Literature Review About The Functions Of Corporate Governance
Corporate governance covers various different but related economic issues or variables in its definition. According to Shleifer and Vishny(1997) in The Journal of Finance, "Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment." The variables are guide line or code how a company is directed, controlled which are processes, customs, policies, laws. According to Mathiesen (2002) corporate governance often investigate and has interest in helping efficient management as a result shareholders interest served like company’s financial matters, rate of return. Corporate governance offers efficient institutional and policy framework, various incentives, privatization, contracts, market exit, legislation, insolvency. Those are known as incentive mechanisms and strategy. Corporate governance is about transparency, fairness and accountably of a institute. "Corporate Governance looks at the institutional and policy framework for corporations - from their very beginnings, in entrepreneurship, through their governance structures, company law, privatization, to market exit and insolvency. The integrity of corporations, financial institutions and markets is particularly central to the health of our economies and their stability." (www.oecd.org)
Corporate governance major function is to enhance the operating performances of the firm and also in the fraud prevention (Yeh, Lee, and Ko, 2002). Black, Jang, and Kan (2002) identify that the better the corporate governance of a firm the better they perform in the market then the companies which have poor corporate governance structure. This result is also supported by the Jensen and Meckling, (1976) and Fama and Jensen, (1983). Corporate governance mechanisms give commanding position to the owners to manage corporate insiders and managers.
The Corporate Governance is a wide and important subject that covers a range of issues from accountability and transparency and the relationship between the board of directors, management and shareholders to help in determining the path and performance of the corporation (Hunger & Wheelen, 2007, p. 18). In brief, corporate governance is the system of controls to ensure that investors can assure themselves that they will get their investment back.
Depending on laws, policies and other standard it might vary, but generally Board of Director describes as bellow:
They make the business strategy.
They recruit and sack top management if required.
They monitor management.
They work for shareholder’s interest
They workout with companies resources
According to Fama and Jensen (1983) the corporate boards of directors are playing the major role in the corporate governance systems. According to Mizruchi (1983, P, 433) The companies ultimate control is lies to the board of directors. Walsh and Seward (1990) divide the control mechanism in two ways both internal and external. The internal control is based on the board governance, ownership of equity, compensation etc. And the external control groups are the institutional investors, legal protections and also the individual investors who actively participate in the capital markets.
The variables selected for internal control mechanism are CEO as board chairman, Outsider ratio in the board, Board size, and number of board meetings held. Ownership pattern is also considered as a governance factors towards the performance of the firm. According to Berla and Means (1932) they identify a relationship between the firms performances and ownership. The find out from their study that firms performances is increased as the management being separated from the ownership of the firm. Jensen and Meckling (1976) introduced the agent conflict that explained issues between the ownership and management of the firm. Fama and Jensen (1983) find out that the agency problem can be resolved by systematic dispersion.
Corporate governance now familiar word to many people because of recent credit crunch and economical changes. But corporate governance came into topic in mid 80’s. American companies find themselves in globalisation. Chief executives became more powerful and reckless in making decision, board directors became administrative puppet. Critics call for larger independence for board members so that they can monitor high management and served shareholders interest.
Corporate governance first face criticism by the bankruptcy of ENRON in 2001. Famous magazine FORTUNE labelled ENRON USA’s most Innovative Company of the year, six years in a row since 1996. Corporate body had been blamed for taking high risk, not taking into consider of inappropriate conflict of interest, big compensation, and unpublished off-the-books activity.
Around the world, there are different styles of corporate governance. For instance, managers dominate the U.S. model; the UK model clearly separates governance from management and the European model does not distinguish between governance from management in a firm. Given these differences, it is important to analyse the performance of firms from each model and try to state some conclusions, not forgetting the model of corporate governance used.
