Post on 29-Jan-2016
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Theoretical FrameworkTheoretical Framework
Learning Outcome
At the end of the lecture, students would be able to: Explain the various approaches/models
to good Corporate Governance; Discuss the issues and solutions to the
separation of ownership and control; Understand the pillars of CG; and Describe the core concepts to sound CG
Theoretical Frameworks
1. Principal-Agent (Finance)Model2. Shareholders / Anglo-American Model3. Stakeholder/Pluralistic Model4. Enlightened Shareholder Model5. Myopic Market Model6. Abuse of Executive Power Model
Principal-Agent Model (cont’d)
Definition of Agency Relationship: A contract under which one or more
persons (principals) engage another person (agent) to perform some service on their behalf, which involves delegating some decision-making authority to the agent” (Jensen & Meckling, 1976)
Sometimes called “Contract for Service”
Assumptions: All individuals will act in their own self
interest, which leads to potential conflicts of interest;
Agents are in a unique position to further their own interests at the expense of the principals;
Shareholders’ wealth maximisation = share value maximisation.
Principal-Agent Model (cont’d)
Theoretically managers work for shareholders (owners).
In reality – shareholders are usually inactive, firm actually seems to belong to management.
Principal-Agent Model (cont’d)
Separation of Ownership & Control
Most shareholders do not wish to take part in firm’s business activities. They act like investors not owners.
Investors tend to be inactive shareholders of many firms.
These absentee owners provide funding to public companies and delegate all aspects of management of the companies from strategic positioning to the daily business operations to the executive management team.
Owners focus on business performance of firm and investors focus on risk and return of stock portfolios.
Why Would Managers Care About Owners?
Managers/directors may act in their own personal interest, if possible, even at the expense of owners.
This situation is known as the principal-agent problem or agency problem.
Solution to Principal-Agent Issue
1. Incentives & monitoring Incentive solution to tie wealth of executive
to wealth of shareholders so that executives and shareholders have the same objectives.
This is called aligning executive incentives with shareholder desires.
Managers will then act and behave in a way that is also best for the other shareholders.
E.g. stock options or stocks or both as a significant component of their compensation.
Solution to Principal-Agent Issue
(Source: Kim, K. & Nofsinger, (2004). Corporate Governance. P6)
Stockholders
Creditors
Employees
Society
Stakeholders Monitors
Within CompanyBoard of Directors
Outside CompanyAuditorsAnalystsBankers
Credit AgenciesAttorneys
GovernmentSC/CCM/IRD
Bursa Malaysia
Managers
Controllers
2. Set up mechanisms for monitoring behaviour of managers.
Stakeholders Model
Key Features Top management also serves as an
agent to stakeholders; Companies are accountable to a broad
range of stakeholders; Promote ethical behaviour in
organisational practices; Criticises shareholder wealth
maximisation.
Stakeholders Model (cont’d)
Key Features (cont’d) Ethical principle gives competitive
advantage; Build reputation; Ethic behaviour minimises agency and
monitoring costs; Employees interest should be protected; Promote good relationship with suppliers.
Myopic Market Model
Key features: Criticises Anglo-Saxon (American) model for
over emphasising on short term perspectives Accounting practice is too concerned with
short term returns – executive rewards Share market misprices – does not take
fundamentals into account Fund managers dominate share market –
performance evaluated on short term basis/ short term forecast.
Shareholders wealth ≠ Share price maximisation
Myopic Model (cont’d)
Reforms proposed: Increase shareholder loyalty and ‘voice’ Reduce ease of shareholder ‘exit’
Restrict voting rights for short term investors
Restrictions on takeover process
Abuse of Executive Power Model
Key Features: Governance problems arose due to abuse of
power by top management; Current CG mechanisms are not adequate to
curb power abuse; BOD is too powerful and serves to promote
members’ interest only; Criticises free market – weakens ethical
constraints (governance problems) Disagrees with pay performance model.
Abuse of Executive Power Model (cont’d)
Reforms proposed: Limit CEO’s term (legislative/statutory
changes) Independent nomination of non-executive
directors (NEDs) Greater power for NEDs
Purpose : to weaken top management entrenched position.
Conditions For Corporate Governance
Source : Siebens, H.(Aug 2002). Concepts and Working Instruments for CG.Journal for Business Ethics (Electronic Journal)
Transparency & Accountability: tell me, show me & involve me
Pluralistic Model = Stakeholders’ Model
Shareholders Value Stakeholders Value
Anglo American Model
Enlightened Shareholders Model
Regulation of power and
competence
Duality Care
Responsible business
Risk Management
Shareholder Value Approach
BOD should govern their company in the best interest of the owners and shareholders
Objectives of the company to maximise the wealth of owners and equity shareholders in the form of share price growth and dividend payments.
