Theoretical Framework

Learning Outcome

At the end of the lecture, students would be

able to:

Explain the various approaches/models

to good Corporate Governance;

Discuss the issues and solutions to the

separation of ownership and control;

Understand the pillars of CG; and

Describe the core concepts to sound CG

Theoretical Frameworks
1.
2.
3.
4.
5.
6.

Principal-Agent (Finance)Model
Shareholders / Anglo-American Model
Stakeholder/Pluralistic Model
Enlightened Shareholder Model
Myopic Market Model
Abuse of Executive Power Model

Principal-Agent Model
(contd)

Definition of Agency Relationship:

A contract under which one or more

persons (principals) engage another
person (agent) to perform some
service on their behalf, which involves
delegating some decision-making
authority to the agent (Jensen &
Meckling, 1976)
Sometimes called Contract for
Service

Principal-Agent Model
(contd)

Assumptions:

All individuals will act in their own self

interest, which leads to potential conflicts of
interest;
Agents are in a unique position to further
their own interests at the expense of the
principals;
Shareholders wealth maximisation = share
value maximisation.

Principal-Agent Model
(contd)

Theoretically
managers
work
for
shareholders (owners).
In reality shareholders are usually inactive,
firm actually seems to belong to
management.

Separation of Ownership &

Control

Most shareholders do not wish to take part in

firms business activities. They act like
investors not owners.
Investors tend to be inactive shareholders of
many firms.
These absentee owners provide funding to
public companies and delegate all aspects of
management of the companies from strategic
positioning to the daily business operations to
the executive management team.
Owners focus on business performance of firm
and investors focus on risk and return of stock
portfolios.

Why Would Managers Care

About Owners?

Managers/directors may act in their own

personal interest, if possible, even at the
expense of owners.

This situation is known as the principalagent problem or agency problem.

Solution to Principal-Agent
Issue
1. Incentives & monitoring
Incentive solution to tie wealth of executive

to wealth of shareholders so that

executives and shareholders have the
same objectives.
This is called aligning executive incentives
with shareholder desires.
Managers will then act and behave in a
way that is also best for the other
shareholders.
E.g. stock options or stocks or both as a
significant
component
of
their
compensation.

Solution to Principal-Agent
Issue
(Source: Kim, K. & Nofsinger, (2004). Corporate Governance. P6)

2.

Set up mechanisms for monitoring

behaviour of managers.

Stakeholders

Monitors

Controllers

Within Company

Stockholders
Creditors
Employees
Society

Board of Directors

Outside Company
Auditors
Analysts
Bankers
Credit Agencies
Attorneys

Government
SC/CCM/IRD
Bursa Malaysia

Managers

Stakeholders Model

Key Features

Top management also serves as an

agent to stakeholders;
Companies are accountable to a broad
range of stakeholders;
Promote
ethical
behaviour
in
organisational practices;
Criticises
shareholder
wealth
maximisation.

Stakeholders Model (contd)

Key Features (contd)

Ethical
principle
gives
competitive
advantage;
Build reputation;
Ethic behaviour minimises agency and
monitoring costs;
Employees interest should be protected;
Promote good relationship with suppliers.

Myopic Market Model

Key features:

Criticises Anglo-Saxon (American) model for

over emphasising on short term perspectives

Accounting practice is too concerned with

short term returns executive rewards

Share market misprices does not take

fundamentals into account

Fund managers dominate share market

performance evaluated on short term
basis/ short term forecast.
Shareholders wealth Share price
maximisation

Myopic Model (contd)

Reforms proposed:

Increase shareholder loyalty and voice

Reduce ease of shareholder exit
Restrict
voting rights for short term
investors
Restrictions on takeover process

Abuse of Executive Power

Model

Key Features:

Governance problems arose due to abuse of

power by top management;
Current CG mechanisms are not adequate to
curb power abuse;
BOD is too powerful and serves to promote
members interest only;
Criticises free market weakens ethical
constraints (governance problems)
Disagrees with pay performance model.

Abuse of Executive Power

Model (contd)

Reforms proposed:

Limit CEOs term (legislative/statutory

changes)
Independent nomination of non-executive
directors (NEDs)
Greater power for NEDs
Purpose : to weaken top management
entrenched position.

Conditions For Corporate

Governance
Source : Siebens, H.(Aug 2002). Concepts and Working Instruments for CG.
Journal for Business Ethics (Electronic Journal)

Stakeholders Value

Shareholders Value
Anglo American
Model

Regulation of
power and
competence

Enlightened
Shareholders Model

Pluralistic Model =
Stakeholders Model

Duality
Care

Responsible
business
Risk Management

Transparency & Accountability: tell

me, show me & involve me

Shareholder Value Approach

BOD should govern their company in the

best interest of the owners and
shareholders
Objectives of the company to maximise
the wealth of owners and equity
shareholders in the form of share price
growth and dividend payments.

