Corporate Governance

Editor's Notes

1. In the 20th century in the immediate aftermath of the Wall Street Crash of 1929 legal scholars such as Adolf Augustus Berle , Edwin Dodd, and Gardiner C. Means pondered on the changing role of the modern corporation in society. Berle and Means' monograph " The Modern Corporation and Private Property " (1932, Macmillan) continues to have a profound influence on the conception of corporate governance in scholarly debates today. Fifty years later, Eugene Fama and Michael Jensen 's "The Separation of Ownership and Control" (1983, Journal of Law and Economics) firmly established agency theory as a way of understanding corporate governance: the firm is seen as a series of contracts. In the first half of the 1990s, the issue of corporate governance in the U.S. received considerable press attention due to the wave of CEO dismissals (e.g.: IBM , Kodak , Honeywell ) by their boards. CALPERS (The California Public Employees' Retirement System (CalPERS) led a wave of institutional shareholder activism (something only very rarely seen before), as a way of ensuring that corporate value would not be destroyed by the now traditionally cozy relationships between the CEO and the board of directors (e.g., by the unrestrained issuance of stock options, not infrequently back dated ). In 1997, the East Asian Financial Crisis saw the economies of Thailand , Indonesia , South Korea , Malaysia and The Philippines severely affected by the exit of foreign capital after property assets collapsed. The lack of corporate governance mechanisms in these countries highlighted the weaknesses of the institutions in their economies.
2. In the early 2000s, the massive bankruptcies (and criminal malfeasance) of Enron and Worldcom , as well as lesser corporate debacles, such as Adelphia Communications , AOL , Arthur Andersen , Global Crossing , Tyco , and, more recently, Fannie Mae and Freddie Mac , led to increased shareholder and governmental interest in corporate governance. This culminated in the passage of the Sarbanes-Oxley Act of 2002. [3] But, since then, the stock market has greatly recovered, and shareholder zeal has waned accordingly. Role of Institutional Investors Many years ago, worldwide, buyers and sellers of corporation stocks were individual investors, such as wealthy businessmen or families, who often had a vested, personal and emotional interest in the corporations whose shares they owned. Over time, markets have become largely institutionalized : buyers and sellers are largely institutions (e.g., pension funds , insurance companies , mutual funds , hedge funds , investor groups, and banks ).
3. In March 2002, CCG was established by SECP and it was included in the listing requirements of Stock Exchanges. An ICG has also been established by government to ensure implementation of CCG & its regulations
4. Need for Corporate Governance The success of modern enterprises depends on the adoption and implementation of good management practices that inter alia seek to protect the interests of stakeholders. Sound corporate governance practices help companies to improve their performance and attract investment while enabling them to realize their corporate objectives, protect shareholder rights, meet legal requirements, and demonstrate to a wider public how they are conducting their business. These practices have become critical to worldwide efforts to stabilize and strengthen global capital markets and protect investors. Research has shown that investors from all over the world will pay large premiums for companies with effective corporate governance. One such study
5. Parties involved in corporate governance include the regulatory body (e.g. the Chief Executive Officer , the board of directors , management and shareholders ). Other stakeholders who take part include suppliers, employees, creditors, customers and the community at large. All parties to corporate governance have an interest, whether direct or indirect, in the effective performance of the organisation. Directors, workers and management receive salaries, benefits and reputation, while shareholders receive capital return. Customers receive goods and services; suppliers receive compensation for their goods or services. In return these individuals provide value in the form of natural, human, social and other forms of capital. A key factor in an individual's decision to participate in an organisation e.g. through providing financial capital and trust that they will receive a fair share of the organisational returns. If some parties are receiving more than their fair return then participants may choose to not continue participating leading to organizational collapse.
