CORPORATE GOVERNANCE

Chapter 1 — Meaning, Theories and Models

Exam-Focused Notes | All Test Questions Covered

Q1. What do you mean by Corporate Governance? Distinguish between Governance and
Good Governance.

Meaning of Corporate Governance

The term 'Governance' is derived from the Latin word Gubernare meaning 'to steer'. In the context of
companies, governance means direction and control of a company.
Corporate governance is "the system by which companies are directed and controlled." — Sir Adrian
Cadbury (1995)
It is also defined as "the system of laws, rules and factors that control operations of a company."
Corporate governance is an umbrella term covering aspects related to: board of directors, executive and
non-executive directors, top management, regulators, auditors and other stakeholders.

Governance vs. Good Corporate Governance

Good corporate governance is based on the following pillars:
• Fair Dealings: Ethical behaviour in all decisions; follows conscience codes of conduct in letter and spirit.
• Transparency: Accurate, adequate and timely disclosure of information to all stakeholders.
• Accountability: Ensuring management is accountable to the board and owners.
• Responsibility: Encouraging cooperation between the company and stakeholders for economic
sustainability.

Q2. Define Corporate Governance. Differentiate between corporate governance and

corporate excellence.

Corporate Governance vs. Corporate Excellence

Corporate governance provides a system and structure for management to pursue corporate goals. Corporate
excellence means efficient and effective achievement of corporate objectives while conforming to law and
ethics.

Corporate Governance Corporate Excellence

Framework for direction and control Efficient achievement of business goals

Focus: Structure, accountability, transparency Focus: Performance, productivity, results

Means to achieve excellence End result of good governance

Commitment to moral values Long-lasting customer relationships

Responsible exercise of power High employee morale, fair returns to investors

Key Point: Good corporate governance leads to corporate excellence. In the long run no company can achieve
excellence without good governance. The two concepts are complementary to each other.
Q3. Explain the benefits of good corporate governance.

Benefits of Good Corporate Governance

• 1. Access to Capital Market: Globalisation and increase in institutional investors have enhanced the role
of intermediaries. Investors now have a wider choice. Good corporate governance helps companies
maximize shareholder value and gain easy access to capital.
• 2. Acquisition and Retention of Talent: Well-governed companies attract hard-working, ambitious, and
competent employees. Edge in attracting, retaining and engaging well-qualified employees.
• 3. Risk Cover: Companies are now exposed to greater risks due to deregulation, growing competition and
structural reforms. Good corporate governance helps reduce risks of fraud, corruption and mismanagement.
It helps increase revenue and profitability.
• 4. Public Image: Good governance improves its goodwill and builds brand image. Infosys, Wipro, TCS and
other well governed companies enjoy international prestige. Positive image provides stability and growth.
• 5. Market Position: Good corporate governance creates customer loyalty, improves strategic thinking and
utilisation of resources, which leads to better operational performance and has a positive impact on market
valuation.
• 6. Innovations: The company must be creative in offering better quality products and services. Companies
discover new opportunities for business through their initiatives in the social sector.
• 7. Wide Range of Constituencies: A good corporate governance regime ensures efficient use of
corporate capital, considers interests of a wide range of constituencies including communities within which
they operate.

Q4. Discuss the basic principles of corporate governance.

Principles of Corporate Governance (Section 1.5)

• Fair Dealings: Ethical behaviour and actions are fundamental. Good corporate governance adopts
unethical and unfair practices (e.g., labour exploitation, debt servicing victimization) are avoided. Rights of all
stakeholders must be recognised and respected in a balanced manner.
• Transparency of Operations: Transparency means accurate, adequate and timely disclosure. A company
must make disclosures of its policies, operations and performance. This is mandatory under rules and
regulations.
• Accountability to Stakeholders: A well governed company respects the rights of its stakeholders.
Minimum financial reporting is not enough — value reporting (sharing information beyond mandatory
disclosures) is necessary. The company is accountable not only to shareholders but to other stakeholders
too.
• Responsibility: Recognising shared responsibility between the company and shareholders. The Board
must encourage stakeholder cooperation. Actions must conform to economic sustainability and social
obligations.
These four principles are represented as the Four Pillars of Corporate Governance: Accountability, Fairness,
Transparency, Responsibility.

Q5. Explain various theories of corporate governance.