UK Corporate Governance Model
The UK model is probably the most complete model of corporate governance in the world and in this report; a special attention is given to it. This model is constantly developing governance codes for chairmen and boards of UK companies to help boards having a clearer vision of their roles. What is really special in UK is that despite the existence of a code of best practices, it is not mandatory to strictly follow that code. This is very important because boards have independence to establish policies more in accordance with stakeholders’ needs. The main objective of these governance codes is disclosure. With codes, everyone with interests in the firms has a clear view about the way firms are led.
Other aim provided by the codes was to highlight the need for equilibrium in the governance systems. In this model of governance, boards and management have their roles and are equally important, assuring a system of internal control to protect the interests of shareholders, as well as protecting the assets of the companies. Contrary to the other two models, boards in the UK model have a very important role. Companies in UK must consider the composition of boards, the way they were nominated and the formation of board committees. The audit committee recommendation was also very important to develop this model because in UK companies, this committee is essential to influence the structure and composition of boards. It also contributed to clearly define who were the non-executive directors and decide which of them were independent.
The UK model is very strict in what concerns reporting and controls. The boards must present an accurate assessment of the company’s position. Due to the existence of codes of best practice in UK, firms are generally very consistent in their structures and the boards clearly know their roles. Definitely, they provided higher quality of governance.
The model does not prohibit the combination of posts (chairman and chief executive), however, it emphasizes that whenever this situation happens, there must be a strong and independent element on the board with a recognized senior member. In the UK model, boards must also have an adequate number of non-executive directors to conserve some independence.
Boards are responsible for the definition of the objectives and also to ensure that they are achieved. Moreover, they monitor the executive team and assess their own performance. They are the centers of corporate governance because they are the link among the various stakeholders and because they appoint the executives that will be responsible for guiding companies towards the realization of the purposed objectives. Chairmen are the leaders of a board and consequently they must ensure boards’ leadership.
This is clearly a model of corporate governance that recommends the separation between chairman and chief executive. Firstly because the characteristics appropriate for each role are somehow different. According to this model’s view, a chairman should be someone with a clear strategic thinking and aware of the environment around the company. Oppositely, the chief executive is less concerned with the planning strategies of the firm, but much more focused on doing the right things at that moment in time. It is a role much more focused on the short-term. In any firm, it is convenient to have a healthy and honest relationship between people that have power of managing the firm and a healthy relation between a chairman of a company and its chief executive is very positive.
US corporate governance model
United States is a market system for excellence. In all developed countries markets play an essential role in terms of efficiency and transparency but United States takes this too serious as their system is build over the beliefs of a market system. Not surprisingly, United States are the country with more demanding market rules and also where punishments are more severe for those who do not respect the market. They know that if the market rules fail, all their system will fail too.
Cases like Enron are more than a problem in one company in a specific period of time. For United States represented a serious problem for their whole system because everything they believed were the best for their market development and efficiency were in question. They had to rethink their system; problems like Enron could not happen again. Regarding Enron’s case we had a tremendous market manipulation. From management to external audits, everything failed. The main problem was “interests conflicts”. External audits, lawyers offices, agency ratings and investment banks that were supposed to work independently from Enron’s management were doing exactly the opposite. Their gains were associated to Enron’s performance, so they had no incentive to denunciate the internal problems. Company performance was increasing considerably with the help of these supposed “external” entities. But, as Ricardo Salgado said some time ago “Trees do not grow to the sky” and it was what happened in Enron. The problems started and soon the Authorities realized all the problems behind Enron and it bankrupt threatening United States economy. The system did not act accordingly to avoid the situation but the competent authorities punished severely the actors of such disaster. It is here where United States model proves to be very efficient. If they cannot avoid similar situations, the system punishes the authors to serve as example and protect the market efficiency and trust. Market based economies need an extraordinary control and trust over the market; hence, the system must guarantee their efficiency.
United States market is the most efficient one for many reasons, as it is the pure market based system. In terms of shareholders capital structures other conclusions came up. Comparing with the European model and companies we conclude that, in general terms, United States companies do not have reference shareholders. It is much more diversified than in Europe where it is usual to see major shareholders that play an essential role to the companies strategy and performance.