6. Parties involved in corporate governance include the regulatory body (e.g. the Chief Executive Officer , the board of directors , management and shareholders ). Other stakeholders who take part include suppliers, employees, creditors, customers and the community at large. All parties to corporate governance have an interest, whether direct or indirect, in the effective performance of the organisation. Directors, workers and management receive salaries, benefits and reputation, while shareholders receive capital return. Customers receive goods and services; suppliers receive compensation for their goods or services. In return these individuals provide value in the form of natural, human, social and other forms of capital. A key factor in an individual's decision to participate in an organisation e.g. through providing financial capital and trust that they will receive a fair share of the organisational returns. If some parties are receiving more than their fair return then participants may choose to not continue participating leading to organizational collapse.
7. Historically, firms were managed by the founder-owners & their descendents. The managerial revolution led to a separation of ownership and control, which is the basis of modern corporation. In modern corporations, shareholders & managers become specialized. Shareholders purchase shares, which entitles them to income – residual returns – from the operations of firm after expenses have been paid. Shareholders invest in different companies to reduce risk. They expect good dividends. Diversification help managers & secure their jobs & earnings In small companies owners control Share holder value is reflected by the price of shares, hence CEOs also concentrate on this.
8. One is interested in maximizing its profit through the success of the corporation while other one is interested in maximizing its compensation for rendering his services. This gives rise to principal-agent problem. Shareholders lack direct control over corporations Problem arises when the agent makes decisions that result in the pursuit of goals that conflict with those of the principal Principal establish governance & control mechanisms. Remains difficult for principals to verify the agent behavior of agent whether it is appropriate The agent sometimes exercises managerial opportunism, which is seeking self-interest with guile (cleverness). Managerial opportunism prevents the maximization of shareholder wealth. Example increased size & Diversification reduces employment risk & increases compensation for managers respectively.
9. Key elements of good corporate governance principles include honesty, trust and integrity, openness, performance orientation, responsibility and accountability, mutual respect, and commitment to the organization. Of importance is how directors and management develop a model of governance that aligns the values of the corporate participants and then evaluate this model periodically for its effectiveness. In particular, senior executives should conduct themselves honestly and ethically, especially concerning actual or apparent conflicts of interest , and disclosure in financial reports.
10. Commonly accepted principles of corporate governance include: Rights and equitable treatment of shareholders : Organizations should respect the rights of shareholders and help shareholders to exercise those rights. They can help shareholders exercise their rights by effectively communicating information that is understandable and accessible and encouraging shareholders to participate in general meetings. Interests of other stakeholders : Organizations should recognize that they have legal and other obligations to all legitimate stakeholders. Role and responsibilities of the board : The board needs a range of skills and understanding to be able to deal with various business issues and have the ability to review and challenge management performance. It needs to be of sufficient size and have an appropriate level of commitment to fulfill its responsibilities and duties. There are issues about the appropriate mix of executive and non-executive directors. The key roles of chairperson and CEO should not be held by the same person. Integrity and ethical behaviour : Ethical and responsible decision making is not only important for public relations, but it is also a necessary element in risk management and avoiding lawsuits. Organizations should develop a code of conduct for their directors and executives that promotes ethical and responsible decision making. It is important to understand, though, that reliance by a company on the integrity and ethics of individuals is bound to eventual failure. Because of this, many organizations establish Compliance and Ethics Programs to minimize the risk that the firm steps outside of ethical and legal boundaries. Disclosure and transparency : Organizations should clarify and make publicly known the roles and responsibilities of board and management to provide shareholders with a level of accountability. They should also implement procedures to independently verify and safeguard the integrity of the company's financial reporting. Disclosure of material matters concerning the organization should be timely and balanced to ensure that all investors have access to clear, factual information.
11. Corporate Governance" despite some feeble attempts from various quarters has remained ambiguous and often misunderstood phrase. For Quite some time it was confined to only corporate management. It is not so. it is something much broader for it must include a fair, efficient and transparent administration to meet certain well defined objectives. Corporate governance also must go beyond law. The quantity, quality and frequency of financial and managerial disclosure, the degree and extent to which the board of Director (BOD) exercise their trustee responsibilities and the commitment to run transparent organization- these should evolve due to interplay of many factors and the role played by more progressive elements within the corporate sector.
