Corporate Governance Issues
Corporate governance deals with the ways in which a firm protects the interests of its investors, lenders, and creditors.It’s the process and structures used to direct and manage business affairs of the company towards enhancing prosperity and corporate accounting with the ultimate objective of realizing shareholders long-term value while taking into account the interests of other stakeholders i.e.
management, customers, financiers, government, employees and the general community. (Shleifer A,Vishny R. , 1986)
Corporate governance clearly elaborates explicit and implicit contracts between the stakeholders and the entire firm for sharing of obligations, rights, and rewards, it also highlights ways of resolving conflicting interests among stakeholders arising out of their roles and privileges. It enhances adequate supervision, enforcing strong internal control systems, and facilitating adequate information-flows to serve as a system of checks-and-balances. It ensures accountability of interested party in an organization through mechanisms that reduce or to some extent eliminate principal-agent problems.
Contracts in reality are typically incomplete. Bounded foresight or transactions costs prevent the contracts that are written from providing for all possible future contingencies. In addition, the courts may be unable or unwilling to enforce some contracts. And even if they do enforce them, the parties themselves may want to renegotiate them given rise to elements of contract incompleteness (Shleifer, A. , Vishny, R. , 1997). The allocation of control rights between the parties concerned is of major importance and ends up bringing a lot of problems in running of many enterprises.
Firms are organized on the ground of contracts to reduce transaction costs arising from the rationality of humans. The managers and others who enter into contracts also are boundedly rational, which makes all contracts incomplete. For external finance contracts, corporate governance is a remedy for reducing transaction costs arising from incomplete governance arrangements of such contracts. Three components of corporate governance established by firms include voluntary disclosure, internal corporate governance and external corporate governance. (Agrawal A and Knoeber C, 1996)
An agency relationship arises where one or more parties called the principal contracts/hires another called an agent to perform on his behalf some services and then delegates decision making authority to that hired party (Agent). In the field of finance shareholders are the owners of the firm. However, they cannot manage the firm because: • They may be too many to run a single firm. • They may not have technical skills and expertise to run the firm. • They are geographically dispersed and may not have time. Shareholders therefore employ managers who will act on their behalf.
The managers are therefore agents while shareholders are principal. Shareholders contribute capital which is given to the directors which they utilize and at the end of each accounting year render an explanation at the annual general meeting of how the financial resources were utilized. This is called stewardship accounting. In the light of the above shareholders are the principal while the management are the agents. Agency problem arises due to the divergence or divorce of interest between the principal and the agent. The conflict of interest between management and shareholders is referred to as agency problems.
(Shleifer, A. ,Vishny,R. ,1997) For shareholders and management, there is near separation of ownership . Owners employ professionals (managers) who have technical skills. Some problems arising due to the above relationship are; managers might take actions, which are not in the best interest of shareholders. This is usually so when managers are not part of the owners of the firm i. e. they don’t have any shareholding. The actions of the managers will be in conflict with the interest of the owners. Agency problems in the above can be due to the followings;
Incentive Problem Managers may have fixed salary and they may have no incentive to work hard and maximize shareholders wealth. This is because irrespective of the profits they make, their reward is fixed. They will therefore maximize leisure and work less which is against the interest of the shareholders. • Consumption of “Perquisites” Prerequisites refer to the high salaries and generous fringe benefits which the directors might award to themselves. This will constitute directors remuneration which will reduce the dividends paid out to the ordinary shareholders.
Therefore the consumption of perquisites is against the interest of shareholders since it reduces their wealth. • Different Risk-profile Shareholders will usually prefer high-risk-high return investments since they are diversified i. e. they have many investments and the collapse of one firm may have insignificant effects on their overall wealth. Managers on the other hand, will prefer low risk-low return investment since they have a personal fear of losing their jobs if the projects collapse. (Human capital is not diversifiable).
This difference in risk profile is a source of conflict of interest since shareholders will forego some profits when low-return projects are undertaken. • Different Evaluation Horizons Managers might undertake projects which are profitable in short-run. Shareholders on the other hand evaluate investments in long-run horizon which is consistent with the going concern aspect of the firm. The conflict will therefore occur where management pursue short-term profitability while shareholders prefer long term profitability. • Management Buy Out (MBO) The board of directors may attempt to acquire the business of the principal.
This is equivalent to the agent buying the firm which belongs to the shareholders. This is inconsistent with the agency relationship and contract between the shareholders and the managers. Pursuing power and self esteem goals This is called “empire building” to enlarge the firm through mergers and acquisitions hence increase in the rewards of managers. • Creative Accounting This involves the use of accounting policies to report high profits e. g. stock valuation methods, depreciation methods recognizing profits immediately in long term construction contracts etc.
Corporate governance reform around the world revolves around the principles employed by the U. S. or UK models of corporate governance such as adequate management compensation shareholder rights, disclosure and transparency, and the use of independent directors who are independent. Corporate governance reform raises some specific challenges for countries like Japan and Germany, which are trying to adapt their models of bank-based or stakeholder corporate governance to a changing international environment. (Dunfee T. , et al, 2001).
In Japan and Germany, the engagement of management has been based on incremental and negotiated term of adjustment based on performance levels. In Germany, shareholders value is associated with performance based pay schemes associating salaries to business or individual performance. Although performance pay has not replaced existing pay schemes, it represents a major decentralization of collective bargaining. In Japan, the lifetime employment system is basically stable, but the system of seniority-based pay is undergoing modifications and merit-based pay is being introduced.
