Corporate Governance Essay

Lecture 3

Agency Theory

Shareholders of a corporation may not be able to run the company when it becomes more widespread and diverse as this would involve too many people in management rendering the whole process time-consuming and unwieldy. In modern listed corporations, where shares are bought and sold on the stock exchange daily, it is impossible for shareholders to take part in the day to day running of the company. As a result, managers have to be employed to run the corporation.[footnoteRef:1] [1: A A Berle and G C Means, The Modern Corporation and Private Property (Transactions Publishers, New Brunswick: New Jersey, 1991) 66.]

The relationship between shareholders and managers is that of principal and agent. The managers are supposed to act on the instructions of the principal which is the corporation as their contract is with the corporation and not the shareholders, however often managers have sufficient expertise to run the corporation according to their skills sets. The duty of the managers is to maximize the wealth of the shareholders and in return receive remuneration (salary) for doing so. However where managers are given free rein in running the corporation, they may lose sight of their duty and run the corporation without the interests of the shareholders in mind. This is known as agency problem and gives rise to agency costs.[footnoteRef:2] They may be interested in short-term profits which make them look efficient and result in larger compensation (salary and bonus) while shareholders may benefit from long-term plans that do not show immediate benefits. [2: E F Fama, ‘Agency Problems and the Theory of the Firm’ (1980) 88(2) Journal of Political Economy 288; E F Fama and M C Jensen, ‘Separation of Ownership and Control’ (1983) 26(2) Journal of Law and Economics 301.]

As a result, shareholders elect a board of directors to set the strategic direction of the corporation to maximize shareholder wealth and to oversee that the management is aligned with the same interests. The board should comprise members who have the skill and knowledge relevant to running a corporation and in some instances, a few of the directors should have in-depth knowledge of the corporation’s business.[footnoteRef:3] The Board does not take over management’s role but oversees its role. Some members are employed by the corporation on a full time basis to oversee the managers and operations of the corporation. These are known as executive directors. Other directors attend board meetings on a monthly or quarterly basis and depend upon information provided by the management and company secretary to make decisions. These are known as non-executive directors who are either independent with no connection to the corporation’s shareholders, board or management and are not service providers to the corporation, and non-independent non-executive directors who usually represent majority shareholders or a group which has an interest in the corporation. [3: M C Jensen and W H Meckling, ‘Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure’ (1976) 3 Journal of Financial Economics 305.]

One of the main problems in monitoring corporations is that the managers have more insider information compared to the shareholders and often the board of directors. This is known as information asymmetry and is one of the problems that arise when shareholders are unable to manage the corporation that they own.[footnoteRef:4] Agency theory dominates perpectives on corporate governance and results in the use of gatekeepers to monitor management.[footnoteRef:5] These gatekeepers are mainly the board of directors but auditors too are now perceived as gatekeepers. These gatekeepers incur monitoring costs to control managers and bonding costs which are the cost of establishing compliance by managers through quarterly reports, internal controls and other frequent checks on the behaviour of managers. In spite of the presence of gatekeepers, not all opportunistic behaviour can be eradicated. [4: A Shleifer and R W Vishny, ‘Large Shareholders and Corporate Control’ (1986) 94 Journal of Political Economy 461.] [5: J Kirkbride and S. Letza, ‘Can the non-executive director be an effective gatekeeper? The possible development of a legal framework of accountability’ (2005) 13(4) Corporate Governance: An International Review 542.]

Stewardship theory

In contrast to the agency theory, the stewardship theory states that managers have an orientation towards achievement, altruism and want to gain a reputation for good work that will make them marketable. They also want the satisfaction of a job well done when the business expands or makes higher profits. This is in line with maximizing shareholders’ wealth.[footnoteRef:6] This theory emphasizes that managers should be trusted and given the necessary authority to carry out their dureis and are stewards who protect shareholder wealth. They will not engage in opportunistic behaviour and as a result there is less need for gatekeepers to oversee them. This theory focuses on empowering managers instead of controlling them.[footnoteRef:7] [6: L Donaldson and J H Davis, ‘Stewardship Theory or Agency Theory: CEO Governance and Shareholder Returns’ (1991) 16(1) Australian Journal of Management 49.] [7: J H Davis, F D Schoorman and L Donaldson, ‘Toward A Stewardship Theory of Management’ (1997) 22(1) Academy of Management Review 20.]