1. Agency Theory
Exists agency relationship between shareholders (principal) and management (agent). The board of directors is
expected to exercise authority on behalf of shareholders. In reality, board may promote their own interests.
Conflict of goals is called the 'agency problem'.
• Managers are inspired by self-interest and take undue advantage at cost of shareholders.
• Governance mechanisms needed to restrict self-serving behaviour.
 • Efficient capital and labour markets can check self-serving behaviour.
• Effective board consists of majority of independent directors.
• Criticism: Overstresses wealth maximisation; overlooks other stakeholders. In India and developing
countries, promoter group is dominant shareholder — agency problem is between majority and minority
owners.

2. Stewardship Theory
Top managers of a company will act diligently as responsible stewards of company assets. They work on their
own to achieve high levels of profits which yield good returns to shareholders. The interests of shareholders are
automatically served when the company's performance is maximised.
• Managers are good stewards, not mere agents of shareholders.
• Managers are guided by the motive of earning personal reputation in the stock market.
• Chief executives should be given authority rather than monitoring and control.
• Adding, financial reporting are main mechanisms to regulate managerial behaviour.
• Assumptions: Contrary to agency theory — the stewardship theory is based on the idea of trustee
relationship. The agency theory is based on the separation of ownership and control whereas stewardship
theory is based on the assumption that board of directors will always work for corporate performance.

3. Stakeholders Theory
A company must be run in the interests of ALL the stakeholders. The interests of stakeholders are numerous
and may sometimes be contradictory. A harmony or compromise is required between them.
• Theory suggests that a company exists not just to maximise shareholders' wealth but to maximise the value
of the company.
• Stakeholders' theory adopts a broader approach — the board of directors consisting of representatives of
various stakeholder groups could be entrusted with this task.
• Criticism: This theory is criticized on the ground that it does not consider the interests and rights of other
stakeholders. It presents a narrow view of corporate governance.

4. Resource Dependency Theory

Focuses on the role of board directors in providing access to resources needed by the firm. Directors play an
important role in providing or securing essential resources to an organisation through their linkages to the
external environment.
• The provision of resources enhances organisational functioning, firm's performance and its survival.
• Directors can be classified into four categories: insiders, business experts, support specialists and
community influentials.
• Power is relational, situational, potentially mutual — organisations may be reliant on each other.
• The resource-based view of the firm is concerned with the management of a firm's internal resources and
capabilities, which may satisfy external stakeholders of the firm.
• Criticism: If directors attempt to serve too many principals they will fail to satisfy those who have genuine
claim on the organisation.

5. Managerial Hegemony Theory

Describes the board as a de jure, but not de facto controlling body. The real responsibility of running and
controlling the company is assumed by corporate management. Management is self-serving (e.g., gaining
increasing control) and boards are passive.
• Board plays a supportive role at best, or at worst, a strategic or stakeholder engagement role; it is to certify
management decisions.
• Critics point to lack of empirical evidence and a general lack of research in comparison to other governance
theories.
 • The agency problem is about effective delegation: 'Indeed, it is not immediately apparent what the limits to
his empowerment were.'

Q6. Describe the Anglo-Saxon model of corporate governance, pointing out its salient
features.

Anglo-Saxon Model (The Outsider Model)

Prevalent in the USA, UK, Australia, Canada, India (to a large extent). Also known as the Outsider Model. It is
market-oriented and characterized by:
• A well-developed Stock Market with considerable depth and liquidity.
• The ownership structure of companies is widely dispersed. For example, the median size of the largest
voting block is 5% in USA and 10% in UK.
• Strict laws concerning inside trading and disclosure of information. A sound stock market provides
safeguards to maximize shareholders' value.
• Unitary or Single Tier Board of Directors — both executive and non-executive directors are elected by
shareholders with voting rights in proportion to their shareholding.
• The board of directors consists inside and outside directors. Inside directors are either employed in the
company or have significant relationship with the company (called executive directors). Outside or
independent directors are neither employed in the company nor are related to the promoters.
• Little role of trade unions — they do not participate in strategic decisions of the company.
• Key Players: Shareholders, directors and management. The ultimate authority lies with the board of
shareholders. The company's power is distributed between these players.

Q7. Explain the German model of corporate governance, highlighting its strengths and
weaknesses.

