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    5 i Corporate Governance: The Basics Agency theory, human. behavior theory, market failure theory suggest that an organization must have control mechanisms thet help mitigate agency costs and improve firm's efficiency. Control mechanisms are necessary to reduce divergence of managers’ interests from shareholders’ interests. A control has a wider meaning. In a narrow sense, it is understood as ‘dominance’ by one on another, from the management point of view, it is understood as the internal organizational control such as planning, organizing, directing, and monitoring. In the organizational point of view, control is taken broadly as the total structures and processes associated with the efficient utilization of resources. From this perspective, control variables are internal as well as external. An organization is composed of owners, managers, employees, banks, suppliers, market, customers, government, tax authorities, media, communities, and the greater socicty. All of them affect, influence, control, and contribute to the success or failure of an enterprise: Corporate governance is probably “the widest control mechanism used for efficient utilization of corporate resources. It can be defined as an organizational control device, which is a hybrid of internal and external control mechanisms with a view to achieving efficient utilization of corporate resources. It is a _Retwork among ‘various corporate players such as shareholders, " taandgers,” employees, “lenders, government, suppliers, and consumers for increasing the value of the firm. Keasey and Wright (1993)'s definition of corporate governance appears to be similar to the above, where it is concemed with structures and processes associated with production, decision-making, and control within an orgenization. They rightly consider accountability as a sub-set 108 incentives Contro! and Development of corporate governance, which involves monitoring, evaluation, and control of organizational agents to ensure that they behave in the interests of shareholders and other stakeholders. However, in practice, corporate ‘goyernance and monitoring mechanisms recently focused on matters like the composition of the Board of Directors, the duties and responsibilities of the executive and non- executive directors, regular monitoring by shareholders, anti takeover devices, voting rights of shareholders, and detailed disclosure of company information that are material for decision making by interested parties. Board composition is concerned with board size, separation of Chairman's and CEO's responsibilities, jead director, proportion of inside and outside directors, and independence of outside directors. Shareholders consist of individual shareholders and institutional shareholders. They monitor the activities. of management through direct negotiations wit management, ee eee ee Gs Bee monitor through bond indenture, nominating directors, and advising in investment decisions. ‘Won-executive or outside directors through their expertise and independence, attend board meetings, enquire about the major financial decisions, executive remuneration, and audit related issues. The use of audit committee encourages auditor independence and performance by making collusion of managers and auditor(s) more difficult. Regulation of financial reporting by government and private accounting bodies can facilitate inter-firm comparisons. Managers design internal contro] system, plan production and investment decisions, organize, direct, coordinate, and monitor people, report to shareholders, face scrutiny, and correct inefficiencies. And finally, market, government, and customers place competitive environment for disciplining the managers. This chapter, however, would consider only a part of corporate governance such as the'role of institutional shareholders, Corporate Governance: The Basics 109 lenders, and non-executive directors. This would include various institutional shareholders’ bodies and their mechanisms of monitoring, previous studies on shareholders’ roles, market-based corporate governance, strengths and limitations of non-executive directors, and the role of capital structure, particularly the debt capital. This chapter will identify the unique features of corporate governance in Europe and developing countries. Finally, it will critically evaluate the human aspect of corporate governance code around the world. 5.1. Third generation corporate governance First generation corporate governance refers to the beginning of corporate governance as a subject in the carly 1990s. Corporate governance emerged as a separate subject apart from management. Previously management or the organization (insiders) used to control and govern: the business. With the increase in agency relation and agency problems in the corporate sector management could not be relied on. There came external partics like management, This first generation Corpo! governance includes , directors, and the role institutional. shareholders. THE first generaijon could not deliver the desiredresult, Management influenced the appointment of nonexecutives and could manage to get with their old friends (old boy network). Therefore came the need for independent _nonexecutives. Again shareholders were dormant. Thus the corporate sector felt the need for a second generation corporate