Managerial Hegemony Theory

This theory states management makes decisions without involvement of the board of directors. Independent directors are not effective gatekeepers because of information asymmetry between the CEO and management and the board. The board is therefore a legal fiction in spite of its formal governing power over the management and is in effect dominated by top management. The board exists only because it is required under corporate laws. It is actually an ally of management as the members are selected by the Chief Executive Officer (CEO) and the board is used to legitimise management’s recommendations. There is a suggestion that directors who are elected during a particular CEO’s tenure may feel loyal to that CEO and neglect their role as gatekeepers.[footnoteRef:8] [8: M.L. Mace, ‘Directors: Myth and Reality’ in T Clarke (ed) Theories of Corporate Governance: The Philosophical Foundations of Corporate Governance (New York, Routledge, 2005) 93. ]

Cadbury Code on Corporate Governance

The Cadbury Code resulted due to financial scandals in the UK. Sir Adrian Cadbury headed a committee established in 1991 by the Financial Reporting Council, the London Stock Exchange and the accountancy profession. The Committee was of the view that while a Code establishing best practices in corporate governance should be introduced, it should not be made compulsory as corporations would end up ticking boxes instead of attempting to genuinely improve governance practices in their firms. As a result the best practices were introduced and corporations were encouraged to comply on a voluntary basis.

The Cadbury Code of corporate governance was one of the earliest comprehensive codes on corporate governance in the UK and advocated self-regulation. It emphasized the difference that the Board can make to the governance of a corporation and that the board should not depend upon auditors or regulators to set standards of good governance. It stated that good corporate governance practices lies with the board and the management takes its cue from the Board. The Code introduced major principles of governance comprising openness, integrity and accountability by stipulating that financial reporting should be honest. This does not mean that corporations were dishonest but these principles were a reaction to the financial scandals in the 1980s and early 1990s. It also set a standard for the Board to be accountable to shareholders as there was a perception that the Board did not always regard itself in this role. It recommended that financial reports should present a true and fair view of the corporation’s financial position. The Cadbury Report suggested making quarterly reports to shareholders and although this was not a recommendation in the Code, the suggestion was later applied by stock exchanges and auditors.

One of the main points raised in the Code was to emphasise that there is a difference between the role of executive directors (EDs) and non-executive directors (NEDs) and the latter had an important role to review performance of the board and take the lead in potential conflict of interest situations. NEDs should lead the Board on issues of strategy, performance, resources, key appointments and standards of conduct. Prior to the Cadbury Code, NEDs were not perceived as making much of a contribution to the board. In addition the Code emphasized the role of independent NEDs (INEDs) who were expected to be independent of the board and management in order to carry out their watchdog role while also providing leadership in key areas. The Code referred to domination of the Board by individuals like the CEO or Chairman and implied that INEDs would reduce incidences of domination. The idea of a ‘shelf life’ for INEDs was mooted although a time frame was not stipulated clearly. The Code recommended that corporations establish a nomination committee to select competent directors to serve on the board and an audit committee to liaise with internal and external auditors. This resulted in greater emphasis on the role of internal audit in addition to external auditors which provided better protection to shareholders. It also recommended a remuneration committee which would recommend salary structures for the Board and senior management which would be disclosed to shareholders. This ensured that their salaries were not determined by one of two individuals only.

The Code’s recommendations on the role of the Board included having a formal schedule and minutes of meetings, training for directors to familiarize themselves with the corporation’s business and with the latest developments in corporate governance and allowing directors access to external advice when carrying out their duties. It also emphasized that the board should take responsibility for establishing internal controls in the corporation.

The Code emphasized the role of auditors and with some foresight they touched upon the conflict of interest when the same audit firm offered audit and non-audit services and as the latter service may bring much higher revenue which may tempt auditors not to be honest in their audits. This became a major reason for the Enron scandal less than 10 years later! The Report recommended the split between audit and non-audit services but most countries including the UK did not implement this until much later. The Report also recommended rotation of auditor firms but this was not incorporated in the Code. Rotation of audit partners has only recently been implemented in many countries.

