Corporate Governance Issues - Essay Example

Corporate Governance Issues Part Governance and Family-owned Firms This first part is a critical discussion of the following ment: “Corporate governance is not applicable to family owned firms, only to widely held large corporations”. The discussion begins with a definition of the key terms Corporate Governance and Family-Owned firms and proceeds with a determination of the connection, if any, between these two terms. Looking at the available literature on the topic of Corporate Governance would give a multitude of definitions that not all the dissertations in the world would be able to contain.1 It is standard practice, however, to accept the definition of the term provided by the Cadbury Report (1995, §2.5): “Corporate governance is the system by which businesses are directed and controlled.” And although the term is related to business management and corporate responsibility, it is distinct and different and encompasses these two, which form but two parts of the more comprehensive nature of governance. According to the Corporate Governance Codes extant in the European Union, there are three broad themes that if taken together provide a clearer idea of what the term really signifies: control of the company, corporate management, or of company and managerial conduct; a legal framework that establishes rules and procedures for proper conduct; and the relationships amongst shareholders, (supervisory) boards, and managers (Gregory et al., 2002). The topic of governance is complicated because of different factors that exist amongst nations and states in different ways and which affect how companies are directed and controlled. For example, just within Europe alone, governance practices in the U.K. differ from those in Germany, Spain, or Italy. Possible reasons for these differences are the specific national cultural milieu, legal origins and frameworks, patterns of corporate ownership and concentration, and traditional financing options. These differences also influence the extent to which companies comply with the rules of good governance. For example, governance codes in the U.K. are more stringent and universally enforced compared to those in the Netherlands. One reason is that since the U.K. is more market-orientated, most corporate funding is raised through the stock exchange, and the base of stock ownership is wider, private companies and government officials are more conscious of fulfilling the guidelines established by corporate governance codes that are recommended for compliance by companies that wish to raise equity through a stock market listing. In contrast, companies in the Netherlands raise most of their funds through bank loans and the base of share ownership is not as wide as the U.K.’s, which means that companies are more concerned with convincing their bankers that they can pay a loan, instead of complying with government mandates to follow good governance practices. Compliance therefore would depend on whether banks so require it. The same can be said of countries such as Italy, Spain, Germany, or France where the ownership of several publicly-listed companies are dominated by a group, whether it is a family or not (Gregory et al., 2002, p. 29-31). This observation also applies to differences between corporate governance in Europe and in America, where the legal system and the oversight of public corporations are highly developed, or in comparison with some East Asian nations such as Japan and China where the ownership of corporations is not as clear and transparent as it is in the West. It is these distinctions in corporate governance across cultures and nations that also determine whether corporate governance applies to family corporations. As would be obvious by now, applicability and compliance are two distinct notions: corporate governance codes may apply to a corporation, or it may even be required by the government, but compliance would depend on the benefits that such compliance would bring with it. Take, for example, the case of Volkswagen AG of Germany, a publicly-listed corporation dominated by a single family. Its Chairman (Ferdinand Piech, a descendant of the Porsche family) owns a majority of the company’s shares and seems to be able to do what he wants: developing products, firing executives, and moving funds to and fro without so much as token opposition from minority shareholders. He can do all these in a nation where the legal system is so clearly organised, and he gets away with it (Economist, 2007). In contrast, consider the other auto-maker in the U.S., Ford Motor Company, where the Ford family owns a large portion of the shares. Technically, it is both a family and a widely-held corporation, but because other shareholders are actively involved in exercising their ownership of the corporation, they can exert pressure on the Chairman and CEO to resign or revamp the management team, as happened recently. There are others who argue that governance does not apply to family corporations because, as several studies showed (Shleifer and Vishny, 1986; Himmelberg, Hubbard, and Palia, 1999; Fahlenbrach, 2004), family firms perform better than non-family owned firms since a single block of owners (or principals) exercise greater control over hired managers (or agents) due to decreased conflict of interest between managers and owners, a result predicted by studies on Agency Theory