CORPORATE GOVERNANCE

CHAPTER 1

What is Corporate Governance?

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Deals with the problems arising from the separation of ownership and control.

Separation of Ownership and Control3

The thousands, or more, investors who own public limited corporations could not collectively make the daily decisions needed to operate a business. Therefore:

The shareholders are owners of the firm

The shareholders elect directors to act as their agents in supervising the firm

The directors appoint officers (or executives) to actually run the firm on a day-to-day basis

Separation of Ownership and Control

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Shareholders

Board

Employees

Management

Ownership

Control

Focus of Corporate Governance

Shareholders elect directors who represent them.

Directors vote on key matters and adopt the majority decisions.

Decisions are made in a transparent manner so that shareholders and others can hold directors accountable.

Company adopts accounting standards to generate the information necessary for directors, investors and other stakeholders to make decisions.

The company's policies and practices adhere to applicable national, state and local laws.

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Principal-Agent Problem6

Principal-agent problem represents the conflict of interest between the principal and the agent.

Primary principal-agent problem in corporations: Principal = Shareholders

Agent = Officers

If shareholders cannot effectively monitor the officers’ behavior, then officers may be tempted to use firm’s assets for their own personal use.

Solutions to Principal-agent problem7

Incentives—aligning executive incentives with shareholder desires.

Monitoring—setting up mechanisms for monitoring the behavior of managers.

Can Shareholders Influence Managers?8

Shareholders do not directly hire/fire managers – so they can’t vote to replace them

Shareholders can influence managers indirectly through the board of directors

Changing board members can be difficult as management controls the process and some inactive shareholders will go along with whatever management wants.

Some “active” shareholders are large enough to try and influence management or change the board, but they are often met with defeat.

Monitors9

Monitors are called for because managers may not act in the shareholder’s best interest.

Figure 1.1 shows that monitors exist: inside the corporate structure

Board of directors

outside the structure Auditors, analysts, bankers, credit rating agencies, and attorneys

in government SECP, FBR

Figure 1.110

Inside monitors-Board of directors

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Oversee management and are supposed to represent shareholders’ interests.

Evaluates management and design compensation contracts to tie management’s salaries to the firm’s performance.

Outside monitors12

Interact with the firm and monitor manager activities Auditors Analysts Bankers Credit rating agencies Attorneys

Government monitors13

The SECP regulates public firms for the protection of public investors

The SECP also makes policy and prosecutes violators in civil courts.

Governance is more than just Board Processes and Procedures

It involves the full set of Relationship between a company’s management Its Board Its Shareholders Its other stakeholders

One size doesn’t fit all. The Board Objectives and Procedures may be the same to all societies but when it comes to applying them to individual countries we have to reckon the peculiar, socio-cultural characteristics, the history of its people, their value systems, their economic system, etc.

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Corporate Governance Guidelines Most worldwide organizations have

strongly promoted good corporate governance by application of the following corporate governance guidelines: 1. Rights of shareholders 2. Equitable treatment of shareholders 3. Role of stakeholders in corporate

governance 4. Disclosure and transparency 5. Responsibilities of the board

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Corporate Governance Guidelines 1. Rights of shareholders

All shareholders must be given their due rights i.e. They all should have Secured ownership of their shares Voting rights Right to full disclosure of information participation on decisions on sale or change in

corporate assets or new share issues Capital structure must be disclosed All transactions should be at transparent prices

and under fair conditions

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Corporate Governance Guidelines

2. Equitable treatment of shareholders All shareholders should have equal opportunity

for redressal of the violation of their rights Insider trading should be prohibited

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Corporate Governance Guidelines 3. Role of stakeholders in corporate

governance Corporate governance framework apart

from the rights of shareholders allow Employees representation on BOD Profit sharing Creditors’ involvement in insolvency

proceedings

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Corporate Governance Guidelines 4. Disclosure and transparency

Financial details, operating results, policies, governance structure should be disclosed

Annual audits should be performed by independent auditors

When in

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Doubtisclose

Corporate Governance Guidelines 5. Responsibilities of the board

Board is responsible for Protecting the company, its shareholders and

other stakeholders Making policies, strategies Monitoring effectiveness

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McKinsey’s Two-Version Governance Chain Models

Model 1: Market Model In Market Model governance chain, there

are efficient, well-developed equity markets and dispersed ownership.

Model 2: Control Model In Control Model governance chain is

represented by underdeveloped equity markets, concentrated(family) ownership, less shareholder transparency and inadequate protection of minority and foreign shareholders.