German Model (The Insider Model)

Prevalent in Germany, Japan, Switzerland, Australia, Netherlands. Also known as the Continental Europe
Model. Main features:
• Weak Stock Market: Debt is the major source of finance due to restrictions on listing of companies.
Universal banks supply both loans and equity capital.
• Concentrated and Cross Shareholdings: In most German companies there are large controlling block
holders of shares. A single owner holds more than 50% of the equity in more than half of the listed
companies.
• Dual Class Shares: One class of shares has more voting rights than the other class. Bank may exercise
veto power.
• Dual Board or Two Tier Board: All public limited companies (AG) and private limited companies (GmbH)
have an executive board (vorstand) and a supervisory board (Aufsichtsrat). The supervisory board consists
of full time managers appointed by the executive board. Strategic planning, day-to-day management and
performance review are the main functions of the executive board. The supervisory board elects and
approves the decisions of the executive board.
• Low Legal Protection: In German model, reliance is more on large investors and banks than on legal
regulations.
• Employee Participation: In German companies, employees elect one third to one half (depending on the
total member of employees) of the directors on the supervisory board. Banks control the disciplinary
mechanism.

Strengths of German Model

• Concentrated capital market, little legal protection for investors but bank finance two tier board structure.
 • Long-range strategic planning is possible. It provides institutional representation and allows decisions for
employees.
• Reduces institutional pressures for short term decisions and allows long range strategic planning.

Weaknesses of German Model

• Overlooks the interests of small shareholders. Not suitable for global capital market as it is too secretive.
• This model reduces mismanagement. But this model overlooks the interests of small shareholders.

Q8. Discuss the Japanese model of corporate governance, stating its characteristics.

Japanese Model
The Japanese corporate governance model is characterized by the following features:
• Small Dominant Groups (Keiretsu): There is a small number of dominant groups (e.g., Mitsubishi and
Mitsui) that are diversified shareholdings and trading relationships. Most of these groups are linked by
cross-shareholdings and vertically integrated by cross-holdings.
• Consortium Financing: Banks and other financial institutions are the main source of funds for Japanese
companies. They provide both debt and equity capital. Banks hold majority of shares on a long term basis
and build strong relationship with the client company.
• Government-Industry Linkage: The industrial groups employ retired civil servants and work together on
government sponsored committees. Retired Government officers are appointed as directors to seek
preferential treatment from the government. The bureaucrats also ensure effective implementation of
government policies.
• Employee Participation: Long serving and committed employees are offered membership on the board of
directors. Senior managers and former employees account for 90 per cent of the company's board of
directors.
• Unitary Board Structure: Boards of major corporations represent the company as an integrated social
unit. The entire board takes all major decisions functioning as by tradition surrendered most of its authority to
the president of the company. The president along with an operating committee of top executives select new
members of the board of directors and evaluate the company's performance.
• High Degree of Autonomy: Banks and financial institutions do not exercise any direct control over a
company so long as the company is run successfully. However, the main bank intervenes by exercising
ownership and market share in case of poor performance.

Q9. Describe the features of the family-based model of corporate governance.

Family-Based Model
Family based model of corporate governance exists in several underdeveloped and emerging countries of Asia
(Korea, Malaysia, Indonesia), Middle East, Brazil, Mexico, Chile, Turkey, Egypt, Kuwait, Saudi Arabia, UAE, etc.
• Closely Held Companies: In most of the listed companies, the promoter's family is a dominant
shareholder accounting for more than 50% of the issued share capital. The founder, his relatives and
associates dominate. Family owns the company for long term and ownership is inherited by succeeding
generations.
• Family Control: The family exercises full control due to ownership, controlling family members on the
board of directors, and outside shareholders have equity but do not exercise much control. Their nominees
are appointed to the board to meet the regulatory requirement.
• Unitary Board of Directors: There is a single board of directors. The board is staffed with family members,
friends and business associates. Outsiders (independent directors) are appointed to meet the regulatory
requirement.
• Family Interest: The company is run primarily for the benefit of the family. Owners extract private gain by
transfer of wealth through sale of assets at lower than market prices. Funds are sometimes diverted for
family's interest. In some cases there have been conflicts of interest between the controlling family and
 minority shareholders.
• Tensions: Within the controlling family may hamper the functioning and creating wealth for the family. But
the model appropriates the minority interest. The family exercises effective control. It is driven by long term
interest of family based model.

Q10. Distinguish between outsider model and insider model of corporate governance.

