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Business Ethics

Corporate Governance:
An Overview
What is a Corporation?
“The business corporation is an instrument through
which capital is assembled for the activities of
producing and distributing goods and services and
making investments. Accordingly, a basic premise of
corporation law is that a business corporation should
have as its objective the conduct of such activities with
a view to enhancing the corporation’s profit and the
gains of the corporation’s owners, that is, the
shareholders.” Melvin Aaron Eisenberg
What is a Corporation?
“When they [the individuals composing a corporation] are
consolidated and united into a corporation, they and their
successors are then considered as one person in law . . . For all
the individual members that have existed from the foundation to
the present time, or that shall ever hereafter exist, are but one
person in law – a person that never dies: in like manner as the
river Thames is still the same river, though the parts which
composite are changing every instant.” Blackstone

“An ingenious device for obtaining individual profit without individual

responsibility.” Ambrose Bierce, The Devil’s Dictionary
Corporate Form
1. limited liability for investors;
2. free transferability of investor interests;
3. legal personality (entity-attributable
powers, life span, and purpose); and
4. centralized management.
Corporate Governance Definitions
• OECD – “internal means by which a corporations are
operated and controlled … which involve a set of
relationships between a company’s management, its board,
its shareholders and other stakeholders.”

• IFC Corporate Governance Manual

– Corporate Governance is a system of relationships, defined by
structures and process. [Shareholders – Management]
– These relationships may involve parties with different and
sometimes contrasting interests.
– All parties are involved in the direction and control of the
– All this is done to properly distribute rights and responsibilities –
and thus increase long term shareholder value.
• “Corporate governance deals with the ways in which
suppliers of finance to corporations assure themselves of
getting a return on their investment”, The Journal of
Finance, Shleifer and Vishny [1997, page 737].
• "Corporate governance is about promoting corporate
fairness, transparency and accountability" J. Wolfensohn,
president of the Word bank, as quoted by an article in
Financial Times, June 21, 1999.
• “The directors of companies, being managers of other
people's money than their own, it cannot well be expected
that they should watch over it with the same anxious
vigilance with which the partners in a private co-partnery
frequently watch over their own.” Adam Smith, The Wealth
of Nations 1776
Corporate Governance System
Basics of Corporate Governance
• By issuing corporate securities, firms sell claims to control the
companies` resources
– The interests of the various security holders differ
– Separation of ownership and control implies agency relationships.
– Interests of agents (management) are different from those of security
holders, particularly from those of stockholders.
– Monitoring the activities of agents is costly - hence, full monitoring is not
– The value forgone due to imperfect optimal monitoring is an explicit
agency cost.
Fiduciary Duty
• The fiduciary duty is a legal relationship between two or more parties (most
commonly a "fiduciary" or "trustee" and a "principal" or "beneficiary") that in
English common law is arguably the most important concept within the
portion of the legal system known as equity.

• A fiduciary will be liable to account if it is proved that the profit, benefit, or

gain was acquired by one of three means:
– In circumstances of conflict of duty and interest
– In circumstances of conflict of duty and duty
– By taking advantage of the fiduciary position.

• Therefore, it is said the fiduciary has a duty not to be in a situation where

personal interests and fiduciary duty conflict, a duty not to be in a situation
where their fiduciary duty conflicts with another fiduciary duty, and not to
profit from their fiduciary position without express knowledge and consent. A
fiduciary cannot have a conflict of interest.
Four core values of the OECD corporate
governance framework
• Fairness: The corporate governance framework should protect
shareholder rights and ensure the equitable treatment of all
shareholders, including minority and foreign shareholders.
• Responsibility: The corporate governance framework should
recognize the rights of stakeholders as established by law, and
encourage active co-operation between corporations and
stakeholders in creating wealth, jobs, and the sustainability of
financially sound enterprises.
• Transparency: The corporate governance framework should
ensure that timely and accurate disclosure is made on all
material matters regarding the company, including its financial
situation, performance, ownership, and governance structure.
• Accountability: The corporate governance framework should
ensure the strategic guidance of the company, the effective
monitoring of management by the board, and the board’s
accountability to the company and shareholders.
Business Case for Corporate
• Well governed companies have lower cost of
• Well governed companies have lower risks
• Higher valuation of companies that are well
IFC Business Case
Advantages of Good Corporate
• Stimulating Performance and Improving Operational Efficiency
– Better oversight and accountability
– Improved decision making
– Better compliance and less conflict
– Less self-dealing
– Better informed
– Avoidance of costly litigation through adherence to laws and regulations

• Improving Access to Capital Markets

– Transparency, accessibility, efficiency, timeliness, completeness, and
accuracy of information critical
– Listing requirements
– Inclusion of Corporate Governance in investment decision process
Recent Corporate Failures
• Enron Corporation
• Worldcom
• Parmalat
• GlobalCrossing
• Aledphia
• Satyam

More recent failure related to risk in the market

• Fannie Mae & Freddie Mac
• BearSterns
• Meryl Lynch
• Lehman Brothers
What went wrong in the recent past?