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Market Model Governance Chain

More common in US, UK, Canada & Australia22

Institutional Context

Independence & Performance

Corporate Context

Shareholder environment

Transparency & AccountabilityCapital Market Liquidity

Non-executive Majority Boards

Aligned incentive

s

Active equity market

Active takeover market

Dispersed ownershipSophisticat

ed institution

al ownership

Shareholder equality

High disclos

ure

Control Model Governance Chain

More common in Asia, Latin America, parts of Europe23

Institutional Context

Independence & Performance

Corporate Context

Shareholder environment

Transparency & AccountabilityCapital Market Liquidity

Insider boards

Incentives aligned

with core shareholde

rs

Under developed new issue

marketLimited

takeover market

Concentrated

ownershipReliance

on family, bank, public

finance

Inadequate minority protection

Limiteddisclos

ure

Corporate Governance Concerns

1. Management Accountability

2. Providing Adequate Incentives To Management

3. Disciplining & Replacement Of Bad Management

4. Enhancing Corporate Performance

5. Transparency

6. Shareholder activism

7. Enhancing Protection

8. Improving Access To Capital Markets

9. Promoting Long-Term Investment

10. Encouraging Innovation

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Issues in Corporate Governance

Corporate Governance conveys different meanings to different people. But to all, corporate governance is a mean to an end, the end being long-term shareholder value and more importantly stakeholder value. All authorities have identified some governance issues being crucial and critical to achieve these objectives. These are:1. Distinguishing the role of Board & Management

2. Composition of Board & related issues

3. Separation of the roles of CEO & chairperson

4. Should the board have committees?

5. Appointments to the board & directors’ re-election

6. Directors’ and executives’ remuneration

7. Disclosure & audit

8. Protection of shareholders’ rights & their expectations

9. Dialogue with institutional shareholders

10. Should investors have a say in making a company socially responsible corporate citizen

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Issues in Corporate Governance1. Distinguishing the role of Board & Management

Board of the company has following functions: Select, decide the remuneration & evaluate on regular basis and when

necessary change the CEO. Oversee indirectly the conduct of company’s business Review and approve the company’s financial objective if necessary Render advice & counsel to the top management Recommending candidates to the shareholders for electing them to

BOD Review the adequacy of systems to comply with all laws and regulations All other functions required by law to be performed

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Shareholders

• Owners who elect BOD

Board

• Delegates responsibilities to CEO

Issues in Corporate Governance2. Composition of Board & related issues

BOD is a committee elected by shareholders. Sometimes, full-time functional directors are appointed, each being responsible for some particular branch of the firm’s work.

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Board of Directors

Executive Directors Non-Executive Directors

Independent Directors

Affiliated Directors (Nominee Directors)

Issues in Corporate Governance 3. Separation of the roles of CEO & chairperson

Combining the role of chairperson with that of the CEO leads to conflict in decision making and too much concentration of power in one person resulting in unhealthy consequences.

The role of CEO is to lead the senior management team in managing the enterprise, while

The role of chairperson is to lead the board to evaluate the performance of senior executives including the CEO.

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Issues in Corporate Governance 4. Should the board have committees? Following committees if made would

lessen the burden of the board and enhance its effectiveness: Nomination Remuneration Auditing

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Issues in Corporate Governance 5. Appointments to the board & directors’ re-election

The board or its specially constituted committee selects and appoints the prospective director and gets the person formally elected by the shareholders at AGM.

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Issues in Corporate Governance 6. Directors’ and executives’ remuneration

Shareholders are entitled to a full and clear statement of Director’s recent and future benefits and how they have been determined.

Remuneration committee must be appointed for this task.

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Issues in Corporate Governance

7. Disclosure & audit 8. Protection of shareholders’ rights &

their expectations 9. Dialogue with institutional shareholders 10. Should investors have a say in making

a company socially responsible corporate citizen

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Need & Importance for Corporate Governance

Corporate governance is needed to create a corporate culture of consciousness, transparency and openness.

It refers to the combination of laws, rules, regulations, procedures and voluntary practices to enable companies to maximize shareholders’ long-term value.

It should lead to increasing customer satisfaction, shareholder value and wealth

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Governance & Corporate Performance

There is a positive relationship between corporate governance and corporate performance. Improved corporate governance is linked with improved corporate performance either in terms of rise in share price or profitability.

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Investors’ Preference for Good Governance

Majority of investors (institutional) consider governance practices to be at least as important as financial performance, when they evaluate companies for potential investment.

They are prepared to pay a premium for shares in a well-governed company as compared to a poorly governed one exhibiting similar financial performance.

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Benefits of Good Corporate to a Corporation

1. Creation & enhancement of a corporation’s competitive advantage

2. Enabling a corporation perform efficiently by preventing fraud & malpractices

3. Providing protection to shareholders’ interest 4. Enhancing the valuation of an enterprise5. Ensuring compliance of laws and regulations

(BCCI)

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