Corporate Governance

Assignment II

Submitted by: Salman Mahmood Chaudhry Zeeshan Zafar

Q1 What is corporation? A company or group of people authorized to act as a single entity (legally a person) and recognized as such in law. A legal entity that is separate and distinct from its owners. Q2 How does Justice Lindlay define a company? A company is meant an association of many persons who contribute money or moneys worth to a common stock and employ it in some trade or business, and who share the profit and loss (as the case may be) arising there from. The common stock contributed is denoted in money and is the capital of the company. The persons who contribute it, or to whom it belongs, are members. The proportion of capital to which each member is entitled is his share. Shares are always transferable although the right to transfer them is often more or less restricted Q3 How does the corporation of today differ from an individual capitalist? The corporation of today differs from an individual capitalist in two important aspects: i. ii. The life span of the corporation is much longer, and It is more rational in decision-making by virtue of the fact that it has the benefit of the collective wisdom of the board of directors.

Besides they take decisions using the principles of cost accounting, budget analysis, data collection and processing, and managerial consulting.

Q4. Discuss the characteristics of a corporation in detail. Six characteristics of the corporate form of business organization:

Ease of formation: It should be easy to form the organization. The formation should not involve many legal formalities and it should not be time consuming. Adequacy of Capital: The form of organization should facilitate the raising of the required amount of capital at a reasonable cost. If the enterprise requires a large amount of capital, the preconditions for attracting capital from the public are a) safety of investment b) fair return on investment and c) transferability of the holding. Limit of Liability: A business enterprise may be organized on the basis of either limited or unlimited liability. From the point of view of risk, limited liability is preferable. It means that the liability of the owner as regards the debts of the business is limited only to the amount of capital agreed to be contributed by him. Unlimited liability means that even the owners personal assets will be liable to be attached for the payment of the business debts. Direct relationship between Ownership, Control and Management: The responsibility for management must be in the hands of the owners of the firm. If the owners have no

control on the management, the firm may not be managed efficiently. Continuity and Stability: Stability is essential for any business concern. Uninterrupted existence enables the entrepreneur to formulate long-term plans for the development of the business concern. Flexibility of Operations: another ideal characteristic of a good form of organization is flexibility of operations. Changes may take place either in market conditions or the states policy toward industry or in the conditions of supply of various factors of production. The nature of organization should be such as to be able to adjust itself to the changes without much difficulty.

Q5 Who participates in governance in the rural and the urban areas? In rural areas, for example, pother players may include influential landlords, associations of peasant farmers, cooperatives, NGOs, research institutes, religious leaders, finance institutions, political parties, the police etc. The situation in urban areas is much more complex and includes the urban elite, decision makers at various levels, north government and the private sector media, elected representatives, government officers of various levels, the middle class, the urban poor, NGOs and interested groups, small scale entrepreneurs, trade unions and so on.

Q6 Discuss the agency theory in detail. What are the problems with the agency theory and how can they be resolved? A supposition that explains the relationship between principals and agents in business. Agency theory is concerned with resolving problems that can exist in agency relationships; that is, between principals (such as shareholders) and agents of the principals (for example, company executives). The two problems that agency theory addresses are: 1.) the problems that arise when the desires or goals of the principal and agent are in conflict, and the principal is unable to verify (because it difficult and/or expensive to do so) what the agent is actually doing; and 2.) the problems that arise when the principal and agent have different attitudes towards risk. Because of different risk tolerances, the principal and agent may each be inclined to take different actions. AT focuses on the relationship and goal incongruance between managers and stockholder. Agency relationships occur when one partner in a transaction (the principal) delegates authority to another (the agent) and the welfare of the principal is affected by the choices of the agent

Assumptions: Bounded rationality Opportunism Information asymmetry The delegation of decision-making authority from principal to agent is problematic in that; 1. The interests of principal and agent will diverge 2. The principal cannot perfectly and costlessly monitor the actions of the agent 3. The principal cannot perfectly and costlessly monitor and acquire the information available to or possesed by the agent

Problems: These constitute the agency problem - the possibility of opportunistic behaviour on the part of the agent that works against the welfare of the principal Agency costs; incur to protect principals interests and to reduce the possibility that agents will misbehave Monitoring expenditures by principals Bonding expenditures by agents Residual loss of the principal Essential sources of agency problems: Moral hazard; more of the agents actions are hidden from the principal or are costly to observe Adverse selection; the agent posseses information that is, for the principal unobservable or costly to obtain Risk aversion; as organisations grow managers become risk averse (They would like to protect their position, managers would like to Max. Chance of success by projects that have already brought success, Managers build structures to increase their chances of control)

Resolving agency problems Principals and agents resolve agency problems through;

 Monitoring; observing the behaviour and performance of agents Bonding; arrangements that penalise agents for acting in ways that violate the interests of principals or reward them for achieving principals goals Contracts between agents and principals specify the monitoring and bonding arrangements