Basis Insider Model Outsider Model

Share ownership Concentrated Dispersed

Voting power High Concentration Low level of takeover

Main shareholders Families, banks & other companies Institutional investors

Corporate control market Private Public

Composition of Board of Large number of directors pointed by

Presence of outside directors
Directors the main block holder

Control on management High Low

Controlling family vs. minority

Agency conflict Shareholders vs. Management
shareholders

Q11. Give a comparative study of various models of corporate governance.

The four major models — Anglo-Saxon, German, Japanese, and Family-based — differ on key parameters:

Basis Anglo-Saxon German Japanese Family-based

Less developed,
Well-developed, Developed,
Shareholding Informally Weak influence
Dispersed Concentrated
concentrated

Size and influ. of

High influence Medium influence Medium to low Low influence
capital market

Two tier Board Unitary Board, High

Structure and Unitary Board, High Unitary Board, Board
based medium degree of cultural
control of Board degree of control a rubber stamp
influence influence

Involvement of
Low Weak-strong High Low
banks

Influence of
High and
financial Coordinated Coordinated Low
institutionalised
institutions

Employee
Low High High Low
participation

Accountability to
Low-High High High Low
community
 Shareholders Vs. Bank Vs. Bank Vs. Controlling family Vs.
Agency conflict
Management Management Management minority shareholders

Q12. Differentiate between: (a) Agency Theory and Stewardship Theory, (b) Stewardship
Theory and Stakeholder Theory, (c) Resource Dependency Theory and Managerial
Hegemony Theory

(a) Agency Theory vs. Stewardship Theory

Agency Theory Stewardship Theory

Managers are self-interested agents Managers are good stewards of company assets

Managers work diligently to maximise company

Conflict of interest between owners and managers performance

Requires monitoring and control mechanisms Requires empowerment and trust

Based on separation of ownership and control Based on trustee relationship

Board should be independent majority Board should empower chief executives

Focus: agency problem resolution Focus: long-term value creation

(b) Stewardship Theory vs. Stakeholder Theory

Stewardship Theory Stakeholder Theory

Focuses on all stakeholders — employees,

Focuses on managers as stewards of shareholders customers, creditors, community, etc.

Primary goal: maximize shareholder wealth Primary goal: maximize value for all stakeholders

Managers are trustworthy and guided by personal Company has obligations towards all sections of
reputation society

Harmony and compromise between competing

Empowerment of management is key stakeholder interests

Board should include representatives of various

Board empowers executives to act autonomously stakeholder groups

(c) Resource Dependency Theory vs. Managerial Hegemony Theory

Resource Dependency Theory Managerial Hegemony Theory

Board directors provide access to critical external Board is a de jure body; real control lies with
resources management

Focuses on the board's role in reducing uncertainty Focuses on the dominance of management over the
and dependence board

Directors bring legitimacy, information, skills and Board merely certifies management decisions;
resources passive role
Power flows from resource access Power flows from management's technical expertise

Effective governance structure is difficult due to

Board accountability is to resource providers management power

Q13. Define 'Corporate Governance' and describe its scope. Discuss the benefits of good
corporate governance.

Corporate governance is a multi-faceted concept. It helps to ensure that the corporation achieves efficiency and
creates value for all. Corporate excellence is impossible without good corporate governance. Good corporate
governance is an essential foundation for long-term success.
Scope of Corporate Governance: Covers relationship between management, board of directors, shareholders
and other stakeholders. It also provides the structure through which company objectives are set, and the means
of attaining and monitoring performance.
For benefits, refer to Question 3 above (Access to Capital Market, Acquisition and Retention of Talent, Risk
Cover, Public Image, Market Position, Innovations, Wide Range of Constituencies).

Q14. Distinguish between Agency Theory and Steward Theory.

Refer to Question 12(a) for a detailed comparison table between Agency Theory and Stewardship Theory.

Key Summary: In Agency Theory, managers are viewed as self-interested agents who need to be monitored
and controlled to act in the best interests of shareholders. The Stewardship Theory takes a more optimistic view
— managers are good stewards who are motivated by higher order needs and will work diligently to maximize
organizational performance. The fundamental difference lies in the assumed nature of the manager:
opportunistic agent (Agency Theory) vs. trustworthy steward (Stewardship Theory).

Corporate Governance — Chapter 1 | Notes based on textbook content | All 14 test questions covered