developed by Jensen and Meckling (1976). These researchers, however, discovered a new form of agency problem where the family as a dominant shareholder uses its power to extract private benefits at the expense of small shareholders, a phenomenon they describe as “expropriation”. When this happens, firm value can diminish due to the abuse of power, where value in the form of benefits flows to the dominant family owner to the disadvantage of minority owners. On the other hand, they also showed that if the large shareholder is an institution such as another widely held public corporation, an investment fund, or a bank, the private benefits of control are diluted amongst several independent owners and the large shareholder’s incentive for expropriation is small. Corporate governance, therefore, can act as a check-and-balance mechanism to balance power within a corporation, whether family-owned or not. Given such findings, we can conclude that corporate governance is applicable to both family and widely-held corporations (whether or not dominated by a single family), but that compliance would depend on the benefits of such compliance, the costs of non-compliance, and how well the company’s minority shareholders demand it as to minimise agency costs such as expropriation. Part 2: Corporate Governance System in Japan in the 1990’s Understanding the corporate governance system in Japan is easier with a better grasp of the cultural and legal systems that influence its development and implementation. Japan is an East Asian nation with a long history and a unique culture, and one way of understanding it is by using the five cultural dimensions of Geert Hofstede (1980/2003; 1991) which are related to the basic sociological concepts of the self, relationship to authority, control of aggression and gender role differentiation, and the influence of Confucianism in society. Based on a series of surveys conducted by Hofstede of Japanese nationals (actually, Japanese employees of IBM in Tokyo), he characterised and scored Japan on the five dimensions as follows: High Power Distance Index (PDI), which is the extent to which the less powerful members of organisations and institutions, such as the family, accept and expect that power is distributed unequally. Inequality is defined from below and accepted, even endorsed, by the followers as much as by the leaders. This leads to a deep respect for authority and acceptance of an established hierarchy in society where followers are committed to obey their leaders. Low Individualism (IDV) as opposed to collectivism, which is the degree to which individuals are integrated into groups. In individualist societies, the ties between individuals are loose and everyone is expected to look after him/herself and his/her immediate family. On the collectivist side that is representative of Japan, people from birth onwards are integrated into a strong, cohesive group, such as extended families, schools, universities, and corporations that continue to protect them, often for life, in exchange for absolute loyalty. High Masculinity (MAS) refers to the distribution of roles between the genders in society, which means that Japan is dominated by masculine values of assertiveness and competitiveness. This cultural aspect does not mean, however, that society is neither caring nor modest, because feminine values co-exist with masculine values across cultures. What this dimension signifies is that the gap between genders is more evident in Japanese society. Average Uncertainty Avoidance Index (UAI), which deals with society’s tolerance for uncertainty and ambiguity. This indicates to what extent a culture programmes its members to feel in unstructured situations. Its score shows that Japanese society balances the possibility of uncertainty by strict laws and rules, safety and security measures, and that its people tend to be more phlegmatic and contemplative, less expressive of their emotions, and characterised by an inner nervous energy. High Long-Term Orientation (LTO) that is typical of East Asian cultures (which includes Korea and China) influenced by Confucianism. Cultural values associated with LTO are thrift and perseverance, respect for virtue and tradition regardless of truth, the fulfilment of social obligations, and saving one’s “face” or how others perceive the self. Japan’s scores on these five cultural dimensions – high PDI, MAS, and LTO, average UAI, and low IDV – are characteristics that are observable in Japanese corporate governance systems: it gives equal priority to the interests of all stakeholders as characterised by close cooperative relationships amongst shareholders and customers, employees, and labour unions. Much importance is given to consensus, which may be time-consuming by Western standards, but this is expected if the good of all stakeholders have to be taken into consideration. Management leadership is therefore by consensus (nemawashi) and respect for authority. This makes it difficult for whistle-blowing to take place, where a lower-ranked subordinate would “correct” a superior for doing something not according to the rules, since subordinates assume that their leaders in authority have the best intentions of the common good in mind even if their indications – such as window-dressing the financial statements – would be considered illegal, immoral, and unthinkable in the West. However, when such deeds are made public, it