The establishment of the audit committee (AC) provides a clear reporting line for auditors as the AC is a sub-committee that is responsible for investigating any unusual financial activity discovered by the auditors. The AC also has to follow up on interim reports by the auditors pointing out deficiencies in internal controls or financial irregularities. It was suggested by the Committee that auditors who suspected or had proof of financial mismanagement by the Board have a duty to report it to the board. This suggestion was not implemented in the Code but has become mandatory under the US Sarbanes Oxley Act 2002 (SOX) after Enron and also under various whistleblower provisions in Malaysia and Australia. The Report also suggested that auditors should self-regulate and impose high standards on the profession. This has not yet been implemented in the UK but has been implemented through SOX in the US and also by the Audit Oversight Board in Malaysia since 2010.

The Cadbury Report emphasised the accountability of the board to shareholders. In many cases, shareholders were apathetic and did not know how to uphold their rights and the board acted without fully taking the shareholders into consideration. The Report was an important and timely reminder to boards that they were there to service the shareholders and were agents of teh shareholders. The Report also suggested that shareholders be empowered through shareholder organisations and through proxies or legal support. While shareholders have been empowered recently, the process has been very slow. The Malaysian Companies Act for example does not permit proxies other than certain categories of persons and the method of voting is also in question. Recently amendments to the Act permit shareholders to sue the corporation with the leave of the court whereas in the past, shareholders could only take action if their personal rights were affected.

The Cadbury report emphasised the role of institutional shareholders as they have the resources and hold sufficient shares to make demands or changes to the board. The Code encourages institutional shareholders to have regular contact with the Board. In many instances, institutional shareholders are represented on the Board by NEDs. The Report’s recommendations have been realised through the Institutional Shareholders Code in the UK and also the Corporate Governance Blueprint 2011 in Malaysia. However as many institutional shareholders in Malaysian GLCs are GLICs and there are political links between the these corporations and political parties, the benefits of institutional shareholders in highlighting shareholders concerns is questionable. There may be instances where the interests of minority shareholders and GLICs may differ as the latter is attempting to fulfil government policies while minority shareholders are merely interested in increasing the value of their investments.

Many recommendations in the Cadbury Report have been implemented and in some instances been made mandatory by the Stock Exchange or regulators. The Report shows foresight and a deep understanding of the requirements of good corporate governance.

Greenbury Committee

The Greenbury committee was established in 1995 to review directors’ remuneration as directors were being paid large salaries with little accountability to shareholders. Large payouts were not justified by performance. The Committee recommended that the remuneration of all directors should be included in a report and tabled before shareholders with details of each director’s salary and not the aggregate. The corporation’s policies for salaries, stock options, long-term investments, pensions termination payments also have to be disclosed to shareholders with accompanying explanations as to justification as for payments made or benefits granted.

Hampel Committee

The Hampel Committee report was published in 1998 and it endorsed most of the recommendations in the Cadbury and Greenbury reports. The Hampel Committee recommended a hybrid approach instead of a purely voluntary approach to corporate governance. It stressed that while the board has the role of leading the company for future strategies and growth it also has the role as corporate watchdog. It recommended separating the role of Chairman and CEO as the latter leads management while the Chairman leads the board. The Committee stressed on the role of INEDs which is separate from other NEDs and EDs. It also stated that the term ‘independent’ required further definition. This is an issue that is difficult to resolve. Stock exchanges such as Bursa Malaysia have defined independent directors as persons who have no commercial or family ties with the board or senior management. However one of the main problems is that directors may not be independent in their mind which is difficult to assess. There are suggestions to limit the term of independent directors to reduce chances of familiarity with other members of the board resulting in greater ‘group think’ than independence. The Hampel Committee also stressed the role of institutional shareholders and indicated that there should be dialogue between these shareholders and the company.

In addition the Committee stressed on the importance of internal controls and financial reporting by stating that the standards applied to yearly financial reports should also be applied to interim reporting. Listing Rules now require companies follow this and also to make public disclosure of any material impact on the company’s financial position. The Committeerecommended that external auditors should have to report independently to shareholders and that companies should limit non-audit services to a proportion of audit services (10%) so as not to compromise auditor independence; an occurrence in Enron which was only discovered several years after the Committee’s report.

Turnbull Report

As a result of the Committee reports above, the UK Combined Code of Corporate Governance was enacted on a comply or explain basis. The Institute of Chartered Accountants in England and Wales (ICAEW) set up a committee to provide guidance to companies to implement the internal control requirements of the Code as sound internal controls and risk management procedures would safeguard a company’s and shareholder’s assets.