• Environment
– Loss of moral fiber of corporations
– Business environment characterized by need to compete with the new
• Boards
– Fundamental weaknesses in business models sought to be compensated by
adoption of aggressive accounting practices
– Ignored ethics and value systems when a much hyped business strategy failed
to deliver as expected and articulated to Wall Street
– Incompetence of board members and overriding of audit committees
• Managements
– Stock option heavy compensation structures
– Bonus linked to short-term revenue growth, EPS and stock price
– An inability to accept failure
– Excessive focus on beating the street

What went wrong in the recent past ?

• Auditors
– Aggressive interpretation of accounting standards
– Independence compromised to obtain lucrative consulting assignments
• Employees
– Compensation linked to stock-price movement
– Large disparity between the highest and lowest paid employees
– Culture of greed promoted within the organization by management
– Manipulative accounting practices
• Analysts
– Ever-greening of reports with an eye on investment banking assignments
– Pressurized managements to beat quarterly estimates
• Investors
– Short term focus of investors


Regulatory reactions
– The Companies Act, 2013
– Clause 49 of listing agreement in India
• Corporate reactions
– Focus on fundamentals of business models
– Focus on strengthening internal controls and information systems
– Stock options
– Enhanced disclosures in MD&A and Annual Reports
– Guidance
– Focus on critical accounting policies
• Aggressive journalism
– Accounting/Governance was the main story for months
• Glorification of the whistleblower
– Time Magazine’s Person of the Year

Key Themes of Current Reforms
• Board structure with large independent directors
• Independent directors and audit committees have enlarged responsibilities
• Stricter independence standards for audit committees
• Enhanced role of the whistle blower
• Board effectiveness and integrity targeted by regulators, politicians and
the media
• Compensation structures are under attack
• New level of discipline brought to SEC reporting and under Clause 49
– CEO/CFO certifications
– Improvement in processes as effectiveness of internal controls need to be
– Improved processes and controls have connected the board to the day to day
functioning of the company
• Real time disclosure and shortened deadlines
• Auditor independence
• Repeal of self regulation for the auditing profession
• Analyzing the analysts

Corporate Governance and Capital Markets

• Investment is an act of faith

• Poor governance
– Undermines integrity of corporations and discourages the use of public
markets as a means to intermediate savings
– Particularly the areas of transparency and disclosure have been a major factor
behind instability in the financial markets across the globe
• Good corporate governance
– Essential pre-requisite for the integrity and credibility of capital market players
– Contributes to the development of a vibrant economy and robust capital
• Recent events have repeatedly proven the importance of corporate
governance standards, including the collapse of large global corporations

What is the Current Status on Corporate Governance Practices?

• Insistence on forms and structures

• Overarching regulations and regulatory overkill
• Inadequate number of strong independent directors
• Large liabilities for corporations and officers
• Has the pendulum swung too far?
• For the first time in the decade-long history of the Index of Economic
Freedom, the United States is no longer among the Top 10 “Most Free
– Wall Street Journal and the Heritage Foundation “Index of Economic
– India is not even in the list of Top 10

What is the Current Status on Corporate Governance Practices?

Greater emphasis on leadership

by example

Boards are returning to basic

value systems
• Each culture should look back to
its roots for value systems
• India’s centuries old principles of
“Dharma” Strengthening
the moral fiber
of the
Value systems are helping corporation
build corporate governance
framework for companies

Boards are redefining value

• Not merely increase in stock

Strengthening capital markets through corporate governance

• Improving the tone at the top

• Code of ethics - Not an annual exercise….talk about and demonstrate the
company's ethical standards again and again
• Get colleagues, business heads to speak about core values
• Make ethics part of the company’s DNA
• When someone does commit an ethical violation, a company should move
to fix the problem and remedy the harm as quickly as possible.
– It also has to take appropriate action against the offending employee - swiftly
and firmly, even if the offending employee is a star performer
• Hold all of your managers accountable for setting the right tone.
– That means disciplining or even firing them when they have failed to create a
culture of compliance
• CXOs themselves have to comply with the letter and the spirit of the rules

Strengthening capital markets through corporate governance

• Make character a part of the set of key hiring criteria

• Make integrity, ethics and compliance part of the promotion,
compensation and evaluation processes as well
• Listen to employees… including the bad news
• Deliver the message of integrity, honesty and truthfulness to
those with whom you do business
• Make it clear that you won't tolerate compliance risks - even if
that means losing a lucrative piece of business or a client or a