is not unusual for senior management responsible for the mistake to make a “humiliating” public apology that may even be televised; in some extreme cases (not uncommon even in recent years), the senior management member commits sepuku or ritual suicide to save face. Another feature of corporate governance in Japan is the proliferation of insiders, mostly promoted from within, or the presence of former government bureaucrats in the boards of directors. Toyota’s board of directors, for example, has sixty members! These cultural characteristics also explain the high level of cross-holdings in Japanese corporations, most of which started as a single company (e.g., Sony had its roots in a company that made rice wine or sake) but which eventually branched out into industrial manufacturing, banking and finance, and real estate that are linked into a complex bank-centred industrial corporate structure called a keiretsu (Nathan, 1999). The Japanese corporate emphasis on long-term (lifetime) employment, promotion and wages based on seniority (and not necessarily merit), enterprise unions, low labour mobility, and so-called patient capital that looks at ultra-long term returns are all part of a governance system that has deep cultural roots (Porter et al., 2000). Although Japan’s corporate governance system has been blamed for fostering corrupt practices, lack of transparency, discrimination against foreign corporations and investors, and the near-collapse of its financial system in the early 1990’s, several supporters cite the same system for the successes that its large corporations (notably automobile makers Toyota and Honda, electronics innovators Panasonic, JVC, and Canon, and computer game-maker Nintendo) have enjoyed since the 1960s and through the crisis years of the 1990’s (Mair, 1999). Nevertheless, in true Confucian fashion, Japan has learned to transform its economic crisis into an opportunity to reform its corporate governance systems, as economic stagnation has convinced more businessmen, corporate boards, politicians, and workers across Japan that unless these systems change, the nation’s survival would continue being threatened. Japan has realised that globalisation and market forces have made the business environment more highly competitive, and unless corporations are able to tap global capital at the same levels as the western companies that are heavily influenced by corporate governance codes that are gaining in universal acceptance, it would find more difficultly winning in the global market place. A study conducted in 2002 showed that whilst Return on Equity (ROE) in America rose from 12.36% to 17.88% from 1983 to 1999, the ROE of the major Japanese companies declined from 8.46% to 1.2% (Fukushima, 2002). The process is still very far from complete, but the presence since 2001 of a Japan Corporate Governance Forum studying how the nation’s governance codes can be developed according to its cultural roots and then ultimately have it converge with that of the west is certainly a right step in the right direction. Part 3: Role and Contribution of Independent Non-Executive Directors. The board of directors of a company is supposed to represent and look after the interests of the owners or shareholders. Although it is the main concern of every owner, such interests are not necessarily limited to generating financial profits for the investments that are signified by ownership. Whilst most owners/investors want their investments to appreciate in value through the accumulation of profits and growth of the company, they (or at least, a majority) may have other intentions in mind, such as the good that the company performs as a legal person that functions and has a role to play in society. Through the years, however, business scandals whether followed or not by huge financial losses, if not outright corporate collapse, point out that corporate boards have developed a set of troubling bad habits mainly driven by greed and the clubby world of board directors under the influence of superstar CEOs (Khurana, 2002). Signs of this problematic sickness are CEOs and executives who appoint their cronies to board positions, boards that rubber stamp executive (i.e., insiders who work for the company) management proposals especially regarding executive payrolls that are scandalously generous, and, as recent experience has shown, complex financial engineering manoeuvres that hide losses and incompetence, artificial inflation of stock prices (so that CEOs and executives get the most compensation), and personal expenses being charged to shareholders (Carr, 2007). A comprehensive set of literature has accumulated around the study of how hired managers with minimal shareholdings have managed to get away with financial murder. One measure proposed by Fama and Jensen (1983) called for strengthening the board to keep self-serving managers under control through audits and evaluations. Another solution was to hire outside directors to monitor the performance of executives (Baysinger and Hoskisson, 1990). These outside directors are intended to be independent and non-executive and act as objective agents of good corporate governance. These non-executive directors are supposed to assist in providing leadership in the organisation by exercising prudence and implementing effective controls so that the risks faced by the company are assessed and managed. Through their