Importance of Corporate Governance - Example

CORPORATE GOVERNANCE Table of Contents Table of Contents 2 Introduction 4 Corporate Governance – Definition 4 2.Importance of Corporate Governance 5 3.Problem of agency 6 3.1Contracts 6 3.2Management Discretion 7 3.3Incentive Contracts 8 4.Legal Protection 8 5.Large investors 9 5.1Large shareholders 9 5.2Takeovers 10 5.3Large Creditors 10 6.Conclusion 11 References 13 Introduction Corporate governance is a central issue for most of the companies operating in today’s globalised economy. It deals with various ways in which the investors of the companies gets themselves assured about receiving a return on their invested funds. Corporate governance primary is involved with answering the following questions: How the investors of a company manage to get returns on their invested amount from the managers of the company? How do the investors of a company ensure that the managers of a company are not involved in stealing their money or making bad investments in some projects? How do the investors exercise their control over the managers of the company? This study discusses all relevant issues related to answering all these three questions mentioned above. The discretionary powers and regulatory controls of primary investors of an organisation like the shareholders and creditors of the company have all been discussed in this study. 1. Corporate Governance – Definition One particular formal definition cannot be assigned to the term “corporate governance”. It is used in many different ways. In general the term “corporate governance” describes a wide variety of issues which are related to the different ways through which organisational activities can be controlled and directed. Broadly speaking it deals with the code of conduct of the business activities followed by the companies. Corporate governance also constitutes wider issues which are related to improvements in the performance of shareholders. It also addresses certain issues related to the stakeholders of the company like the accountability of the business organisations towards the fulfilment of the particular interests of its stakeholders. Stakeholders include anyone related to the organisation, starting from shareholders to the customers, suppliers, employees, the community, etc. and the company is accountable to each of them (Turner, 2009, p.5). 2. Importance of Corporate Governance The primary objective of any business organisation to develop a well structured corporate governance mechanism is to ensure that it provides maximum returns and benefits to the economy as a whole which includes all its stakeholders. Hence, corporate governance includes the inter-relationships between the shareholders, corporations and creditors. It also includes relationships between financial institutions, financial markets and business corporations. The issues related to corporate social responsibility (CSR) is also included under corporate governance which is based on the activities of the organisation in relation to its business environment and culture (Claessens, 2003, p.5). In today’s world issues related to corporate governance are at top priority for any business organisation. Certain events of business failures, Global Financial Crisis (GFC), corporate frauds and scandals in the recent past have contributed towards the need of significant development in the field of corporate governance in the world. Most of the incidents of scandals and frauds in the business environment are contributed towards the lack of corporate governance in the part of managers, directors and other insiders of the companies. Moreover the ultimate sufferers are none other than the stakeholders of the companies itself. In today’s era of globalised economy, where most of the companies are operating all around the world, there is an opportunity for reaping up huge profits in business. However, it has also added to the company’s worries about the increasing competition in the market and significant fluctuations in capital flows. Moreover investors are now more concerned about getting committed to invest funds in companies. Before investing they want to make sure that the companies are involved in following sound business activities so that it reduces the possibilities of mismanagement and corruption which can hurt the investors. Hence corporate governance is of significant importance for a business organisation to ensure that the investors get fair return in lieu of the investments made by them (CIPE, 2002, p.2-3). 3. Problem of agency The financiers or investors of a company invest their funds in a company to get back the returns generated from their money by the firms. Hence, corporate firms act as agents of the investors of the company whose primary task is to increase the wealth of the stakeholders of the company. However, more often the managers of the company are motivated to part away with the profits made by the firm out of the money invested by the investors of the company. This gives rise to various agency problems and corporate governance works for solving these agency problems in an effective and efficient way. The agency problem may arise from the contracts, discretion power of managers and other incentive contracts. 