Corporate Governance - An Economic Perspective

“In a more globalized, interconnected and competitive world, the way that environmental, social and corporate governance issues are managed is part of companies’ overall management quality needed to compete successfully. Companies that perform better with regard to these issues can increase shareholder value by, for example, properly managing risks, anticipating regulatory action or accessing new markets while at the same time contributing to the sustainable development of the societies in which they operate. Moreover these issues can have a strong impact on reputation and brands, an increasingly important part of company value.”- reported in UN Global Compact Financial Sector Initiative, 2004.

There is an abundance of write-up on corporate governance in various journals and newspapers particularly in the wake of major corporate frauds and scandals across the past one and half decades. Conventionally, corporate governance is understood as the plethora of rules, regulations, customs, policies, laws and guidelines the compliance of which is vital as they affect the way of administration of a company to a great extent. It binds the company in a relationship with the stakeholders like the shareholders, directors, employees, customers, creditors, suppliers and the society at large. Because the directors and officers of a company are bound by their fiduciary duty towards the stakeholders in general, in controlling the management of the company they need to use good business practices and have accountability and integrity. However, while the above is the traditional way of defining corporate governance, a large many other viewpoints of corporate governance is also available and a lot of research work has been involved on the same over the years. In the following paragraph I have taken a different view of the concept and made a modest attempt at analyzing good corporate governance as an indicator of economic efficiency.

Economic theories of Corporate Governance

Ideally, to narrow down the meaning of the term ‘corporate governance’ into a bunch of mere rules, regulations, policies and laws would be doing injustice to this much researched concept. The boundary of this topic is vast. An economic analysis of it has led to a great debate between two conflicting notions of corporate governance and accordingly two theories have evolved: the shareholder theory and the stakeholder theory. While the former is a narrower version, the latter is much wide in scope. As per the restricted shareholder theory the main aim of an organisation is to maximise the wealth of shareholder who are the real owners of it. This theory stems from the traditional economic concept of ‘principal-agent’ or ‘Agency contract’ as the source of existence of companies. A ‘principal-agent’ relationship arises when the owner of an organisation does not manage it himself. In case of companies the owners or shareholders appoint persons to manage and control the affairs. Here the shareholders are the principals and they appoint directors as agents to run the company on their behalf. The arrangement is mutually beneficial. Shareholders in general lack specialized business knowledge that goes behind generating large returns on their investment and maximising their wealth, and managers may lack the fund which the former provide them with. For maximisation of shareholder net wealth what is required is the optimum allocation of resources, putting them to most productive uses, etc. Hence, it is the duty of the directors and management of the company to see that the organisation is run on the best possible manner in the interest of shareholders. However, due to this separation of ownership and control, shareholders who are the true owners of a company, do not control it, the control rather lies in the hands of the managers and directors who do not own the organization. Under this theory, the main problem in corporate governance is this separation that fuels divergence of interests and the directors may divert from the profit maximising aim and be rather interested in maximising their self interest like increasing their perks and salaries, their reputation (which may be at the cost of shareholder benefit), diversion of company assets for personal uses etc. Such a divergence of interest can be the root cause of bad corporate governance.

While the shareholder theory of corporate governance attaches supreme importance to the shareholders as owners of the company, the much wider view presented by the stakeholder theory takes into account all the formal and informal, written and unwritten relations of a company viz., creditors, employees, suppliers, customers, other contractual parties, members of the society, institutions with various interests like those for environmental health hazards, governments and so on. This theory takes a broader notion of corporate governance and holds companies to be “socially responsible” organisations that are typically to be managed in the interest of the public. Thus, the performance of a company is not only to be judged by the increase in shareholder value but also from timely creditor payments, enhancement of employee salaries and betterment of job conditions, increase in market share, better relations with suppliers, customers, the government (which would encompass the better compliance with rules and regulations part) etc. Therefore, companies with better corporate governance are those that have dedicated and long standing suppliers, customers, creditors and employees, and those with good compliance record and little or no litigation against.