Q7 What is the stewardship theory? What are the criticisms of the theory? Stewardship theory assumes that managers are stewards whose behaviors are aligned with the objectives of their principals. The theory argues and looks at a different form of motivation for managers drawn from organizational theory. Managers are viewed as loyal to the company and interested in achieving high performance. The dominant motive, which directs managers to accomplish their job, is their desire to perform excellently. Specifically, managers are conceived as being motivated by a need to achieve, to gain intrinsic satisfaction through successfully performing inherently challenging work, to exercise responsibility and authority, and thereby to gain recognition from peers and bosses. Therefore, there are non-financial motivators for managers. The theory also argues that an organization requires a structure that allows harmonization to be achieved most efficiently between managers and owners. In the context of firms leadership, this situation is attained more readily if the CEO is also the chairman of the board. This leadership structure will assist them to attain superior performance to the extent that the CEO exercises complete authority over the corporation and that their role is unambiguous and unchallenged. In this situation, power and authority are concentrated in a single person. Hence, the expectations about corporate leadership will be clearer and more consistent both for subordinate managers and for other members of the corporate board. Thus, there is no room for uncertainty as to who has authority or responsibility over a particular matter. The organization will enjoy the benefits of unity of direction and of strong command and control. Criticism: Stewardship theory is criticized for having too optimistic an idea of human nature, in assuming rational and legal behavior. That is, it does not reflect the interplay of power, conflict and ideology. Furthermore, a certain passive element may be attached to the involvement of the board: While the support of the management by the board can [in principle] make sense, the influence of the board on the inner-organizational elements is not foreseen, however, under the stewardship theory. From this passivity perspective, governance would rather play a supporting than a strategic role. Q8: Compare and contrast Agency theory and the Steward Theory in detail.

a) Behavioral differences between Agency and Steward theories: There are a number of behavioral differences between the agency theory and steward theory of corporate governance. The agency theory assumes that managers act as agents

of owners of the company, while under the stewardship theory they act as stewards. b) With regard to psychological mechanisms: the agency theory states that motivation revolves around lower order and extrinsic needs, while Stewardship theory says it revolves around higher order and intrinsic needs. c) With regard to situational mechanisms, the agency theory states that management philosophy is control oriented while in the stewardship theory it is involvement oriented. Q9 What is the difference between shareholders approach and stakeholders approach to corporate governance? Critically analyze both approaches.

The stakeholders in a firm are individuals and constituencies that contribute, either voluntarily or involuntarily, to its wealth-creating capacity and activities and who are therefore its potential beneficiaries and risk takers. Shareholders are stakeholders in a corporation, but stakeholders are not always shareholders. A shareholder owns part of a company through stock ownership, while a stakeholder is interested in the performance of a company for reasons other than just stock appreciation. Stakeholders could be:

employees who, without the company, would not have jobs bondholders who would like a solid performance from the company and, therefore, a reduced risk of default customers who may rely on the company to provide a particular good or service suppliers who may rely on the company to provide a consistent revenue stream

Although shareholders may be the largest stakeholders because shareholders are affected directly by a company's performance, it has become more commonplace for additional groups to be considered stakeholders, too.

Shareholder approach (interchangeable with stockholder): A shareholder is simply an individual, organization, or company that legally own share(s) of stock in a joint-stock company. By owning shares of stock, a companys shareholders collectively own the company itself and therefore have the right to vote on decisions that affect how the company is run. This usually means the shareholders as part owners will push for company actions that increase their own financial returns. Definition: A company that uses the shareholder approach to conducting business typically views the impact of business operations on profit. In addition, the length of concern for changes in

business operations is usually short-term; such as focusing on meeting quarterly or annual results. Attributes:

Shareholders are primarily concerned with the companys bottom line. In a traditional business models, shareholders have the primary influence on the companys strategy, usually resulting in business model with the foremost objective to increase the companys stock value. In a shareholder business model, a company only addresses the needs and concerns of four parties: investors, employees, suppliers, and customers; with investors and customers receiving the most attention.

Stakeholder approach: To make an analogy, stakeholder and shareholders are like sparkling white wine and champagne. All champagne is sparkling white wine, but not all sparkling white wine is champagne. Similarly, all shareholders are stakeholders, but not all stakeholders are shareholders. A stakeholder is anyone that can be affected by a companys actions, objectives, and policies. This includes both internal stakeholders, such as employees and managers, and external stakeholders, such as shareholders, suppliers, customers, surrounding communities, creditors, the government, to name a few. The terms common use came about only after R. Edward Freeman published his book Strategic Management: A Stakeholder Approach in 1984. Definition: A company that uses the stakeholder approach to conducting business typically views the impact of business operations on a wide range of issues; including, but not limited to: profit, reputation, employees, supplies, customers, shareholders, the environment, and the communities where the company conducts business. The length of concern for changes in business operations is usually short-term and long-term; such as understanding the need to meet business objectives on a quarterly or annual basis, but also appreciating the need to focus on the impact on the company beyond just an annual timeframe. Attributes:

Stakeholder-oriented companies are primarily concerned with a companys triple bottom line Whereas shareholders have a legal right to directly affect a companys policies and actions, the other groups incorporated stakeholders can influence a company indirectly as many stakeholders have no involvement with the company in any financial or legal way. o In other words, not all stakeholders are equal or entitled to the same considerations.