governance. This refers to some improved version of corporate governance like independent nonexecutiyes ~ and eable institutional shareholders. Second generation too ‘was concemed mainly for the interest of the shareholders x stakeholders, T) third “generation corporaie governance came inte plage wich refers to broader version Itke OO competitive enviri various stakeholders including 110 Incentives Control and Development emy sand the community. This_asked for more financial ss ead whe commun employees, say on executive pay, Sharehalders— 5.2. Corporate board “A corporate board consists of 5 t members di ding on size. Until 1970s boards were composed of internal management key executives” such as ion, finance, marketing and human resource, From carly 1980s, in the developed” countries like UK, USA boards are dominated by external member: independent nonexecutive directors. They danyers, financial and economic experts and other learied persons of the society. The external members are independent of management and owners and have no financial and economic interest in the companies. There has been another change in the board over the past. In the past, CEO was the hea oth the management and the organization. From early 1980s, CEO is the head of management and the chairman is the head of ofganization. That is, there has been split of duties between the CE the Chairman. CEO is the key executive of the organization and chairman is an outsider to the organization and an independent nonexecutive. Chairman and CEO are like the president and prime minister respectively in a parliamentary democracy. Chairman and other nonexccutive directors are mainly ornamental and honorable persons, and the relation between the executives and . Honexecutives is a matter of coo; eration, understanding and respect rather than conflict, suspicion and hierarchy. Thternai “Wembers have co: iny-specific_ knowledge and externals have corporate board usual iis two times in_a month. External members get a fee (TK5000_in Bangladesh for a meeting). Agendas are strategic ‘issues like financing new investment, : —_—_——".” © Basics +. Corporate Governance: Th and efficient use of corporate resources, ‘Nonexecutives assist the negotiation between the interested peice and mediate on occasions. They represent some wien m erests and may put the point of view of public interest. a are expected to consider the repercussions of the proposals or decisions of the interested parties. A corporate board now typically consists of key executives such as CEO, directors of finance, production, marketing and human resource, and nonexccutives executive remuneration, from academia, judisiary and civil society. 5.3. Market-based corporate governance The evidence suggests that US corporations have pursued shareholder-friendly policies in the 1990s. Management's acceptance of shareholders’ perspective was greatly aided by lucrative stock option plans, which allowed executives to reap big financial benefits from increased share prices. The move towards shareholder and market preeminence is also apparent in the. way corporations have recognized themselves. There has been a broad. trend towards decentralization. Large companies are trying hard to become more nimble and to find ways to offer employees higher- powered incentives. At the same time extemal capital markets have-taken on a larger share of the reallocation of capital. The large volume of mergers is evidence in point. Venture capital funding companies also have increased by an order of magnitude over the 1990s. As managers have ceded authority to the markets, the scope and independence of their decision-making has narrowed i.e., increased influence of markets on cozporate decision- making. Markets could be more effective than managers when it comes to moving capital from declining industries to emerging industries, The act of migrating between businesses may exacerbate intemal conflicts. Employees know that their firm- Specific knowledge is likely to become less valuable once the firm changes course and starts pursuing new lines of business. If 112 Incentives Control and Development decisions of where to cut and where to expand jobs were left to a democratic body of. workers, the heterogeneity in employee preferences would make the process of change slow and costly. When shareholders determine in which direction a company should go, the decision can be made swiftly without favoring any particular group of workers. Jensen (1986) takes the view that the 1980s takeovers were ultimately caused by a failure in the internal governance mechanisms of US corporations. One of the big drawbacks of the corporation was that it could and did subsidize poorly performing divisions using the cash generated from successful ones, instead of returning the free cash flow to the investors. There are evidences of failure of intemal control systems; management failures, board's inefficiency, -lack’ of auditor” independence. The internal contro] systems react too late to major changes. On the other hand, changes motivated by the capital market are sometimes accomplished quickly. Competition can_yeduce agency and {rove. orporate control by moving managers and owners closer to. profit Taxtmization. More competitors. mean more opportunities. for. benchmarking or other types of comparison, which can lead to sharper incentives. Protecting the rights