In the US model there are the all-powerful Chairman/CEO and management dominates the boards. Giving that, we better understand the necessity of market regulation and efficiency because, otherwise, the system collapse.
European Corporate Governance model
European model can be less efficient. It is the opposite of the US model where the market does not act with the same force as in the US. In the US any market distortions are quickly and severely punished in order to give confidence back. A market cannot work efficiently without confidence and in some countries in Europe there are cases of market abuse where the competent authorities do not act accordingly. Portugal is one of that examples where there are market abuses and the justice do not act and the market confidence are affected with negative impacts over the overall performance of the market.
Another important point to consider in the European model and characteristics of their companies is the existence of reference shareholders. The existence of reference shareholders can be good in a perspective of stability and long-term strategy but have negative impacts for small shareholders and companies are not so attractive to short-term investment.
When the market does not act efficiently and there are reference shareholders others problems came up such as “information asymmetry”. It is a crucial point for efficient markets that have as fundamental characteristic that all investors share the same information and act rationally. When these two assumptions are not met the market will suffer and confidence will be hurt. With this asymmetry the model have to guarantee minority shareholders interests.
German Corporate Governance Model
After pointing the main characteristics of the European model of corporate governance we think that is important to add a brief glance over the German corporate governance. Our project focus in German enterprises; hence, it is important to make an appointment about their specific characteristics. European Union has some guidelines about corporate governance but giving the multitude of models and countries in Europe all of them have different characteristics. Given that, and following our project, we will briefly describe the German one as Germany represents the “engine” of Europe and is one of the strongest economies in the World.
The model starts from the same principle as all others. Their purpose is to give confidence to the internal and external investors and all other stakeholders of the company. German model basically separate the governance in two separate areas. There are the Management board that must guarantee the profitability of the company and all their activity by defining strategies, managing people and overall company’s performance. This department has a specific Chairman that coordinates management work. On the other hand, there is the Supervisory board. Supervisory board is expected to “appoints, supervises and advises” the members of management. For important decisions this supervisory board is called to give their opinion and advise in the decision making process. Again, as it happens in with the management board, there is a Chairman that coordinates the supervisory board.
Regarding the way that they are elected, Shareholders in the general meetings elects the supervisory board. The German corporate code also states that, depending on the size of the company; there must be a representative of employees in the Supervisory board.
Credit crunch, a term mentioned in abundance in the years 2008-2009, was often followed with phrases such as lack of accountability, inconsistencies in the system, directors’ remunerations; fiscal policies; and lack of transparencies in the system; bankruptcies in capital market, government bailouts, unemployment, and need of better regulations in the news media all over. The financial crisis of 2008-2009 affected people; the International Labour Organisation forecasted in early 2009 50 millions jobs would be lost by the end of the year , it affected financial markets; banks had lost more than 1 trillion dollars to toxic assets and bad loans by the end of 2009 .
As stated before, corporate governance code is just a guideline for organisations to follow to ensure that they are run ethically and morally. However, one of the biggest drawbacks of such an approach is that it is not legally binding and has not been fully incorporated in the legal system yet.
The UK Corporate Governance Code 2010 was a revision of the previous combined code, following a review of financial institutions by Sir David Walker in 2009. Many recommendations were implemented; nonetheless the FRC policy of ‘comply or explain’ was maintained. This has been a topic for debate for many observers as to whether The Code’s policy of ‘comply or explain’ is a hindrance for its lack of legal legislation or a benefit due to its flexibility. As organisations only have to explain to the shareholders for their non compliance, Mitchel and Saka argue that these organisations are “accountable to no one, company executive play their selfish games, enriching a few and impoverishing many. Shareholder, employees and customer are routinely ripped-off, sold worthless pensions, and endowment mortgages and other financial products” (Mitchell and Sikka, 2005). In their work they state that corporations are not presenting genuine accountability to the society.