Shareholder Value Approach

Aims of sound corporate governance not

only to meet objectives of shareholders
Also takes into account the interest of other
individual or groups with a stake in the
company.

Criticisms of Stakeholders
Value Approach
1. Firms contribution - it is harder to measure

the firms contribution to the welfare of

employees, suppliers or customers than to
measure its profitability.
2. Market Value - there is no market value of the
impact of past and current managerial
decisions on future welfare of stakeholders.
3. Efficiency & Effectiveness - with the
enlarged and restricted fiduciary duty concept,
it would be questionable whether effective
work can be done by management.

Pillars of CG

Legal & Regulatory Framework

Compliance and legal protection
Directors & Board of Directors
Board independence,
Composition and size; &
Role of CEO/Chairman
Board Committees
Audit, remuneration & nomination

Pillars of CG (contd)

Company Secretary & Whistle blower

Professional advise & independence
Auditors & Internal Control
Independent
assurance,
risk
management system
Shareholders & Stakeholders
Rights & activism
Institutional Shareholders
IS activism
Capital Structure
Debt vs. equity financing

Core Concepts of CG

Openness
Willingness to
provide
information
to
individuals and groups about the company
(without giving away commercially sensitive
information).
Honesty
Not lying, cheating or stealing, fair and
upright; not hiding ones real nature (oxford
dictionary).
In an age of spin and manipulation of facts,
honest information is by no means prevalent.
A sign of questionable honesty is some
measure of scepticism and disbelief.

Core Concepts of CG
(contd)

Transparency
Refers to ease with which an outsider is
able to make a meaningful analysis of a
company and its actions.
Refers
both to information about
financial position of company and
Non financial issues such as direction
the company is taking, strategic
objectives, etc.

Core Concepts of CG
(contd)

Independence
Defined as a person free from influence
from another individual or individuals and
free from conflicts of interest.
Refers to the extent which procedures
and structures are in place so as to
minimise (or avoid completely) potential
conflicts of interest that could arise.
Independence can also be undermined
by familiarity.

Core Concepts of CG
(contd)

Accountability
Requirement for a person in a position of
responsibility to justify, explain or account
for/answerable for his/her actions in the
course of his duties.
Responsibility
Having authority over something and liable
to be held accountable for the exercise of
his/her authority.

Core Concepts of CG
(contd)

Fairness

Impartial or un-bias and things done with a

sense of justice.
All shareholders should receive equal
consideration.

Reputation

Reflects the overall way in which the company is

perceived by the market and in the wider
community.
Influenced by code of ethics, corporate social
responsibility, fair treatment of staff, attitudes to
customers,
community
involvement
and
willingness to obey the spirit as well as the letter
of the law.

Core Concepts of CG
(contd)

Corporate Social Responsibility

Refers to business decision making
linked to ethical values, compliance with
legal requirements and respect for
people,
communities
and
the
environment (www.bsr.org)
Viewed as a comprehensive set of
policies, practices and programmes that
are integrated throughout business
operations,
and
decision
making
processes that are supported and
rewarded by top management.

Role of Exit & Voice in CG

Relates to shareholders power in monitoring

the actions/performance of the BOD.
Exit
shareholders not satisfied with companys
affairs have the right to sell shares of the
company.
inability to voice due to strong influence by
a certain individual on BOD.
Voice
Shareholders have the power to approve or
reject corporate transactions either through
shareholders activism with assistance of
the Minority Shareholders Group.

Factors Influencing CG
System

Insider
Countries : Germany,
Japan & Asian
countries
Firms owned by
insider shareholders
Little separation of
ownership & control
Rare hostile takeover
activities
Weak investor
protection in law

Outsider
Countries: UK, USA
Firms controlled by
managers but owned
by outside
shareholders
Prevalent separation
of ownership & control
Frequent hostile
takeover activities
Strong investor
protection in law

Factors Influencing CG
System (contd)

Insider
Potential abuse of
power

Majority shareholder
tend to have more
voice

Ownership
concentrated in
small
group
shareholders

a
of

Outsider
Potential for
shareholder
democracy
Shareholding
characterised more by
exit than voice
Dispersed ownership

Factors Influencing CG
System (contd)

Insider
Excessive control by
insider shareholder
Wealth transfer from
minority to majority
shareholders

Outsider
Moderate control by
large
range
of
shareholders
No transfer of wealth
from
minority
to
majority shareholders

Questions
1. What key elements show good governance?
2. Explain

one of the theoretical models

describing corporate governance.
3. What are the essential pillars that forms the
corporate governance framework?
4. What should shareholders do when they are
not happy about the governance of a
corporation?