The Turnbull report stated that the board should consider the nature and extent of risks facing the company, risks that are of acceptable level of the company, likelihood of those risks arising, the company’ s ability to reduce those risks and its impact, costs of managing the risks and the benefit. The Board should communicate its assessment to the management which will have to implement board policies on risk and control through standard operating procedures which give employees the authority, information and skills to manage risks. The company has to put in place policies and processes to manage risks in its documentation and reporting procedures.

The Board has to review whether the internal control systems in place are effective and this should be done on a continuous basis (annual). Any weaknesses should be addressed and procedures put in place to reduce those weaknesses and the board needs to make a statement to this effect in the annual report. Internal auditors are an important part in ensuring that internal controls are in place and they should be required to make a risk assessment to report this.

Higgs Report

This Report was issued in 2003 to review the role and effectiveness of NEDs. The review was due to changes in Europe, several committee reviews in the UK and the SOX in the US due to scandals like WorldCom, Enron and Parmalat (Italy).

The Report stated that the BOD is collectively responsible for promoting the success of the company and supervising its affairs. Board sub-committees should publish a report in the annual report and the number of board meetings and each of its committees should be disclosed. The board should reflect a diversity of experience and skills but should not be so large as to be unwieldy. The Report recommended that ½ the BOD should be INEDs and there should be more EDs to replace NEDs as EDs have information about the company. The Report also stated that the board should meet at least once a year without EDs and chairperson present to discuss matters.

The Report recommended that prior to taking up an appointment NEDs should conduct due diligence on the company to find out more about its financial position, CG reputation, the type and extent of business, obtain information about other members of the board and their skills, the financial viability of the company, the background of its main shareholders, whether there was any threatened legal action against the company, risks attached to joining the board, conflicts of interest and whether the director could make a contribution to the company.

The Report also recommended that a senior independent non-executive director should be appointed to liaise with shareholders in the event that the shareholders had any concerns which they felt were not taken seriously by the rest of the Board. The Report recommended that the definition of independence should be included in the Code and should mean that the director is independent in character and judgment and there are no relationships or circumstances that will affect the directors’ judgment. An independent director must not be a former employee unless there is a gap of 5 years since he/she was employed, have a material business relationship with the company within 3 years, have received additional remuneration from the company or participated in share option scheme etc., have close family ties with the directors, advisers or senior employees, cross-directorships with other directors, represents significant shareholder or served on the Board for more than 10 years.

The Higgs report in hindsight was able to draw lessons from Enron and the Report stressed on the independence of directors as Enron had many INEDs who were not independent in judgment and character as they had close ties with the other members of the board and senior management.

The Higgs report also recommended that the nomination committee (NC) should comprise a majority of INEDs and should be chaired by a INED. It should evaluate a balance of skills, knowledge and experience on the board and prepare a role and prepare a description of the role and capabilities of required for a particular appointment. It should also state in detail the process used for appointments and if the positions have not been based upon external advice or open advertisements, it should provide an explanation. Another recommendation was for NEDs get a letter of appointment with details about the time commitment, committee memberships and involvement outside board meetings expected. In return NEDs should disclose to the chair the nature and extent of their other appointments and confirm that they will be available to carry out their role.

The Higgs report emphasized the role of the nomination committee to ensure proper succession planning for appointments to the board and proper induction for new appointees. It recommended training for directors to update their skills and knowledge and also recommended annual performance evaluation of the board and various committees which should be reported in the annual report. It recommended a time frame for NEDs which is a maximum of 9 years but the preferable term is 6 years and stated that the nomination committee should evaluate if they are able to give the time and responsibility required of them. EDs should not take on more than 1 NED position and should not become a chairperson of another company. The Chairperson must not hold a similar position in another company.

The Report recommended that a NED’s remuneration should reflect the workload, scale and complexity of the business and the responsibility involved. It should be divided into annual fee, meeting attendance fees, chairmanship of board committees,any further roles such as senior INED but they should not be given stock options. NEDs should take their concerns to the chair and their fellow directors and should ensure that their concerns are recorded in the minutes of the meeting. If they feel that resignation is the only course of action left, a written statement should be made to the chairperson for circulation to the board giving reasons for the resignation. The remuneration committee should work closely with the NC to ensure that the incentives for directors and senior executives are appropriately structured to avoid rewarding poor performance. Senior INEDs should attend meetings with a range of shareholders to develop a balanced understanding of themes, issues and concerns of shareholders. In addition, NEDs should upon appointment, meet with major shareholders as part of the induction.

Further Readings - (Chapter 2, Corporate Governance in Malaysia)