12. Co rporate governance mechanisms and controls are designed to reduce the inefficiencies that arise from moral hazard and adverse selection . For example, to monitor managers' behavior, an independent third party (the auditor ) attests the accuracy of information provided by management to investors. An ideal control system should regulate both motivation and ability. Adverse selection , anti-selection , or negative selection is a term used in economics , insurance , statistics , and risk management . On the most abstract level, it refers to a market process in which "bad" results occur due to information asymmetries between buyers and sellers: the "bad" products or customers are more likely to be selected. A bank that sets one price for all its checking account customers runs the risk of being adversely selected against by its high-balance, low-activity (and hence most profitable) customers. In economics and contract theory , information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry. Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions. For example, an individual with insurance against automobile theft may be less vigilant about locking his car, because the negative consequences of automobile theft are (partially) borne by the insurance company.
13. Internal corporate governance controls monitor activities and then take corrective action to accomplish organizational goals. Examples include:
14. Monitoring by the board of directors : The board of directors, with its legal authority to hire, fire and compensate top management, safeguards invested capital. Regular board meetings allow potential problems to be identified, discussed and avoided. . [5] Different board structures are optimal for different firms. Moreover, the ability of the board to monitor the firm's executives is a function of its access to information. Whilst non-executive directors are thought to be more independent, they may not always result in more effective corporate governance and may not increase performance Executive directors possess superior knowledge of the decision-making process and therefore evaluate top management on the basis of the quality of its decisions that lead to financial performance outcomes. It could be argued, therefore, that executive directors look beyond the financial criteria.
15. Remuneration : Performance-based remuneration is designed to relate some proportion of salary to individual performance. It may be in the form of cash or non-cash payments such as shares and share options , superannuation or other benefits. Such incentive schemes, however, are reactive in the sense that they provide no mechanism for preventing mistakes or opportunistic behavior, and can elicit myopic behavior.
16. External corporate governance controls encompass the controls external stakeholders exercise over the organisation.
17. Demand for information: A barrier to shareholders using good information is the cost of processing it, especially to a small shareholder. The traditional answer to this problem is the efficient market hypothesis (in finance, the efficient market hypothesis (EMH) asserts that financial markets are efficient), which suggests that the shareholder will free ride on the judgements of larger professional investors. Monitoring costs: In order to influence the directors, the shareholders must combine with others to form a significant voting group which can pose a real threat of carrying resolutions or appointing directors at a general meeting. Supply of accounting information: Financial accounts form a crucial link in enabling providers of finance to monitor directors. Imperfections in the financial reporting process will cause imperfections in the effectiveness of corporate governance. This should, ideally, be corrected by the working of the external auditing process.
18. In Pakistan, the SEC introduced the Code of Corporate Governance in March 2002 as a first step towards systematic implementation of principles of good corporate governance. The Code has been incorporated in the listing regulations of the stock exchanges and is applicable to all public listed companies. It is a compilation of “best practices” to provide a framework by which the business and management of listed companies are to be directed and controlled.
19. The Code encourages representation of independent non-executive directors and those representing minority interests on the boards of directors of listed companies. As a further guarantee of compliance with this provision, the Code requires that the chairman of a listed company "shall preferably be elected from among the non-executive directors of the company and that the board of directors shall clearly define the respective roles and responsibilities of the chairman and chief executive, whether or not these offices are held by separate individuals a the same individual."
20. The Code requires every listed company to establish an audit committee that will comprise not less than three members, including the chairman. Majority of the members of the committee, it is further directed, "shall be from among the non-executive directors of the company” To further enhance their role, it requires that the chairman of the audit committee be preferably a non-executive director.