In a stakeholder business model, a company can address or be influenced by the needs and concerns all people, groups, and places affected by the company (including the same parties that shareholders affect investors, employees, suppliers, and customers).

As successful companies use sustainability and CSR more in frequently, stakeholder-oriented business models will also become more common.

Q10: Discuss the three broad versions of the corporate governance system given below: a) Anglo American model: the Anglo-American Model of Corporate Governance is a liberal model of governance in a body corporate. Adapted from and influenced by the systems of governance followed in the USA and the UK, this system of governance accords primary importance to shareholder interest and as a result, the role played by banking and financial institutions in the governance of an enterprise is drastically reduced. The shift from other models of governing a body corporate to the current worldwide trend of the Anglo-American Model began as a result of the constant increase in the demand and need for capital by a body corporate. A brief look at companies around the world would present a picture of a financial crisis at some point of time or the other. One such manifestation of the unhealthy financial situation would be the inability to repay the existing liability of banks and financial institutions. As a result, a restructuring of the loans was in order, and the financial institutions demanded drastic changes in the system of corporate governance of these companies. Being the chief and indispensable source of funds, body corporate was in effect forced to comply with the changes in the set-up of corporate governance. However, as capital requirements grew, companies turned elsewhere in an attempt to finance their operations, and the next logical option was equity financing, or in other words, selling shares of the company to raise capital. This added a third wheel to the system of corporate governance that prevailed in the body corporate, that of the shareholders- their rights and interests. These shareholders elected the members of the Board of Directors directly, and the Board in turn went on to elect the CEO, giving rise to a single- tiered system of electing the BOD of a company, and banks and financial institutions playing a bare minimum role. The protection of shareholder interest is the chief characteristic of the Anglo-American Model of Corporate governance and the fundamental principle behind its existence and global acceptance as the most favourable Model of governance in a body corporate. b) German model:

The German model governs German and Austrian corporations. Some elements of the model also apply in the Netherlands and Scandinavia. Furthermore, some corporations in France and Belgium have recently introduced some elements of the German model. EWMI/PFS Program / Lectures on Corporate Governance - Three Models of Corporate Governance December2005.doc 10 The German corporate governance model differs significantly from both the Anglo-US and the Japanese model, although some of its elements resemble the Japanese model. Banks hold long-term stakes in German corporations6, and, as in Japan, bank representatives are elected to German boards. However, this representation is constant, unlike the situation in Japan where bank representatives were elected to a corporate board only in times of financial distress. Germanys three largest universal banks (banks that provide a multiplicity of services) play a major role; in some parts of the country, public-sector banks are also key shareholders. There are three unique elements of the German model that distinguish it from the other models outlined in this article. Two of these elements pertain to board composition and one concerns shareholders rights: First, the German model prescribes two boards with separate members. German corporations have a two-tiered board structure consisting of a management board (composed entirely of insiders, that is, executives of the corporation) and a supervisory board (composed of labor/employee representatives and shareholder representatives). The two boards are completely distinct; no one may serve simultaneously on a corporations management board and supervisory board. Second, the size of the supervisory board is set by law and cannot be changed by shareholders. Third, in Germany and other countries following this model, voting right restrictions are legal; these limit a shareholder to voting a certain percentage of the corporations total share capital, regardless of share ownership position c)Japanese model: The Japanese model is characterized by a high level of stock ownership by affiliated banks and companies; a banking system characterized by strong, long-term links between bank and corporation; a legal, public policy and industrial policy framework designed to support and promote keiretsu (industrial groups linked by trading relationships as well as crossshareholdings of debt and equity); boards of directors composed almost solely of insiders; and a comparatively low (in some corporations, non-existent) level of input of outside shareholders, caused and exacerbated by complicated procedures for exercising shareholders votes. Equity financing is important for Japanese corporations. However, insiders and their affiliates are the major shareholders in most Japanese corporations. Consequently, they play a major role in individual corporations and in the system as a whole. Conversely, the interests of outside shareholders are marginal. The percentage of foreign ownership of Japanese stocks is small, but it may become an important factor in making the model more responsive to outside shareholders .

Q 11: Discuss the obligations that a corporation has to the following in detail: Society: A corporation is a creation of law as an association of persons forming part of the society in which it operates. Its activities are bound to impact the society as the societys values would have an impact on the corporation. 1: National interest 2: Political non-alignment 3: Legal compliances 4: Rule for law

Investors: A company ideally has the following obligations to investors: 1: towards shareholders 2: Measures promoting transparency and informed shareholder participation 3: Transparency: 4: Financial reporting and records Employees: By providing equal access and fair treatment to all employees on the basis of merit: 1:Fair employment 2:Equal opportunities employer 3:Encouraging whistle blowing Customers: A companys existence cannot be justified without its catering to the needs of the customers. Their obligations include: 1: Quality of products and services 2: Products at affordable prices 3: Unwavering commitment to customer satisfaction