US and UK With rising operational costs in UK, US and other western countries, firms have taken up the route of outsourcing to reduce costs. As explained in ‘Section 2.3.1. Increasing Shareholders Primacy’ outsourcing offers firms a direct and quick way to reduce manufacturing costs. Many firms such as Wal-Mart, Tesco, GAP, Nike, Leo Mattel and other firms have resorted to outsourcing their work to China, India and other South Asian countries. When work was outsourced from these firms, it resulted in many job losses, however, the firm had an obligation to maintain the shareowner primacy. As a result, Corporate Governance and business operations were subverted to meet these obligations. The ethical needs of meeting the job requirements of the employees and business needs of local vendor have been ignored. The net result is that corporate governance has now converged to meet the shareholder primacy. Since the previously mentioned firms are publicly listed and there is a dispersed ownership structure, the thesis question has been proved. However, there is no guarantee that corporate governance is practiced by the small firms in Asia to whom work is outsourced. Many of these firms often employ child labour, exploit their workers and make them work for long hours in dangerous environment. These small vendors do not practice corporate governance and all their efforts are directed to meet the commercial requirements of the MNCs. Such a dual behaviour creates some conflicts that are not answered by the existing framework of corporate governance. 3.3. Corporate Governance and Share Holder Primacy in India and Asian countries The Indian software industry has become a huge success story with companies such as Infosy, Wipro and many others becoming the leading software developers for western companies. These Indian firms have very strict codes on corporate governance and ethical behaviour and take extreme efforts to ensure that corporate governance is at the highest level. Many of these firms are publicly listed and the share prices for these firms figure among the top 100 indices of the bourses. The corporate governance system has been merged with the firms business processes and strategies. It has to be noted that starting from 1990, the SEBI, the main regulatory authority for the Indian stock market created a number of committees to help create certain corporate governance standards that would be applicable to the listed firms 13. For formal convergence to be initiated, the requests of the industry are met with the legislative action. Corporate governance systems may be formally adopted by a nation or a body of industrial organisations. However, the acceptance of these principles has to be done on a voluntary basis by individual firms. The common concern of managers is to meet their quarterly targets and so on till the yearly growth targets of business are achieved. In this haste and urgency, there are chances that corporate governance systems would be either ignored or bent or converged to meet the business requirements. Meeting business requirements means that a firm would be meeting the shareholder primacy 14. 4. Conclusion The paper has researched the topic of corporate governance, shareholder primacy, dispersed ownership structure, and attempted to find the relation between them. A research question was framed to define the relation and the question was “Corporate governance systems worldwide are inevitably converging towards a model based on shareholder primacy and dispersed ownership structure”. The following conclusions have been framed. Firms have implemented internal corporate governance controls and are subjected to external controls to monitor the activities of the management and further take suitable actions for accomplishing the organisation goals. Therefore, the firm is obliged as per government rules and covenants to impose these controls and ensure corporate governance requirements are met. There are two main models of corporate governance, Anglo American Model or the Liberal model and the continental methods. The Liberal method gives more importance in protecting the interests of the shareholders. The continental method attempts to meet the needs and requirements of employees, customers, community and other stakeholders. Empirical observations have shown that 80% of investors are ready to pay more for firm that has implemented corporate governance systems. The main perception behind paying the premium for well-governed firms is that there is a greater assurance that the firm is professionally managed and that their returns are safer. It has even been seen that share movement of 63% of firms that showed consistent growth and practice ethical practices in accounting, took environmental protection seriously, showed a much higher stock movement. On the other hands, firms with poor governance and where financial malpractices were reported in the media, quickly saw a downward share price movement. Firm performance has a positive relation with share option pans and these plans in some cases, direct managers efforts The study showed that with current upheavals in the market place, there is a great urgency and need for the management to turn profits. As seen in the paper, shareholder primacy has assumed great significance. Shareholder primacy and dispersed ownership structures are interrelated in publicly listed firms. In many cases, the shareholders who trade on stock markets are interested only in the financial performance of the firm. If the firm makes profits, pays dividends and bonus shares and if the earning per share is high, then the stocks are traded in larger volumes. Management of the firm wants share prices to rise and the corporate governance systems are thus converged to meet shareholder primacy and with a dispersed ownership structure. 4.1. Answering the research question Corporate governance systems have become strategic business tools that firms often used to ensure compliance to laws and regulations. Many firms have attempted to converge the practices of corporate governance with their business practices. The primary goals of the business processes are to meet the business targets and sales revenues. When the revenues, turnover, productivity and efficiency are increased, this automatically increases the net worth of the firm. Once the firm shows profits, the share price would be expected to rise and thus the shareholder primacy would be met. Thus, one would see that the main target of the firm has been met. Now, corporate governance has other duties and roles such as meeting the obligations and needs of employees, customers, vendors and other community members. As seen in the paper, firm use methods of outsourcing, sub contracting, restructuring and other methods to increase profits. Many of these methods are actually in conflict with the ethical behaviour of catering to employee welfare. However, in the haste and urgency to show profits, corporate governance would converge with shareholder primacy. Thus the research question has been answered. References Armour. John., June 2003. Shareholder Primacy and the Trajectory of UK Corporate Governance. ESRC Centre for Business Research, University of Cambridge, Working Paper No. 266. Afsharipour. Afra., 2009. 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