21. In this study, we examine whether variation in firm-specific governance is associated with differences in firm value in case of Pakistani stock market. To examine the relationship between corporate governance and firm performance, a corporate governance index (CGI) is developed as a proxy for firm-level governance quality with a variety of different governance practices adopted by listed firms. Tobin’s Q is used as valuation measure. Proxy is a variable in which itself there is no interest but from which a variable of interest can be obtained. As GDP is often used as proxy for Standard of living. Tobin’s q = Market Value/Asset Value For evaluation of market Tobin's q = Value of Stock Market/Corporate net worth Inflationary time q will be lower than P/B or conversely high
22. The sample of 50 firms is selected: which are representative of all non-financial sectors and active in their sector, comprises more than 80% of market capitalization and listed on KSE. The data is obtained from the annual reports of these firms for the year 2003, 2004 and 2005. The Tobin Q, CGI and other control variables are constructed and average is taken out for these three years.
23. In order to construct corporate governance index for the firms listed on KSE, a broad, multifactor corporate governance rating is done which is based on the data obtained from the annual reports of the firms submitted to SECP. • The index construction is as follows: for every firm, there are 22 governance proxies or indicators are selected, these indicators are categorized into three main themes. • The three categories or sub-indices consist of indicators: eight factors for the Board, seven for ownership and shareholdings and seven for transparency, disclosure and audit.
24. The weighting is based on subjective judgments. The assigned priorities amongst and within each category is guided by empirical literature and financial experts in this area. • The maximum score is 100, then, a score of 100 is assigned if factor is observed, 80 if largely observed, 50 for partially observed and 0 if it is not observed • The average is taken out and we arrive at the rating of one sub-index. By taking the average of three sub-indices we obtain CGI for a particular firm.
25. empirical specification of the model is       • where Qiis the firm performance measure, the CGIiis a vector of governance index and Xiis a vector of firm characteristics for these three years.  
26. In exploring that good corporate governance causes higher firm valuation, an important issue is endogenity. The firms with higher market value would be more likely to choose better governance structure because of two reasons. First, firm’s insiders believe that better governance structure will further raise firm value. Second, firms adopt good governance to signal that insider behave well. Empirical: derived from or guided by experience or experiment. 2. depending upon experience or observation alone, without using scientific method or theory, esp. as in medicine. 3. provable or verifiable by experience or experiment.
27. Along with three governance indices, board, shareholdings and disclosure, a set of control variables which include size (ln assets), leverage (debt/total asset ratio) and growth (average sale growth) are used in estimation. Firm size and growth control for potential advantages of scale and scope, market power and market opportunities. The leverage controls for different risk characteristics of firm
28. This endogeinety problem in estimation is resolved by applying Generalized Method of Moments as estimation technique. • The instruments: Age is natural logarithm of number of years of listing at KSE, Profit is logarithm of net income/total assets , DFOR is dummy variable which is one if the firm has foreign investment and zero otherwise, DN is a dummy variable if the firms has block holder zero otherwise, DKSE, is a dummy variable if the firm is included in KSE 100 index and zero otherwise.
29. There is positive and significant relationship between CGI and Tobin’s Q supporting our hypothesis that corporate governance affects firm value. The CGI remains positive but significance level reduces with adding more explanatory variables. This shows that the inclusion of omitted variables have improved the specification of the model. Therefore we find some evidence that corporate governance effects firm’s performance. This result suggests that a certain level of governance regulations in emerging market like Pakistan has not make the overall level of governance up to a point that governance remain important for investor. The inter-firm differences are matters to investor in valuing firm.
30. The results based on sub-indices reveal importance of Board composition, ownership and shareholdings with firm performance. However investors are not willing to pay a premium for companies that are engaged in open and full disclosure.
31. The results of firm performance including control variables are also consistent with prior research. The coefficient of size is positive and significant in most of the cases. This shows that the listed firms that are likely to grow faster usually have more intangible assets and they adopt better corporate governance practices. The coefficient of growth is significant and positive because higher growth opportunities are associated with higher firm valuation. The coefficient of leverage is positive and significant, is consistent with the prediction of standard theory of capital structure which says that higher leverage increase firm’s value due to the interest tax-shield