professional experience, either as active or retired executives in other corporations, they bring with them a different mindset that would help management meet their objectives and assist in reviewing management performance. As representatives of the owners, non-executive directors can help uphold the culture, values, and standards of the company and look after the interests of all shareholders (Mallin, 2004). The role of the non-executive director can be summarised into four key elements: (1) Constructively challenge and contribute to strategy formulation and development; (2) Scrutinise and monitor management performance and how it works to meet goals and objectives; (3) Ensure that financial information is accurate and that control systems for financial and risk management are in place; and, (4) Determine appropriate executive compensation levels and play an important role in executive appointment, removal, and succession planning. Although they are outsiders, non-executive directors should not feel indifferent to the plight of the company whose owners they represent. Their behaviour and conduct should help outsiders acquire or deepen their confidence in the management and in the future of the company. Being independent and critical-minded are key virtues in non-executive directors, and they should not have any conflict of interest within the company or, more importantly, with any of the executives or non-executive directors. Such conflicts would go against independence in decision-making. In most companies, non-executive directors have to be properly orientated on the company’s operations, which would normally be accomplished through site inspections and meeting other workers and managers on the field. The more familiar these are with how the company operates: its strengths and weaknesses, opportunities and threats, the better able would non-executive directors be in contributing their informed and relevant insights that would help solve problems even before they happen. They must learn to assess information, even (or more specially) at board meetings where information shared and exchanged should be fresh, timely, clear, sufficient, and accurate (Banwell, 2003). A non-executive director must also be trustworthy and respectable of other board members, sensitive to others inside and outside the board, able to act as a check and balance mechanism for corporate management, know how to ask intelligent questions and to listen and be sensitive to the views of others within and outside the board and the corporation, engage in constructive debate, challenge assumptions and legal violations, and be courageous enough to speak up when s/he has to do so. Very often, the independent non-executive director is the last line of defence between a scheming management that is only after its own advantage and an unwitting group of public shareholders. Playing the role of a non-executive director is never easy. As recent corporate experiences have shown, having this position occupied in the board even by someone of unquestionable integrity is never a guarantee that the company is immune from the selfish acts of a cabal of scheming insiders. However, having independent directors can act as a deterrent, even though at times the best they can do is delay the agony or serve as a token line of resistance from the most dangerous enemy that a corporation can have, which is the executives who abuse their power and who may even resort to threatening independent directors that unless they go with the tide, they too would be subject to the lawsuits that could be filed for their negligence. Perhaps, what happened at the companies that experienced recent high-profile scandals such as Enron, Global Crossing, Ahold, Parmalat, etc. is similar to the phenomenon called the Stockholm syndrome where terrorist victims sympathise with the cause of the terrorists after time spent together. This may also happen as outside directors see the difficulties of management as it meets the challenges of globalisation and competition, and who may feel justified in tolerating the ‘initially’ small violations of governance codes here and there until, slowly, little things become big things, and what began as an innocent act snowballs into a huge boulder of scandal that the outside director, instead of calling the public’s attention, may end up trying to stop, in the process crushing him/her. Like Caesar’s wife, outside directors must be beyond suspicion, sensitive to their own weaknesses, immune to the blinding light of hubris, and heroic enough to cry wolf upon seeing the shadow around the corner. Hindsight teaches us that when it comes to protecting the rights of shareholders, it may often be better to err on the side of caution than to be sorry. Reference List Banwell, I. (2003). Guidance for non-executive directors. London: DTI, p. 97-98. Baysinger, B.D. and Hoskisson, R.E. (1990). The composition of boards of directors and strategic control: Effects on corporate strategy. Academy of Management Review, 15, 72-87. Cadbury, A. (1995). Report of the committee on the financial aspects of corporate governance: Compliance with the code of best practice. London: GEE. Carr, E. (2007). “In the Money: A Survey of Executive Pay”. The Economist, 18 January, p. 1-18. Economist (2007). “The big-car problem”. London: The Economist, 24 February – 2 March 2007, p. 69-71. 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