The reasons stated for this include
• ‘Chairman and CEOs determine their own remuneration by sitting on each other’s remuneration committees as non-executive directors (p.30).’
• Companies place much importance to their profits, before the stakeholders despite their attempts to look socially responsible. This is clearly evident from the majority of the Listed Companies ratio of contributions to towards the charitable work to the profits they earn. (http://www.nps.gov/partnerships/fundraising_individuals_statistics.htm)
• External audits for corporation accounts have become a legal requirement. The independent auditors report should highlight any issues and risks that are related to the corporation. Mithchell and Sakka (2005) say ‘Auditors are producing reports which ‘are not worth the paper they are written on’ (p.26).
The Code’s voluntary nature encourages directors to misuse it when appropriate. Its objective to encourage firms to adopt good corporate governance is directly undermined as a result.
Around 70% of the investors in UK stock market are institutional investors. These investors have diverse portfolios spreading many markets. Due to the volatility associated with such portfolios, institutional investors expect high returns for their investment. As a result, their expectations mostly are in the relative short term, contradicting usually with the objectives of corporate social responsibilities the corporation might have. Hence, their representatives on the supervisory board influence the management to undertake excessive risk practises in order to earn extra return in the short-term. Sometimes the contrary was true, as highlighted by The Cadbury Report and the Myners Report (1995) which stressed the importance of institutional investors holding regular meetings with executive investee companies (Corporate Governance and Accountability, Bill Solomon).
Another significant are of concern is the implication of the corporate governance codes to the smaller companies. Hampel’s distinction in terms of the size of the company and the relative importance of the standards of corporate governance they maintained highlighted another important fact, the non compliances of smaller firms who had made the transition to become a bigger firm. This holds true for Parmalat. Upon its issuance of bonds for expansion, its CEO was also the Chairman of the company. This is also a non compliance in the corporate governance code.
Corporate governance has become a global industry. The fallout from the credit crunch and the stricter Basel II capital adequacy requirements will affect both the cost and availability of funding.
On the other hand, RBS, one of the leading financial institutions in the world, came under controversy when its director received a bonus over the fiscal year 2008-2009. Opinions by the government and the financial analysts pointed towards short term goals in relation to the hefty takeovers resulting in large debts.
One must realize, business strategy does play a significant part in a corporation’s demise; however, Northern Rock, was no more worse managed or directed than many similar financial institutions at that time. Its failure is often linked to a wrong strategy at the wrong time. The majority of its funding came either directly from the wholesale funding markets or through the securitization and selling of parcels of mortgages. In August 2007, banks lost trust in each other because they had no idea who was holding “toxic” investments. So the wholesale markets dried up and Northern Rock could not find sufficient funds to meet its large and growing mortgage lending commitments. By the time the process of unravelling the global financial mess began, many reputable institutions had failed, with investors losing their money. Moral hazard cost society heavily, but had little consequence for many of the executives who created and presided over the problems. Better governance was needed from their boards, and the consequence of inadequacy will be greater regulation and higher costs for all of us. (Why the “Credit Crunch” May Be Good for Corporate
Governance, Terry Carroll).
Enhanced emphasis was placed over the roles of gatekeepers after 2001. Enron, one of the principal factors behind the creation of the Sarbanes –Oxley Act in the US Senate, was a prime example of ‘bad’ corporate governance. However, a part was also played by Arthur Anderson, the audit firm responsible for their accounts. In theory, considering how much confidence investors put in them, the reputation of the gatekeepers would not be sacrificed for one client. One of the primary reasons brought forward for this inadequacy was the absence of competition among the gatekeepers. There were only 5 firms dominating the market at that moment. Such a concentrated market would result in implicit collusions developing easily and each of the major firms following a common competitive strategy without fear of being undercut by a major competitor (Coffee, 2000). The independence of the auditors is considered paramount in maintaining an objective viewpoint on audits as offering consultancy services to the same clients they audit would cause a conflict of interests. The likelihood of those gatekeepers acting as whistleblowers would most likely diminish as a result; they would consider factors the importance of clients to their consultancy department and the risk of losing the client. That been said, auditors cannot be held accountable if fraud has taken place, as they can point to being victim of dishonest management practices by the client, even if they themselves were guilty (Coffee, 2002).