of investors (property tights) is very important for attracting new skilis, finance, and styles of corporate governance. Access to business services, especially those that reduce economy wide transaction costs, such as telecommunications and transportation are necessary for growth in business and corporate governance. - Simplifying tax ‘code, simpler tax and other administrative rules provide less opportunity for arbitrery bureaucratic interference. One important task for competition agencies is to prevent other executive bodies at the state and local Jevels from maintaining or creating new barriers by restricting the flow of goods and investments between countries, regions, or eyen local levels. Obstructing the entry of new domestic or foreign enterprises, or granting privileges to favored Corporate Governance: The Basics 113 existing enterprises mean lack of competition, higher costs and inefficiency. National legal protections have a profound influence on the willingness to invest resources in firms and are a central institution of corporate governance. In the developing countries, families are the dominant owners of corporations. Family owned businesses could use their influence to limit competition to obtain favorable finan“ government. Thus crony capitalism (close ties betwe: interests and government) can be a strong deterren ' investors, particularly in a country, which : macroeconomic shocks. Lack of investor protection enforcement, and transparency are also held respo: growth in business and industry, outside investors, 1: governance. There appears to be a positive relati good corporate governance including market co: performance. Table shows that the countries with high. :. competitiveness and good governance tend to perform better is terms of human development, GDP per capita and industrial value added. Table 5.1. Market and competitive environment, corporate governance. and performance. Value added per employee in manufacturing industrics at current prices ($000, 1995-1997).. Valués are in order of minimum, average, and maximum. Tndustrieiized — Basten Developing Countries European , Countries countries : Market, competitiveness and corporate governance Property rights” 5.2, 6.2, 6.8 2.6, 3,9,5.3 3.3, 4.664 Rule of lav” 3.9, 6.1, 6.8 2.6, 3.9, 5.2 1.9,4,65 Intellectual property 5,5.8,6.4 2.5,3.7,5 2.6, 3,9, 5.9 tights? : oe corapetition 1,12,24 28, 43,579, 38,58" Growth competition 114.30, 23,42, 39 2,39, 59 114 Incentives Control and Development + ranks: * Anti -director rights* 145 2 2355 formance tr . . 90, 92,93 66, .68, .77 .25, 63, 88 GDP per capita? 16, 22, 33 1,6, 14 -5, 5,25 Value added" Food products 36, 50, 110 6,8,9 2, 15, 64 Textile 29,40, 58 2,3.5 2, 13, 42 Wearing apparels 19, 26, 49 2,3,5 1, 12, 34 Leather 26, 45,93 3,3,5 2, 14,46 Footwear 20, 38, 53 23,5 41, 15,33 ‘Wood 26,50,68 3,5.7 1, 16, 48 Furniture 23, 48, 68 3,4,6 2, 13,44 + Paper , 41,70, 130 2,7, 13 2, 18, 70 Priming & publishing 45,60, 109 6, 8,12 1,24, 72 Industrial chemicals 62, 160, 251 5, 8,17 2,38, 158 Other chemicals 50, 100, 264 9, 11,15 * 3,28, 104 Rubber 44,55, 100 2, 8,13 3, 19, 60 Plastic products 47, 58,70 4,8,10 3, 17,51 Iron & steel 53,75, 161 3,8, 11 4,34, 119 Metal products 33, 50, 78 4,6,9 2,.19,53 Blectrical machinery 46,70, 113 2. 4,9 1,24, 84 ‘Transport equipment 50, 65, 109 4,8, 13 2, 33, 86 “Human Development Report, United Nation, 2000 "hve Gtobal Competitiveness Report. Oxford University Press, 2000 ‘La Porta el al (1908) and Pister et al (2000) “Compiled from the United Nations, Industrial Statistics, 2000 5.4. Changing environment and the evolution of corporate governance structure " Governance regimes are combination of specific organizational forms, including markets, corporate hierarchies, associations, and network that coordinate economic activity among organizations in an industry or economic sector (Campbell and Lindberg 1990). Scot (1995: 23) gives three pillars of institutions: institutions as coghitiye; normative, and regulative structures that provide stability and aneaning to social behavior. Organizational practices that. meet minimum constraints are regulatory requirements. But Corporate Governance: practices and structures do not spread ‘simply because they are legitimate but because organizational decision makers regard them as acceptable solutions to the particular problems they face. Matching problems with solutions is problematic because solutions are too abundant, so there arises the need to know and select the best practices, Takeovers were the most dramatic force in USA for bringing about CManges in corporate governance practices in the 1980s; response to that were golden parachutes. Ownership structure also has changed from individuals’ ee the institutional shareholders. In declding SESE TpRaSNGe Te TOS in firms look to what other firms have done through either direct contact or observation. They maintain corporate elite networks composed of the ties formed through’ shared board members. Executive remuneration, changes in corporate. structure, susceptibility to takeovers, the propensity to acquire, and the likelihood ‘of adopting a poison pill are influenced by interlock network. There are evidences of members of board who sat on 40 other corporations (Davis and Greve 1997). - 1 ake Control is also associated with 'problems'. ‘We devote more joney and energy where there are problems. Again, ina sotiety, the nature of problems Changey i or timé to time an erefore we are facing the of gontrol mechanisms, feel Tear, istribution and we have differemt set ‘or the recent environmem probh > WE i he increasing need for-government:. regulation. With the increasing complexities in organizationa settings, we design sophisticated accounting and control systems: In the ¢ recent time, economists are increasingly debating for equity in distribution; 116 Incentives Control and Development politicians for increased government regulation, and business community for good corporate governance. 