There are problems with both the theories as also with the principal-agent concept. In a company, the principal-agent problem and the divergence of interests would not have arisen if it were possible to write ‘complete contracts’ at the very inception of the company. A complete contract in this case would have meant a contract specifying every contingency and every single mandatory act for the agents or directors in every possible situation. The problem is, it is not possible to foresee every contingency ex-ante, and that is why contingencies are contingencies and not certainty. A complete contract could have ensured that there is no divergence of interests. Hence there would have been no need to worry about corporate governance problems. We do worry because complete contracts are not feasible and it is impossible to predict everything the future holds for us. The incompleteness provides the scope of ‘residuals’ and the question arises as to ‘how to efficiently allocate those residuals’. It is because of this that we need a mechanism that provides for efficient decision making in situations that were not foreseen at the inception of the contract. Such efficient decision making would imply efficient use of discretion and accountability of directors. Thus good corporate governance is required to reduce the chances of ex-post opportunistic behaviour by directors and managers and divergence of their interest from the real owners of a company so that investors do not shy away their investment in companies due to non-reliance on directors. This would result in a hold-up situation and adversely affect the economy. It is to check the occurrence of such situations that the shareholder theory of corporate governance has developed.

As in the shareholder theory, even in the stakeholder theory there are chances that all ‘investors’ (meaning all ‘stakeholders’ here) shy away their investment because they do not get proper returns on their investment. To take an example, there may be a non-optimum investment of employees into the human capital of the company, the suppliers may under-invest in the form of low quality raw-materials and customers may under-invest by buying less of the company products. Similarly creditors may under-invest by unfavourable credit terms, while underinvestment from distributors may take the form of inefficient distribution network and so on. The basic idea of corporate governance is to ensure the most optimum investment from all stakeholders and optimum allocation of all types of resources and that there is continuity and sustainability of efficient business relationship amongst all components of a company that make firm specific investment.

The right corporate governance strategy suitable for an enterprise can provide solutions to most of these problems of divergence of interest, hold-up, inefficient allocation of financial and other resources, unproductive uses of resources, diversion of company’s assets for personal use etc. Meanwhile, before proceeding further into discussing what will be an ideal corporate governance mechanism, it is worthwhile to have a quick look at the various methods to align the directors’ and managers’ interest with those of the shareholders:

- To give more power to shareholders for overseeing and controlling management activity. This can take the form of certain legal protection in the form of minority rights, prohibitions of insider-dealing, increase of disclosure norms etc.

- To try and give incentives to managers for efficient management and accountability in the form of attractive perks, stock options, sweat equity etc.

- To make laws stricter with respect to compliances and norms to be followed (the kind of corporate governance us professionals are more inclined to think of)

- To use the markets for corporate control like take-overs etc.

Shareholder theory vs. Stakeholder theory

Both the shareholder theory and stakeholder theories of corporate governance have come in for criticisms. The following criticisms are often labeled against the shareholder theory:

- There is an overemphasized and practically baseless presumption of strong managers vs. weak shareholders conflict which has paved the way for all the corporate governance theories of resolving monitoring and diverse interest problems. The argument in favour of this is that widely dispersed ownership in companies is not the general norm but more like an exception, and it would be erroneous to think that corporate governance is just meant for large public listed companies only. Each small company is a unit in the economy and each make fractional contribution towards the betterment of the economy. After all, the sea is made up of millions and billions of drops of water. One drop of contaminated water can bring down the quality of water of the entire sea. Unlike the widely-held companies where managers enjoy greater control rights vis-à-vis the shareholders, in closely held companies, the greatest power is generally in the hands of controlling shareholder, usually some individuals or a family, or a group of companies. There is no reason to think that these companies do not need to put emphasis on corporate governance. Even in such companies due to dominance of majority shareholders, the minority shareholders’ rights might suffer.

- The shareholder theory gives a narrow view of corporate governance in the sense that it overemphasizes shareholders though they are not the only ones who make investments in a company. A company is the outcome of a bundle of people who make specific investments in their capacity as customers, employees, creditors, suppliers and distributors apart from shareholders. Corporate success is thus a team effort. Any good governance system cannot have optimum output unless it takes into account all the parties involved, in other words, all the stakeholders.

