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Free Corporate Governance Mechanisms Essay Sample
Mallin (2010) wrote that the corporate governance is a term referring largely to the guidelines, processes and policies that impact on the running, regulation and controlling of the businesses. The major determinant of the good corporate governance is accountability of people in the governance. The mechanisms that reduce the principle-agent problem are also important. The officers and constitution define the internal factors which guide the corporate governance. Other external factors like consumer groups and government regulations also play a significant role in guiding the corporate governance. It is mainly concerned with the relationship between the different stakeholders in a company.
The stakeholders include the company’s board of directors, share holders, employees and gatekeepers. The company gatekeepers are the third party professional persons who monitor the internal performances. Corporate governance also highlights the structure of setting the company’s objectives giving guidelines of how to reach them (Mallin, 2010), and gives the ways of monitoring performance while ensuring a balance between economic and social goals. It ensures satisfaction of individual, corporate and societal interests.
Parties to Corporate Governance
These are the most influential entities who get involved in the corporate governance. They include the governance agencies, authorities, stock exchanges and management. Others who have indirect influences may include suppliers, employees, creditors and the larger community.
Ownership Elements and Structures
This defines the kinds of shareholders that a corporation has. Mallin (2004)asserts that the observable measures of the concentration of the ownership and the level of the internal ownership measure the structures. Some structures include corporate groups like pyramids, cross-shareholders, rings and webs. The engagements with the firm shareholders and other firm stakeholders may differ from the different ownership structures.
Family ownership: In most jurisdictions of the corporate governance, family interests dominate the ownership structures. In this case, such corporations are normally subject to a superior oversight in comparison to the others.
Institutional ownership: This is a corporate governance structure where an institution controls the market entity with pooled funds from the intended beneficiaries. Such may include the pension funds, annual funds and other financial institutions like banks. They generally form the institutional investments.
Corporate Governance Gatekeepers
The gatekeepers of the corporate governance include the external entities that keep watching on the inside management of the firm, the third party intermediates to the company composed of the auditors, the investment banks, the security analysts and lawyers (Mallin, 2004). They have a role in serving the board, investors and other stakeholders, by verifying and certifying the corporate disclosures such as firm financial statements, then issue reliable advice. The areas to consider in the corporate governance are;
Company structure: This includes the structure of the board that has a serious influence on the management and control of the firm. The board establishes the objectives, policies and selects the executives who carry out the specified objectives and policies.
Financial structure: This is the proportion between the debt and the equity which has an influence on the corporate governance of a company.
Institutional environment: This encompasses political, legal and regulatory environment which determines the nature and quality of the corporate governance.
Failure of the Corporate Governance
Failure in the corporate governance is mainly attributed to poor designation of reward packages, excessive share options by shareholders in the wealth creation, application of short term share price performance stock options in management and failure to deliver the targeted earnings from trading.
The worldwide financial crisis was attributed to the poor corporate governance that hit all the economic sectors in the world recently highlighting inadequacies of the corporate governance mechanisms (Solomon, 2007). They align the interests of the directors with those of the shareholders. For the economic sectors to avoid such cases there is a greater need to address the inadequacies to improve the functionality of the mechanisms. The recent years have seen high profile scandals in the corporate governance sector involving the abuse of power and other criminal activities by the corporate officers. Factors that guide the actions of the corporations include the corporate governance, internal leadership and policies. The factors played a major role in stimulating the recent financial crisis. The corporate governance mechanisms are trained towards lessening the inefficacies arising from the management moral hazards and adverse selections. A perfect example is the attesting of the accuracy of the managerial statements provided to the investors. According to Mallin (2004), the idealistic value is seen in the mechanism’s ability to control both the motivation and ability.
Internal Controls
Internal controls take corrective measures to achieve the organizational goals after checking the activities. Board of directors have the legal authority to monitor activities of the firm. They take action by hiring, firing and compensating the management which helps in the safeguarding the capital invested in the firm. Identification, discussion and avoidance of the potential problems can be done through having regular board meetings. Constant monitoring of the firm executives makes it easier for the shareholders to access the firm’s information that help in making decisions and evaluates the management based of the quality of decisions that guides the company into the financial performance.
Internally, the control procedures are implemented by a single entity board of directors. Others may be audit committees which give the reasonable assurance of the entity hence achieving the objectives of reliability on the proper financial reporting, efficiency in operations and laws and the regulation compliance.