3.1 Contracts Problem of agency is an important part of contractual firms. In case of agencies there is a separation of control and ownership. The manager of a company raises funds from the financial investors in order to utilise it for some productive purpose or cashing out its holdings in the company. The investors in turn seek to have returns generated from their funds. However, the question lies behind the fact that how the investors can be rest assured that the managers of the company utilises their funds properly. This gives rise to the agency problem. Generally there is a contract between the investor and the manager which includes specifications regarding the utilisation of the fund and the method of distribution of profits between them. However the problem lies behind the fact that most of the contingencies in future are uncertain and it is technologically infeasible to have complete contracts. Hence residual control rights are required to be allocated between the investor and the manager which is addressed efficiently through the ownership theory. Managers have discretion regarding the choice of allocation of funds because of the significant residual control rights enjoyed by them. This type of discretion has some set limits which are mostly dealt with corporate governance mechanisms. However in practical situation courts do not interfere in most of the petty issues between the investors and managers and lot of small investors are there who are not aware of these rights and do not exercise them. Hence managers end up with having extensive control rights over fund allocations. 3.2 Management Discretion The managers having significant discretion powers over the decision of allocation of investors’ funds and may try to expropriate them. It is this manifestation of the problem of agency which he investors are required to take care of. In these days, in many cases law comes to the rescue of the investors against misappropriation of their funds. Managers are encouraged to expropriate the funds of the investors for various reasons. The concept of corporate governance works on the constraints put on the managers by the investors to prevent misallocation of funds. Next managers can also exercise their discretionary powers by not returning the money back to the investors. 3.3 Incentive Contracts As discussed earlier managers end up in getting significant control rights and have great opportunity to fulfil their self interests through the utilisation of funds invested by the investors. In certain cases it may even result in managers taking inefficient decisions leading to the loss of investors. Hence a solution to this problem can be the provision of an incentive contract which results in the alignment of interests of the managers and the investors. These incentive contracts can be in the form of share ownership, dismissal threat in the event of low income, etc. However these incentive contracts can create problems by creating self-dealing opportunities for the managers where the contracts are not negotiable with large investors but the board of directors of the company who are poorly motivated (Shleifer & Vishny, 1996, p.7-12). 4. Legal Protection The primary reason of investors providing external finance to the companies is to have control rights over the company. External financing can be viewed as a contract between the suppliers of finance and the company as a legal business entity. If there is any violation of the terms and conditions laid down in the contract then the investors can move to the court to exercise their control rights. The nature and type of legal obligations of the managers towards the investors give rise to the corporate governance systems in the companies. Some of the vital legal rights of shareholders include their voting rights in important corporate decisions related to mergers, takeovers and election of company directors. However, exercising of these voting rights by the shareholders of the company can prove to be expensive at times. Although the board of directors are elected by the shareholders, the interests of the directors may not align with the shareholders. The managers of the company also have the duty of being loyal to the shareholders. This duty of managers is more prominent from the legal restrictions imposed on the managers which prevents them from stealing the invested money of the financiers, having excessive commission and issuance of additional securities to the insiders of the company and their relatives. Some of the legal restrictions help creating constraints for the managerial activities like they have to consult the directors of the company before taking any vital decisions in favour of the company. Similar to the shareholders, the creditors of the company are also entitled with certain legal rights which they can exercise. This legal protection for the creditors are often more effective because the courts are able to verify the violation caused to the debt contract due to a default in the part of the company and its managers (Shleifer & Vishny, 1996, p.21-25). 5. Large investors Large investors can have better control rights than small investors through legal protection. The ownership rights of the company get concentrated in the hands of few large investors. It helps in strengthening legal protection too. This type of concentration of ownership rights can occur through large shareholders, creditors and takeovers. 5.1 Large shareholders Concentration on shareholdings is the direct way of aligning control rights and cash flows of external investors of the company. It implies that some of the investors of the company can have substantial ownership stakes of the company. The shareholders then have incentive in various activities like collecting information and monitoring the company management. A substantial amount of pressure can be exercised over the management of the company through their voting rights. With this the shareholders can even oust the company management through takeovers. In certain extreme cases where the large shareholder holds more than 51% of the shares of the company, they have complete control over the company and its management. Hence large shareholders of a company address the problem of agency through their interests in maximising the profits of the company and have their interests over the firm respected by having significant control over the company assets. 