Anglo-Saxon Model
• US, UK, Canada, Australia, New Zealand
• Shareholder value maximization
• “outsider” model – arms length investor
• Internal governance mechanisms
– board of directors
– employee compensation
• External mechanisms
– market for corporate control
– monitoring by financial institutions
– competition in product and input market
• Reliance on legal mechanisms to protect shareholder rights
• Short term financial performance key
German (Continental) Model
• Co-determination - partnership between capital and labor
• Social cooperation
• The two-tier board structure that consists of a supervisory board
and executive board – greater efficiency in separation of
supervision and management
• Cross–shareholding in financial – industrial groups
• Role of banks as major shareholders
• Primary sources of capital – retained earnings and loans
Japanese Model
• Formal role of large and almost entirely executive boards – single tier
• Historical roots of the Keiretsu network interlocking business
• Existence of significant cross holdings and interlocking-directorships,
• Lifetime employment system plays in corporate policy
• Role of banks
• Market share maximization over shareholder value maximization
• Long term perspective
Corporate Governance Framework in
• Concentrated Ownership
• The observation that there is little separation
between ownership and control
• Holding structures and reorganizations used to
deny free exercise of ownership rights
• Inexperienced Directors
• Government Intervention
Market for Corporate Control
• “Friendly Takeover”
– When a bidder makes an offer for another, it will usually inform the
board of the target beforehand. If the board feels that the value
that the shareholders will get will be greatest by accepting the
offer, it will recommend the offer be accepted by the shareholders.
• A takeover would be considered "hostile" if
1) the board rejects the offer, but the bidder continues to pursue it, or
2) if the bidder makes the offer without informing the board
Theory (Agency Problem)
• Berle and Means (1932) – separation of
ownership and control through modern
corporation structures
• Agency Problem
• Agency costs – monitoring and compliance
More Theory
• Conventional Wisdom (Manne 1971) :
• The business literature describing the classical functions of
boards of directors typically includes three important roles:
(1) establishing basic objectives, corporate strategies, and
board policies: (2) asking discerning questions; and (3)
selecting the president.
Some Early Research (Manne 1971)

• First classical role

– Found that boards of directors of most large and medium-sized
companies do not establish objectives, strategies, and policies
however defined
– These roles are performed by company management
– Presidents and outside directors generally agreed that only
management can and should have these responsibilities.
• A second classical role assigned to boards of directors is that of asking
discerning questions - inside and outside the board meetings. Again it was
found that directors do not, in fact, do this. Board meetings are not
regarded as proper forums for discussions arising out of questions asked
by board members.
• A third classical role usually regarded as a responsibility of the board of
directors is the selection of the president. Yet it was found that in most
companies directors do not in fact select the president, except in the two
crisis situations cited earlier.
Research that confirms Stewardship Theory

• Theoretical Challenges to Agency Theory

– Stewardship theory, the alternative perspective, takes an
altogether broader frame of reference, being based on the
original and legal view of the corporation in which
directors have a fiduciary duty to their shareholders to be
stewards for their interests.
• Muth and Donaldson (1997) challenged agency theory, which underpin
conventional assumptions about the benefits of checks and balances –
– Boards with well connected, executive directors perform better than those
that meet the paradigms of conventional governance thinking

• Also research has shown that increasing governance conformance and

compliance may not add to corporate performance - it can actually
detract - Donaldson and Davies (1994)
Types of Directors
Executive directors can be defined as those that also
hold an executive position in the company.
Non-executive directors are Supervisory Board
members that do not hold an executive position in
the company.
The Effective Board
• Clear strategy aligned to capabilities
• Vigorous implementation of strategy
• Key performance drivers monitored
• Effective risk management
• Sharp focus on views of the capital market and
other key stakeholders
• Regular evaluation of board performance
What does the market look for in a board
• Asks the difficult questions
• Works well with others
• Has industry awareness
• Provides valuable input
• Is available when needed
• Is alert and inquisitive
• Has business knowledge
• Contributes to committee work
• Attends meetings
• Speaks out appropriately at board meetings
• Prepares for meetings
• Makes long-range planning contribution
• Provides overall contribution
Implementing effective strategy and change
• The blueprint for the strategy
• The business case
• The transformation program
• A mobilized organization
• A ‘transformation map’
The audit committee’s main responsibilities

• To monitor the integrity of the financial statements

• To review the company’s internal financial controls, internal
control and risk management systems.
• To monitor/review the effectiveness of the internal audit
• To make recommendations to the board on the
appointment/removal of the external auditor
• To monitor/review the external auditor’s
independence/objectivity and the effectiveness of the audit
• To develop/implement policy on the engagement of the
external auditor to supply non-audit services
• To review arrangements by which staff may raise concerns
about possible improprieties (‘whistleblowing’)
Flotation – who ends up steering the boat?