Balance of power in governance structure is another control measure that demands that a firm’s president should not be the same entity’s treasurer. This is mostly in companies where each individual’s actions are under the check and scrutiny by the separate entities. Remuneration should be performance based in relation to its proportion. This could take any form like cash, shares or other benefits.
External Corporate Governance Controls
These are basically the power of control that the firm’s external stakeholders have over the management. They include competition which boosts the internal firm input for the greater market share, debt covenants which regulate the investment patterns, performance information, demand and assessment, government policy and regulations, the labor market, pressure from the media which controls the firm management actions and the fear for takeovers that motivates the managers to be more creative in the firm.
The external financial reporting is the primary responsibility of the board of directors which must have the highest degree of reliability on a firm’s chief executive officer and the chief financial officer. They must have a sense of integrity in a provision of the accurate financial information as the heads and overseers of all internal financial systems. They should remain dependent on the professional services of the competent accountants and internal auditors.
Corporate Governance Systematic Problems
The first problem emanates from the demand of information which is a threat from the shareholders and other stakeholders forming a voting group who can be threaten to carry resolutions or appoint fresh directors during the general meetings of the firm. Another problem arises from the monitoring costs which are used to bar shareholders. The costs of processing good information for the investors are met through the efficiency of the market hypotheses. Finally, to monitor the firm’s directors, the investors need the financial information and imperfections may cause ineffectiveness eventually hurting the corporate governance. This can however, be corrected by the external auditing processes.
Corporate Governance Theories
Theories dictate companies to recognize the fact that they have the official, contractual, social and market driven compulsions to their non shareholder stakeholders. The non shareholder stakeholders include creditors, customers, investors, suppliers and policy makers (Mallin, 2010). Under the governance theories, the board needs the enough pertinent skills and understanding to review and challenge the management performance. The board has to have the ample size, right sovereignty and commitment level to fulfil its errands and duties. Integrity should be a fundamental factor for choosing the corporate officers and members of the board. There is an established code of conduct for the directors and the overall executive. This promotes the responsible decision making processes.
In summary, the theories of corporate governance embrace the transparency and disclosure. These should be seen in the roles and responsibilities of the management and the board, to give the stakeholders a sense of accountability in the business organization. To verify and safeguard the company’s financial reporting, the management should implement the proper procedures in a more transparent way, disclosing the material matters that concern the organization in time and a well balanced manner. According to Mallin (2010), this ensures that all the investors have a clear access to the facts and information.
The Agency Theory
This is a theory that highlights the relationship between the resource holders. Whenever an individual (principal) hires another individual (agent) in order to perform a service, followed by decision making and delegation authority to the agent, there is a relationship that develops. In essence, the theory views a firm as a nexus of contracts (Mallin, 2010). The major relationships are between the stockholders and the managers, debt holders and stockholders. Harmony is not the term to use while defining the relationships, but rather conflicts that arise between the associations of the stakeholders. The various conflicts bring about issues like business ethics and corporate governance; agency costs are expenses used to sustain this relationship and includes bonuses to motivate the managers to act in the shareholder interests.
Relationships between managers and shareholders: The agency theory is sourced from the problems and conflicts in organizations arising from the self interest behaviour. Personal goals and ambitions that are parallel to the goals and objectives of the company, which is to maximize the shareholder wealth, is usually the main source of conflicts between the managers and shareholders (Mallin, 2010: Mallin, 2004).
Self-interest manners: Managers will always seek to capitalize on their own efficacy at the expense of the shareholders in an imperfect labour and capital market. On the other hand, agents have the capability to work in their self interest at the expense of the interests of the firm, because of the information asymmetry and uncertainty. Managers illustrate this kind of behaviour when they make the private use of corporate resources in the form of privileges, and the avoidance of the optimal risk positions. Risk fearing managers evade profitable opportunities which the firm shareholders would prefer to invest in. The external investors understand that the firm will make decisions contrary to their best interests, while the investors discount prices they are willing to pay for the firm’s securities.
Potentially, an agency conflict risk may arise just because the firm’s manager owns less than 10% of the firm’s common stock (Mallin, 2010). Consequently, the shareholder’s wealth maximization could be secondary to a range of other managerial goals. For the fear of unfriendly takeovers in firms, a manager may wish to maximize the size of the firm through creation of large, rapidly growing departments and increase of executive status, creation of more opportunities where lower and middle level managers get in and with increased salaries. This enhances their job securities.