As against the above, the stakeholder theory is also not free from criticisms. The following are some criticisms labeled against it:

- This theory is criticized by many as being too wide for companies to ensure compliance with. It is difficult to consider the incentives and disincentives of all stakeholders involved. It is equally difficult to set the efficient levels of investment by all stakeholders.

- The stakeholder theory leaves scope for the directors or managers of a company to take shelter under the wider coverage of the term stakeholder to avoid questions about company’s bad results.

The right approach

What follows from the above is that both theories have drawbacks, but both equally have benefits. The shareholder theory helps directors and managers fix the target for efficiency levels to be reached based upon single criteria of shareholder wealth maximisation while the stakeholder theory helps them avoid underinvestment from a number of business components and thereby aids long-term growth of the company and ultimately paces up economic growth. However considering the greater economic benefits to the nation, the stakeholder theory definitely gains an edge over the shareholder theory. In order to make the stakeholder theory more suitable, therefore a new stakeholder approach has developed and this new approach narrows down the meaning of a stakeholder and considers only those parties as stakeholders who have direct firm specific investment in the company. The contributions of all stakeholders are important and go hand in hand to increase shareholder net wealth. Hence the shareholders have incentive to take into account other interest groups in overall corporate governance and the importance of developing long term relations with various components by companies. In this way not only is wealth maximized, but also jobs are secured and business becomes more sustainable.

As the views on corporate governance differ, for making effective policy recommendations for corporate governance best practices, the proponents need to have an insight into the various theories developed and their relative merits and demerits. It is only then that we can have the best corporate governance structure. It is not just about having a fixed set of rules and regulations and making proper compliances with them, it is much more. It is about putting the economy forward in the path of growth.

Competition vs. Corporate Governance While discussing corporate governance and its wider implications for the economy and the right approach to corporate governance, a question that arises is whether corporate governance is at all necessary in the presence of appropriate competition in the product market. Such competition would provide positive incentives for companies to take care that it has the best governance structure in place. Companies that are uncompetitive because of bad cost structure would automatically be wiped out of the market. This would mean that no external regulatory intervention would be necessary. Things like market for corporate control, managerial stock options, etc. are some recent developments that are fueled by this idea. Nonetheless, good corporate governance mechanism is a combination of many things including competition in the product, capital and labour market, economic efficiency, and the legal set up. These together provide a systematic approach to corporate governance. However, the problem with such a systemic approach is that it is not a very easy task to develop such a mechanism after taking into consideration so many aspects.

How bad corporate governance affects the economy

While discussing corporate governance as a contributor to economic efficiency, it is worthwhile to take up the point raised by Professors Merritt B. Fox and Michael A. Heller, of the Columbia Law School in their much referred to study “Corporate Governance Lessons from Russian Enterprise Fiascoes” published in the New York University Law Review in 2000. In analyzing the connection between economic efficiency and corporate governance, these researchers took up the example of Russian economy immediately after its transition into privatization. Researching into the poor performance of the Russian corporate sector and the fall of the Russian economy after its transition while most authors and researchers noted such causes like unwanted bureaucratic interference and poor economic policies, they noted bad corporate governance in the corporations as the reason and linked it with the failure of the economy. In their view, an in-depth knowledge of the circumstances that arose in Russia does not only give an idea of the transition policy, it also sheds important light on the theory of corporate governance in general.

The crash of communism in Russia saw a rapid privatization of erstwhile state owned enterprises following. This was accompanied by creation of the Russian stock markets and formulation of major business, corporate and labour laws. In the opinion of these authors, the low stock price showed poor corporate governance and was an indicator of the fact that the assets of the enterprises were being mismanaged and misutilised and put to less productive uses for the sole benefit of insiders. Rather than elaborating on good corporate governance practices, the authors have identified how ‘bad corporate governance’ by a company can adversely affect the economy of a country.