The US model of managerial capitalism was characterized by a wide dispersion of share ownership and the separation of ownership and control, and German and Japanese models of internal control was geared toward protecting managers to a greater degree than the US model. After the stock market crash of March 2000, US model of managerial capitalism changed toward corporate governance centered on the maximization of shareholder value. Many shareholders never come together and have limited knowledge and understanding of company’s business.
Entities may stop paying dividends and investors don’t care. They are most of the time unaware when executives squander vast amounts of corporate money. Investors living under ‘democratic capitalism’ are faced with many barriers to control their company’s management hence worsening the already volatile agency relationship. Managers as agents of shareholders (principals) can engage in self-serving behavior that may be inconsistent with shareholders’ wealth maximization principle.
To put in check managerial opportunism, members may use different and diverse range of corporate governance mechanisms, which include monitoring by boards of directors and mutual monitoring by managers as well as monitoring by large outside shareholders . In addition, internal governance mechanisms may include various equity-based managerial incentives that align interest of agents and principals. Finally, the external factors, such as the threat of takeover. If the shares of the firm are undervalued due to poor performance and mismanagement, Shareholders can threatened to sell their shares to competitors.
In this case the management team is fired and those who stay on can loose their control and influence in the new firm. This threat is adequate to give incentive to management to avoid conflict of interest. (Cowan R. , et al 2000) . Williamson O. E suggested that a combination of internal and external governance mechanisms may reduce principal-agent costs and align interests of principals and agents. Within this theoretical framework, emphasis has been placed on the monitoring and control dimensions of governance. Indeed the Cadbury Report’s terms of reference were specifically restricted to financial or accountability aspects.
Both policy and research attention has thus been focused on the roles of non-executive directors and the functioning of boards, disclosure practices, companies relationships with auditors, executive remuneration issues and the roles of institutional investors (Short et al. , 1999). Corporate governance is both about ensuring accountability of management in order to minimize downside risks to shareholders and about enabling management to exercise enterprise in order to enable shareholders to benefit from the upside potential of firms (Keasey and Wright, 1993; Tricker, 1984).
This distinction has sometimes been referred to as the wealth-creating and wealth-protecting aspects of corporate governance. Other ways of resolving the conflicts between shareholders and management include; Pegging/attaching managerial compensation to performance This will involve restructuring the remuneration scheme of the firm in order to enhance the alignments/harmonization of the interest of the shareholders with those of the management e. g. managers may be given commissions, bonus etc. for superior performance of the firm. (Dunfee T. W. et al, 2001)
Threat of firing – This is where there is a possibility of firing the entire management team by the shareholders due to poor performance. Management of companies has been fired by the shareholders who have the right to hire and fire the top executive officers. Direct Intervention by the Shareholders Shareholders may intervene by insisting on a more independent board of directors. By sponsoring a proposal to be voted at the AGM making recommendations to the management on how the firm should be run. Managers should have voluntary code of practice, which would guide them in the performance of their duties.
Executive Share Options Plans In a share option scheme, management can be given a number of share options, each of which gives the holder the right after a certain date to subscribe for shares in the company at a fixed price. The value of an option will increase if the company is successful and its share price goes up. The theory assumes that this will encourage managers to pursue high NPV strategies and investments, as shareholders will benefit personally from the increase in the share price that results from such investments.
Incurring Agency Costs- these are incurred by the shareholders in order to monitor the activities of their agent. They include contracting costs incurred in devising the contract between the managers and shareholders. The contract is drawn to ensure management act in the best interest of shareholders and the shareholders on the other hand undertake to compensate the management for their effort. Such cost may be negotiation fees, legal costs of drawing the contracts fees or the costs of setting the performance standard, other agency costs are monitoring Costs e. g. audit fees legal compliance expenses e.
g. Preparation of financial statement according to international accounting standards, company law, capital market authority requirement, stock exchange regulations etc. Ensure that only competent and reliable persons who can add value are elected or appointed to the board of directors (BOD). Ensure that the BOD is constantly held accountable and responsible for the efficient and effective governance of the corporation so as to achieve corporate objective, prospering and sustainability. Change the composition of the BOD that does not perform to expectation or in accordance with mandate of the corporation
Leadership-Every corporation should be headed by an effective BOD, which should exercise leadership, enterprise, integrity and judgments in directing the corporation so as to achieve continuing prosperity and to act in the best interest of the enterprise in a manner based on transparency, accountability and responsibility. Appointments to the BOD-It should be through a well managed and effective process to ensure that a balanced mix of proficient individuals is made and that each director appointed is able to add value and bring independent judgment on the decision making process.
Strategy and Values-The BOD should determine the purpose and values of the corporation, determine strategy to achieve that purpose and implement its values in order to ensure that the corporation survives and thrives and that procedures and values that protect the assets and reputation of the corporation are put in place. Structure and organization-The BOD should ensure that a proper management structure is in place and make sure that the structure functions to maintain corporate integrity, reputation and responsibility.
Corporate Performance, Viability & Financial Sustainability. The BOD should monitor and evaluate the implementation of strategies, policies and management performance criteria and the plans of the organization. In addition, the BOD should constantly revise the viability and financial sustainability of the enterprise and must do so at least once in a year. Corporate compliance-The BOD should ensure that corporation complies with all relevant laws, regulations, governance practices, accounting and auditing standards.
Corporate Communication-The BOD should ensure that corporation communicates with all its stakeholders effectively. Accountability to Members-The BOD should serve legitimately all members and account to them fully. Responsibility to stakeholders-The BOD should identify the firm’s internal and external stakeholders and agree on a policy (ies) determining how the firm should relate to and with them, increasing wealth, jobs and sustainability of a financially sound corporation while ensuring that the rights of the stakeholders are respected, recognized and protected.
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