On the other hand, serving management may want to follow variations at the expense of shareholders who could vary their individual assortments by buying shares in other companies. Managers may be encouraged to work in stockholders’ interests through getting the incentives, constraints and punishments. These methods only apply where shareholders observe the managers’ actions. Therefore, it is important for stockholders to incur agency costs in order to reduce and eliminate the moral hazard problems.
Shareholder-management conflict costs; these are the costs that the shareholders bear to encourage and entice the managers to maximize shareholder wealth instead of their own interests. They fall into three groups (1) costs spent on monitoring management activities, (2) the expenses on structuring the organization in a way limiting the undesirable behaviour and (3) opportunity costs incurred in the shareholder imposed restrictions. This is necessary as shareholders may lose wealth if management behaviour alteration is not monitored. The excessive agency costs may also be incurred in case the shareholders began ensuring close monitoring of all the managerial actions to conform to shareholder interests. Therefore, cost-benefit context must be put in mind in the agency cost determination.
Mechanisms for dealing with the conflicts; shareholder-manager agency conflicts has two ways through which they can be dealt with. In a way, the managers get compensation on the basis of changes in stock price. Because managers get great incentives to maximize the shareholder wealth, the agency costs are pushed low. Under such contract terms, the economic events not under the management control and affect the firm earnings, making it difficult to contract talented managers.
The other side has stockholders monitoring all the managerial action. The disadvantage with this is that it is expensive and unproductive. The two seems to be solutions but are also the extremes. The ultimate and the most optimal solution is in the middle of the two. The executive compensation remains tied to the performance with a degree of monitoring. Other than that, managers do act in shareholders’ interests by getting the performance based incentives and the shareholders direct intervention. Managers also get motivated by facing threats of getting fired and the threat of taking over.
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Stockholders and creditors conflict; in this conflict, creditors have the main say on the part of the firm’s earnings in form of interest and principal imbursements on the liabilities, and on the firm’s assets in the event of insolvency. A conflict arises because the stockholders have the overall control over the management decisions. These are the pronouncements touching on the organization’s flow of cash and hence the risks of the firm. The creditors consider the firm assets when lending money to the firm to ascertain the amount risk it is taking to cover in the firm’s assets and capital constitution of debit and impartial financing, and other anticipations regarding the modifications in their risk levels. At the same time, shareholders induce the firm management to take on the new projects with the greater risks, against the anticipation of the creditors. This raises the rate of return on the firm’s debit, hence causing the outstanding bond value to fall. In case of a success in the risky ventures, the stakeholders get the benefits because the returns of the bondholders are fixed at the original low risk rate. In case of a fail, the loss is shared among the bondholders.
Another conflict may arise when shareholders fail to finance the profitable projects. This is mostly in the firms’ undergoing financial distress. They fear the actions may profit bondholders much more than shareholders, which simply secures the creditors’ claims. This conflict has the adverse effects in the market and the firm, for example, a situation where a firm’s total value declines in a way not proportional to its stock value price arises from such conflicts. In this case, the firm’s outstanding debt declines more than the increase in the firm’s common stock. Bondholders protect themselves from the stockholder’s attempts to seize wealth from creditors through the creation of restrictive agreements about future crediting.
Creditors, on the other hand may refuse to continue funding if they feel that managers are taking advantage of them. They can also apply a charge an interest above the market price rate to compensate for the expropriation risks. This means that businesses dealing with lenders in an unfair style either loses access to debit markets or face high interest rates and very restraining agreements. In either case, they are injurious to the investors. Such are the constraints applied to the management actions aimed at usurping wealth from other firm stakeholders.
Transaction cost economics theory
Transaction costs may refer to the expenses in making an economic exchange or simply the cost of engaging in a market (Solomon, 2007). It is an economic prediction of economic tasks by firms and their performance on the market. Some of the terms common in this area are; search and information costs which refer to the expenses in determining the availability of the required goods on the market at the lowest price, bargaining cost which is the amount required to reach an acceptable price with the other transaction party, leading to a contract drawing, and policy and enforcement costs which are the expenses used to ensure that the other party sticks to the agreement.
The firm using this theory is the main governance structure. In this theory, markets and firms form organizations which control and coordinate the economic transactions. The firm grows when the internal transaction costs are higher than the external transaction costs (Solomon, 2007). Transaction costs have determinants such as frequency, specificity, uncertainty, limited rationality and opportunistic behaviour.