5.2 Takeovers In countries like United States and United Kingdom, large shareholders are less common in the companies situated there. A particular concentrating ownership mechanism has been developed there which is known as hostile takeover. In case of a hostile takeover, a tender is made by a bidder on behalf of the company which is meant for the dispersed shareholders of the company. If the offer is accepted by them then they acquire the control rights of the company. Hence takeovers can be explained as an ownership concentration mechanism made in quick time. Takeovers actually address the problems associated with governance in the company. Most importantly takeovers result in the increase of market value of the acquired firm. It has been often argued that takeovers provide a solution for the problems associated with free cash flows because often in results in distribution of company’s profits to its investors over a period of time. However takeovers mechanisms are often more expensive nature. Hence takeovers as a means of corporate governance mechanism are not so easy (Shleifer & Vishny, 1996, p.29-30). 5.3 Large Creditors Large creditors of a company like banks are also large potential investors of the companies. Just like the large shareholders, they also have substantial interest on the returns generated by the companies because of their huge investments made in the company. The borrowings of the firms mostly include short term borrowings. Hence the creditors of the companies have the powers in the form of control rights which they can exercise in case of violation of the debt agreement by the companies. The large creditors of a firm can interfere in the major decision making process of the company by having substantial rights over the cash flows in the form of various control rights possessed by them. Furthermore, the banks can have equity holdings along with debt in many companies in which they make their investments. Hence large creditors of a company can be assumed to having the power of governance over the company similar to the large shareholders of the company. Actually the large creditors become more effective on having substantial legal rights which they can exercise (Shleifer & Vishny, 1996, p.31-32). 6. Conclusion Corporate governance is the most vital issue for any corporate organisation in today’s world. With the globalisation of economy, most companies operate in different countries of the world and strive for earning more profits. The international market is growing at fast rate. Certain events of business failures, Global Economic Crisis, corporate frauds and scandals in the recent past have contributed towards the need of significant development in the field of corporate governance in the world. Corporate governance mechanism of any organisation primarily deals with addressing the issues related to returning back of money to the investors of the company by generating more profits. Corporate governance mainly deals with solving the agency problem associated with separation of finance and management. This study reveals that agency problem is a quite serious issue related to the corporate governance mechanism of a firm. There is a significant amount of opportunities for the managers of a company part away with funds of the investors or to waste them by investing in bad projects. Next different broad approaches related to corporate governance have been discussed. Financing by investors can be based on the manager’s reputation or through highly optimistic view of investors of getting back their money which they have invested. It has been argued that governance is the key to the success of such financing. Legal protection of the control rights of an investor is an important consideration in corporate governance. Concentrated ownership in the form of large shareholdings, financing by large creditors like banks and takeovers are also important corporate governance mechanisms which assist the investors in getting their money back. However efficiency of corporate governance is increased through ownership structure of a firm which is less concentrated (King, Tian & Zhang, n.d., p.3). Hence all these corporate governance mechanisms proves to be the key towards investors having control over the managers of the company and making them functional in giving back their invested amounts in the form of distributing the profits generated by the firms. References CIPE. (2002). Instituting Corporate Governance in Developing, Emerging and Transitional Economies: A Handbook. [Pdf]. Available at: http://www.cipe.org/sites/default/files/publication-docs/CGHANDBOOK.pdf. [Accessed on May 2, 2012]. Claessens, S. (2003). Corporate Governance and Development. [Pdf]. Available at: http://www.ifc.org/ifcext/cgf.nsf/AttachmentsByTitle/Focus_1_CG_and_Development/$FILE/Focus_1_Corp_Governance_and_Development.pdf. [Accessed on May 2, 2012]. King, T. H. D., Tian, W. & Zhang, C. X. (no date). Corporate Governance, Active Shareholder and Ownership Structure. [Pdf]. Available at: http://www.afr.zju.edu.cn/upload/866992d5-a8ee-4636-bcca-40b32e64d184.pdf. [Accessed on May 3, 2012]. Shleifer, A. & Vishny, R. W. (1996). A Survey of Corporate Governance. [Pdf]. Available at: http://www.nber.org/papers/w5554.pdf. [Accessed on May 3, 2012]. Turner, C. (2009). Corporate Governance: A Practical Guide for Accountants. UK: CIMA Publishing. Read More