The authors have raised two pertinent questions: The one as to what are the consequences of corporate governance problems for the economy of a country and the second as to why these problems are so widespread. They have identified two economic functions of the firm, namely, maximising the firm’s wealth and in case of enterprises owned by shareholders, distributing the wealth so gained on a pro rata basis to them. In their view, companies will have good corporate governance if they are characterised by both the aim of maximising shareholders’ wealth and making a pro rata distribution of that wealth amongst the shareholders. This implies that bad corporate governance in a firm at the micro level might arise from its inability to fulfill any one or both of these economic functions. While failure to meet these objectives might be due to a variety of reasons, only one such reason may be the existing legal set up, quite in contrary to the more popular viewpoint.

These authors have identified seven symptoms of diseased corporations which go in to point towards their bad corporate governance. Out of these the first five relate to maximisation of wealth and the last two relate to pro rata distribution of this wealth and according to them these are the seven ways by which, in their words “loosely constrained and poorly incentivised managers cause social welfare losses” and all seven of which can be identified with poor corporate governance. Accordingly inability of firms to maximise wealth may be deduced from the following five symptoms that point towards its inefficient and non-incentivised managers:

- a firm’s continued operation even though it should be shut down immediately,

- inefficient capacity utilization by viable firms,

- inefficient investment in negative present value projects,

- failure to implement positive net present value projects

- failure to identify positive net present value projects.

Two symptoms that indicate the firm’s inability to make pro rata distribution of wealth generated are:

- diversion of claims of the corporation

- diversion of the assets and opportunities belonging to the firm by the managers.

These seven symptoms go in to show how the economy of a country suffers due to the bad corporate governance in firms. Thus, in their study of the state of corporate governance in Russian enterprises, Professors Fox and Heller have made an analysis of economic functions of a firm and the various ways in which poor corporate governance in companies can inflict damages to the economy of the country. For economically less developed countries like India the analysis of Professors Fox and Heller seems to be an eye opening one.

Does the company secretary fit in to the economic efficiency theories?

From the above discussion on the point raised by Professors Fox and Heller, it is easy to link that the company secretary can make a difference. Non-pro rata distribution of wealth generated by firms to the shareholders resulting from diversion of claims of the company by the managers from rightful claimants can definitely be put to check by the presence of a company secretary in the organisation. A company secretary can ensure that managers do not divert claims of the company by refusing to give effect to share purchases by outsiders, or by refusing to accept board directors lawfully elected by such shareholders, or by issuing shares to insiders against inadequate consideration and so on. It is the job of the company secretary to ensure that such malpractices do not occur, and he is the compliance officer of the company charged with ensuring proper compliance with all legal requirements. These fall within the purview of his day to day activities. The company secretary can therefore be instrumental in effecting pro rata distribution of residuals generated by a firm and thereby make his contribution towards the economy. Similarly, the company secretary may also be instrumental in ensuring that the company has a long lasting relation with all its stakeholders and thereby increase the sustainability of the organisation for greater economic benefit.

Conclusion

Developing an all-proof framework for efficient corporate governance that ensures complete legal compliance, efficient allocation of resources, optimum level of investment from all stakeholders in a company, long-lasting business relationship and sustained business and economic growth and which at the same time ensures that directors and managers remain accountable to the shareholders is a herculean task. And if developed, such a corporate governance mechanism would be an ideal one. The reason is simple, quite contrary to the popular belief, corporate governance does not start and end with merely a set of rules, guidelines and policies to be complied with. It is much more with much wider implication and good corporate governance has its positive impact on the economy of the entire nation. It is not just about directors and managers remaining accountable to shareholders, or even the wider version that targets the stakeholders as the beneficiaries of good governance. It is rather about treating a company as an economic unit at the minimum and that what it does, does not merely affect its employees, creditors, investors, competitors, customers and the government, the impact is on the entire economy. For economically developing countries like India, this consideration gains all the more importance and we are compelled to think that the rightly planned corporate governance structure in companies that puts due emphasis on economic development of the country is the demand of the hour.

Originally Published in Chartered Secretary, April 2011 issue. The Chartered Secretary is a monthly magazine of The Institute of Company Secretaries of India