5.5. Regulation: an averaging process Regulation is _a mechanical process whereas governance is knowledge and wisdom. Regulation is structured and objective but Seermance is ideas, unstructured “and jective. and subjective. Regulation is an averaging process whereas novernance ig qualitative and widely diversed. Governance is an “Suiiscint process and many of TS dees are ot easily understandable by ordinary people. Therefore, a compromise among diverse ideas is necessary for consumption of the ordinary peopic. This is done through regulations. These regulations are easily understandable -and acceptable by the majority people. Therefore regulations are less risky and face less criticism and resistance. Thus regulations are necessary for uniform behavior of majority members in a society. However, regulations are quantitative and cannot. always capture the qualitative aspects of a phenomenon. These are fixed und binding and therefore do not allow flexibilities and freedom. ‘Thus regulations can restrict growth of knowledge and creativity. Fer example, there are debates as to the number of nonexecutives in a corporate board. Some say 1, some 2 and some for the majority, BSEC favors 1/5" tq 2/3", Bangladesh Bank for sninimum 2, and Bangladesh Enterprise Institute for majority. But the theory is not interested in the number rather it is interested in tiveness of this governance mechanism, Again, regulation defines independence of nonexecutives as free’ from financial st and independent of management. But these two ideas are de thet can be applied in varied ways. BSEC has a check list orate governance to be followed in the corporate sector. It cee ©) board of directors, (ii) appointment of CFO, Head of ernal audit committee, and company seoretary, (iii) audit > Corporate Governance: The Basics 117 ~~ committee, (iv) statutory auditors, (v) subsidiary company, (vi) duties of CEO and CFO, and (vii) reporting and compliance of corporate governance. Regulations are the end result of theories. But theorics are not the areas of ordinary people. Majority people like prescriptions or policies (regulations) in clear terms. Therefore, preseription:: « policies are produced from theories. Regulations are short-cut versions of theories. “ Theories are broader but regulations are specifi governance fegulations in Bangladesh only pres independent nonexecutives.in the corporate sector but wy argue for nonexccutives in all sectors including public °> < even in the ministries (Chowdhury 2004, 2015). Each mini UK has four nonexccutives. Therefore regulations shor! broader and have space for accommodating further. Worki+ Profit Participation Act 1969-is applicable for companies only : garments industry emerging in 1990 although fulfills all other conditions of the regulation do not qualify for profit so. tel) Co crit simply because they are not companies. As a result, the theory, th essence and the idea behind employee profit sharing could not sce its total use. 5.6. Measures of corporate governance There are ways to give figures to measure corporate governance although these are imperfect Board of directors’ composition is a ‘ong measure of corporate governance. Higher the percentage of directors, the better is the strength of governance, Further the existence of independent audit, compensation, nomination, and governance committees increase the value of governance. CEO membership on nomination and or compensation committee undermines governance. Similarly combining the roles of tue CP ~{od chairman in one person sels sasinst He check and betansy in the board. Existence 0: ‘independent directors as well as financial 118 Incentives Control and Development experts in the audit c ittee is consi a strength for i i is higher if they governance. Independence of outside directors is have no personal, family, and business relationship with the company. Chowdhury (2003) documented evidence of [ptevious executive directors of a company turning non-executives after retirement in the same company in UK. He called them dependent nonexecutive directors.