On September 13, 2008, Lehman Brothers filed for bankruptcy, becoming one of the largest banking failures in global history. While, unlike Barings, it was not brought down by fraud, some would say the company was in part the architect of its own demise, as it was as vigorous as many in promoting the development of what has now been called “subprime” lending. Although the bill was picked up by the shareholders of the financial institutions that failed and by taxpayers, there was growing anger that the executives had reaped handsome rewards—even where losses were incurred. This has left another legacy for better governance to resolve (Why the “Credit Crunch” May Be Good for Corporate
Governance, Terry Carroll).
‘If further crises are to be avoided, these inadequacies need to be addressed so as to ensure that these mechanisms function more effectively in the future.’
A generic contextual issue of business ethics performance in the society is the organisational culture (Svensson and Wood, 2003). Giacalone and Knouse (1997) argue that business should use an approach, which influences the organisation as a whole regarding its business ethics. Yamaji (1997) presents a similar opinion in stating that business ethics and indeed corporate governance should not just be a code, but implemented in the line of business as a corporate philosophy.
As mentioned before, institutional investors, occupying 70% of the market in the London Stock Exchange, have been criticized for not actively taking part in the business proceedings due to lack of time due to their extensive diversification (Fry, 2009). The Companies Act (2006) proposed the idea of online voting, using the medium of electronic communication, to encourage more shareholder participation. This could mean online voting might become much more prominent in these meetings (Mallin, 2010).
The presence of non-executive directors in the board has been argued in favour by Alvarez and Marsal, stating that they act as whistle blowers, and should be listened to and respected, as the shareholders count on them (Stern, 2009). However, the presence of them in a non-executive role often conflicts with their interest as they need to monitor the executive directors and work with them as part of the board (Mallin, 2010). The presence of non-executive directors in the audit committee was also proposed by the FRC to review the audit and asses that the objectivity of the audit has been maintained.
An important aspect in corporate governance and the direction the company adopts regarding it are the roles of the CEO as well as the chairman. The CEO has the executive responsibility for the running of the company business; on the other hand, the chairman has responsibility for the running of the board (Mallin, 2010). The issue of independence in the personal working as the director and working as the CEO is highlighted in The Combined Code (2008) which states that the roles of chairman and CEO should not be exercised by the same individual. This stance of the code is further strengthened as both positions have a very diverse role to play in the business entity (Ashton, 2008). Enron, before its collapse, had Kenneth Lay acting as both the chairman and the CEO. Marks and Spencer, has Stuart Rose acting as both as the chairman and the CEO. The Codes ‘comply’ or ‘explain’ policy meant they had to explain to the shareholders about this decision. Again, the voluntary basis of the code highlighted the indifference in applications of the code.
Criminal law has been acting as a restraint for poor corporate governance. Application of criminal laws regarding fraud in the US has been much stricter, whereas in the UK the law have been inadequate in its purpose of protecting the investors (Musikali, 2009). The less severe nature of the laws act as less a deterrent in companies’ policy regarding background checks, etc. Allan Sanford, who the SEC said had been under strict observation for close to 4 years for suspicious activity, was involved in a partnership with the English Cricket Board involving cricket tournaments featuring international teams. The multimillion dollar deal was signed by the ECB to in response the lucrative Indian Premier League started in India, highlighting ECB’s failures in carrying out the relevant background checks. However, enforcing strict criminal sanctions to regulate business activity is generally conceived as being an overreaction. It is argued it would make firms unnecessarily risk aversive, as a result driving down profitability (Musikali, 2009).
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