Stakeholder Theory
This theory considers a larger perspective of the constituents. It is an organizational management and business ethics theory that looks into the morals and values in managing a firm. It mainly identifies and models a group which is the stakeholders of a firm. It describes and recommends methods through which the management can give due regard to the stakeholder group. It highlights who and what is really important in a firm. The theory recognizes the shareholders as the owners of the firm, which has a binding to put their interest first. The theory also recognizes other parties in the corporate governance including government bodies, trade unions and associations, communities and other associated corporations, employees and the prospective customers. This theory is co-operational and integrates resource based and market based view with a socio-political view of the corporate governance.
Stewardship Theory
It is an assumptive theory that says that if managers are left on their own, it will act in their positions responsibly. It takes them as stewards of the assets they control in the firm. It is the opposite of the agency theory.
Class Hegemony Theory
In this case, the managers have the complete dominance of the firm as they believe that they are an elite group on the firm hierarchy. The managers promote others based on their abilities to fit into the new elite group. This can be equated to the imperialism in management.
Managerial Hegemony theory
The fact that firm managers have day to day experience running and leading the company makes them effectively dominant in their respective areas of prowess. This tends to make them isolated and hence make them feel superior and elite. This may considerably bring about the poor work relationships and may end up weakening their influence in the firm (Mallin, 2010). Principles and codes of the corporate governance have been developed from the stock exchanges, corporations, investors and associations of the directors and managers. Compliance is not a mandate, but the stock exchange listing the requirement codes has effect on the corporate governance.
Need for Corporate Governance Codes
Mallin (2004) indicates that the corporate governance necessitates effective and prudent management which can deliver the long term success of the company. The codes enhance the quality on engagement between investors and companies. This helps to improve the long term returns beneficial to shareholders and the efficient exercise of the governance responsibilities.
There are several sections in which principles of the corporate governance codes fall in (Mallin, 2004). The first section is leadership where the effectiveness of the board comes in mind. The board of directors in any firm is responsible for making decisions for a long term success of the company. It is important to have a clear outline of responsibilities between the running of the board and the executive responsibilities of the firm. The code denies the single individuals from wielding the excessive power over the firm. The roles and their effective administration by the board are conferred on the hands of the chairman. Non executive directors also have a role in the firm leadership through the constructive challenging and assisting to develop strategic proposals of the firm’s board.
The second aspect of the codes is effectiveness. Solomon (2007) writes that the appropriateness in balance of skills, experience, independence and knowledge of the firm by the board and committees comes under scrutiny. This enables the proper discharge of their duties and responsibilities. The effectiveness is also reflected in the recruitment and appointment processes. Appointment procedures for new directors should be based on formality, rigorousness and transparency. Orientation for new managers who should dedicate an adequate time for the company for an effective discharge of their responsibilities is necessary. Timely supply of the quality and appropriate information discharge to the managers for the effectiveness is also necessary. To further boost the effectiveness, formal and rigorous yearly evaluation of the performance of committees and the directors is necessary at the regular intervals. It is also necessary for the firm to have regular elections, which would be a subject to the continuous satisfactory performance.
Mallin (2010) argues that managers should be accountable by presenting a balanced and comprehensible assessment giving the firm’s financial position and future prospects. The determination of the nature of risks that the firm undertakes is at the disposal of the board of directors, which lays down the strategic objectives and ways of achieving them. There is need for a maintained sound risk management and the internal control systems in the firm. There should be a formal and transparent arrangement for application of the corporate reporting and risk management principles, which will help maintain the favourable relationship with the auditors.
According to Solomon (2007), another important aspect of the codes of the corporate governance is remuneration. In order to attract and retain the firm managers and directors to work towards the success of the company, sufficiency should define the kind of remuneration they get from the main shareholders. It is also necessary to avoid overpaying just for this particular rationale. Corporate and individual performance should be the main aspects to attract a significant share of the reward, with the formal and transparent procedures for developing the policies used. The policies should give no manager a chance to decide the amount of remuneration to receive.
Conclusion
Corporate governance plays a major role in the performance of companies around the world. The recent global financial crisis was as a result of inadequacies in governance that needed to be addressed, to avoid a repeat of the crisis. Corporate governance code covering the relationships with the shareholders demands that there be a dialogue between the firm managers and shareholders, to bring about the mutual understanding of the firm objectives and to ensure that there is healthy relationship with all stakeholders (Solomon, 2007). This can take place through an annual general meeting, to encourage investors for the continued participation.