\Frequency of board meetings and audit “committee can be good for corporate governance. Age of directors is also relevant for governance. Age below 70 is sometimes considered good for governance. Existence of peer review or some form of evaluations Tor the performance of the board gives value 1 to govemance, otherwise 0. Director share ownership is another criterion for good governance. This can be measured by taking the jumber of shares held by directors by the total number of shares outstanding of the firm. Also, number of share options given to them as a percentage of the total shares outstanding can motivate managers to take increased risk. Executive compensation in the form of bonus, shares, and share options as a percentage of total compensation enhances Jong-termism as against short-termism. Similarly _employee share ownership and share option bring Betorigingness. and thus help pot comperuis govemence Hom: _ kuditservice provided by The auditor is considered good for governance. This variable takes the value 1 if the auditor does not provide any of the non-audit services and O otherwise. Similarly ratio of audit fees to the non-audit fees paid to the auditor in a given year—can be considered as a signal for auditors’ independence and is good for governance. Dey (2008) through fier Malate found het the alas “oF the above measures of corporate governance is high in high agency conflict group and low’ in low agency conflict group. She concluded that firms with higher levels of agency conflicts have more efficient governance UCT ; One result inconsistent with stan cory though, is ‘<, the percentage of stock and option compensation of executives nce: The Basics i}g Corporate Governa! conflicts. She however, did not that is negatively related to agency 7 give sufficient explanations for this result. i i orate governance creditors’ orientation and corp g 5.7. Europe, / The two-tier structured board of directors is common in Germany as opposed to the widespread one-tier board model in corporations and large limited liquidity companies. It means that there is a agement board which actually rums-the firms and a pervisory board with outside directors (nonexecutives) onl 0 members), which appoints the management and has the task of monitoring it. Ten members of the supervisory boards are elected, by the employees or appointed by the trade unions (co- determination of employees) and another ten members are by the shareholders. In, firms with more than 500 employees, one-third “qnembers and in companies with more than 2000 employees half of the members are elected by the employees. In China there must be at least 3 members in a supervisory board. Supervisory board hires and supervises executive directors and CEO, It must approve major business decisions. The supervisors may attend the meetings of the executive or management board as nonvoting delegates. Ownership in European companies is highly concentrated. In about 85% of 171 industrial companies in Germany. during 1990 there was at least one Shareholder owning more than 25% of the voting shares. Institutional sharcholders account for 15% and families 20%, Furthermore, the companies Particularly, the top ones are linked to cach other by capital and personal interlocks. The role of institutional shareholders is much less important compared to USA and UK. Europe has a small public stock market. In 1993 only 664 eyed tes listed out of a total 3000, Similarly Italy has only con nea 74 the Netherlands 239 arid Belgium 165 listed pais ee rance has the highest number of listed companies in . Pe, In terms of contribution to GDP, the market capitalization in 120 Incentives Contro] and Development Furopean stock markets ranges from 1% to 40% of GDP (Table 7.3). Creditors ‘particularly banks play an important role in corporate governance in Europe. Bauns (2001) studiéd vote castings in 24 largest stock corporations in Germany and observe that banks cast more than 84% of the votes present in annual general meetings. Protection of outside shareholders is less veloped. Corporate laws i rather than sharehoid, ‘The laws do not require quarterly reports to Shareholders, disclosure of board membership, and executive salary and bonuses. Corporate governance in Europe is a mixture of economic, political and cultural factors. Separation of mariagement and the supervisory board dates back to the nineteenth century. German tax laws favor debt finance of firms more than equity finance. German households invest their finds only to a small extent in stock. Tax regulations channel retirement provisions predominantly into other forms of investment. The main pillar of pension payments, the public social security system, does not build up’ capital ‘stock rather pension commitments of. employers to the employees are financed by building up reserves within the company. Recently however, the two-tier board and creditors oriented corporate governance in Europe are under pressure. Globalization . around the world and the international nature of capital markets are creating increasing pressures for changes for shareholders orientation, and disclosure of accounting policies. Also, ageing population, increasing unemployment led to the need for reform in pension system particularly tying it to national and international capital markets. There are also evidences of failures of supervisory boards, and discussions are underway for making these boards * ig Tore transparent and responsible. In France however, there is a i choice between the single board and the two-tier board, Regarding e codetermination however, it appears to be mainly a political issue Corporate Governance: The Basics 121 sto infri i trade and no politician is daring to infringe on it as employees and tra unions consider it as one of their ‘social assets’. 5.8. Developing countries, family control and corporate governance . Large shareholders in developing countries are predominantly families and majority of the companies are family managed and controlled. The Owner-director or manager is invariably

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