Aims of sound corporate governance not only to meet objectives of shareholders
Also takes into account the interest of other individual or groups with a stake in the company.
Shareholder Value Approach
Criticisms of Stakeholders Value Approach
1. Firm’s contribution - it is harder to measure the firm’s contribution to the welfare of employees, suppliers or customers than to measure its profitability.
2. Market Value - there is no market value of the impact of past and current managerial decisions on future welfare of stakeholders.
3. Efficiency & Effectiveness - with the enlarged and restricted fiduciary duty concept, it would be questionable whether effective work can be done by management.
Pillars of CG
Legal & Regulatory Framework Compliance and legal protection
Directors & Board of Directors Board independence, Composition and size; & Role of CEO/Chairman
Board Committees Audit, remuneration & nomination
Pillars of CG (cont’d)
Company Secretary & Whistle blower Professional advise & independence
Auditors & Internal Control Independent assurance, risk
management system Shareholders & Stakeholders
Rights & activism Institutional Shareholders
IS activism Capital Structure
Debt vs. equity financing
Core Concepts of CG
Openness Willingness to provide information to
individuals and groups about the company (without giving away commercially sensitive information).
Honesty Not lying, cheating or stealing, fair and
upright; not hiding one’s real nature (oxford dictionary).
In an age of ‘spin’ and manipulation of facts, honest information is by no means prevalent.
A sign of questionable honesty is some measure of scepticism and disbelief.
Core Concepts of CG (cont’d)
Transparency Refers to ease with which an outsider is
able to make a meaningful analysis of a company and its actions.
Refers both to information about financial position of company and
Non financial issues such as direction the company is taking, strategic objectives, etc.
Independence Defined as a person free from influence
from another individual or individuals and free from conflicts of interest.
Refers to the extent which procedures and structures are in place so as to minimise (or avoid completely) potential conflicts of interest that could arise.
Independence can also be undermined by familiarity.
Core Concepts of CG (cont’d)
Accountability Requirement for a person in a position of
responsibility to justify, explain or account for/answerable for his/her actions in the course of his duties.
Responsibility Having authority over something and liable
to be held accountable for the exercise of his/her authority.
Core Concepts of CG (cont’d)
Fairness Impartial or un-bias and things done with a
sense of justice. All shareholders should receive equal
consideration. Reputation
Reflects the overall way in which the company is perceived by the market and in the wider community.
Influenced by code of ethics, corporate social responsibility, fair treatment of staff, attitudes to customers, community involvement and willingness to obey the spirit as well as the letter of the law.
Core Concepts of CG (cont’d)
Corporate Social Responsibility Refers to business decision making
linked to ethical values, compliance with legal requirements and respect for people, communities and the environment (www.bsr.org)
Viewed as a comprehensive set of policies, practices and programmes that are integrated throughout business operations, and decision making processes that are supported and rewarded by top management.
Core Concepts of CG (cont’d)
Role of ‘Exit’ & ‘Voice’ in CG Relates to shareholders’ power in monitoring
the actions/performance of the BOD. Exit
shareholders not satisfied with company’s affairs have the right to sell shares of the company.
inability to voice due to strong influence by a certain individual on BOD.
Voice Shareholders have the power to approve or
reject corporate transactions either through shareholders’ activism with assistance of the Minority Shareholders’ Group.
Factors Influencing CG System
Insider Countries : Germany,
Japan & Asian countries
Firms owned by insider shareholders
Little separation of ownership & control
Rare hostile takeover activities
Weak investor protection in law
Outsider Countries: UK, USA Firms controlled by
managers but owned by outside shareholders
Prevalent separation of ownership & control
Frequent hostile takeover activities
Strong investor protection in law
Factors Influencing CG System (cont’d)
Insider Potential abuse of
power
Majority shareholder tend to have more voice
Ownership concentrated in a small group of shareholders
Outsider Potential for
shareholder democracy
Shareholding characterised more by ‘exit’ than ‘voice’
Dispersed ownership
Insider Excessive control by
insider shareholder
Wealth transfer from minority to majority shareholders
Outsider Moderate control by
large range of shareholders
No transfer of wealth from minority to majority shareholders
Factors Influencing CG System (cont’d)
Questions
1. What key elements show good governance?2. Explain one of the theoretical models
describing corporate governance.3. What are the essential pillars that forms the
corporate governance framework?4. What should shareholders do when they are
not happy about the governance of a corporation?