Corporate Governance and Its Importance to Organizations - Report Example

Introduction: Corporate Governance and its importance to Organizations The issue of corporate performance and corporate governance has always been the focus of markets and market participants. Since there is a correlation between corporate performance and market results with linkages to the movements of share prices, the topic of corporate governance has been the realm of business analysts and market groups. However, in recent years there has been an explosion of interest in these topics by the laypersons as well as in the popular press (with each feeding on the other) because of the incidence of corporate scandals involving the senior management figures in the United States and elsewhere. Further, the serious researchers have started to study the phenomenon of corporate governance in detail over the last few decades (European Commission, 2011, 80). Before launching into a discussion of how corporate governance is important to organizations, it would be pertinent to note that in many studies, it is implicitly assumed that corporate governance is centred on the role of directors on the boards of the firms. There are many researchers who have characterized corporate governance as the board’s duty to govern the firm and their primary role being to exercise power over the top management and the employees (Colpan, Hikino et al, 2010, 93). Hence, it follows from this characterization that the topic for this paper is about corporate governance as it relates to board composition and structure. Corporate governance is indeed important for organizations as good corporate governance leads to better results and enhancement of shareholder value. Since, shareholder value and its enhancement is the raison d’être of organizations, it follows from this that better corporate governance leads to all round increase in shareholder value leading to enhancement of the firm’s reputation and ability to grow further. On the other hand, if a firm is performing poorly or is plagued by scandals involving its senior management, there is every possibility that this might lead to loss of reputation, loss of customer base and finally diminished confidence from the market leading to drops in shareholder value (European Commission, 2011, 98). It was mentioned that enhancing shareholder value is the reason why firms exist. It must also be mentioned that in recent years, there has been a trend towards enhancing value for all stakeholders (customers, partners, employees, shareholders and the society at large). The key term stakeholder as opposed to shareholders has gained traction with the advent of corporate social responsibility and a trend towards keeping all stakeholders happy. No matter which term one uses or prefers, it is indeed the case that firms have a duty towards their constituents much like elected officials have towards the voters (Colpan, Hikino et al, 2010, 80). To fulfil this duty, firms need to be better governed and better administered and hence good corporate governance is called for. This report is aimed at firms wishing to internationalize and contains review of theoretical and empirical studies on board composition along with recommendations for such companies. Literature Review Non-Executive Directors The literature on the presence of non-executive directors on the boards of firms indicates that there is a positive correlation between the presences of outside directors on boards as opposed to “insiders” as directors (Jai Choi et al, 2007, 950). Further, if the outside directors are not CEO’s or executives of other firms, there is another dimension to the performance of the firms. The first point is that having directors who are not executives lends more criticality to the operations of the firm as these directors can contradict and question the management about key decisions. However, the flip side is that they might lack the operational and strategic expertise needed to understand the operational aspects of the firm on whose board they are members. So, it is the practice that firms usually pick directors who are on the boards of other firms as well and who are/have been associated with firms in similar lines of businesses. The proportion of outside directors to executive directors is something that has been found to be variable according to the overall board strength and the sector in which the firm operates. Further, there are laws in many countries that mandate a certain proportion of the board to be made up by non-executive directors which has been found to have a beneficial effect on the performance of the firm. Since this report is aimed at firms wishing to internationalize, having non-executive directors who are drawn from global companies and who have expertise in global best practices would be a good idea to increase firm performance (Yermack, 2004, 2289). It would be a good idea if 30% of the board strength is made up of non-executive directors. This board composition would ensure that firms would have adequate objectivity in their board governance and at the same time would not miss out on the insider perspective that executive directors bring to the table. Further, compulsory retirement of outside directors after a fixed term would benefit the firm in not engendering conflicts of interest (Jay Choi et al, 2007, 959). CEO/Chairperson Duality The issue of whether a CEO who doubles up as the chairperson of the board can lead to agency problems and issues of disproportionate power has been studied in the literature reviewed for this paper. The findings indicate that by having the positions split between two individuals would be a way to control agency problems and does not compromise the effectiveness of the board. For instance, it has been the case that there needs to be adequate control and oversight of the CEO and other executives by the board and CEO Chair duality might endanger this oversight. On the other hand, firms evaluate cost effectiveness of such a duality and it has been found that from a cost and benefits perspective, it might make sense for having the duality (Sampson-Akpuru, 2008, 87). But, the costs associated with agency problems might need to be factored in such a case. So the findings indicate that the issue of CEO Chairperson Duality is complex and hence depends on the firm characteristics and other factors. An interesting and relevant (to the topic) finding is that firms that have the chairpersons as CEO’s tend to internationalize more than other firms and the most preferred route for such internationalization is through acquisitions of foreign firms. Hence, it can be said that the issue of CEO Chairperson Duality should be viewed from multiple perspectives and according to the specific needs of the firms (Ying Kwok, 1998, 80). International Diversity on the Board In recent years, there has been a trend towards having a certain proportion of directors from outside of the country in which the firm operates. The presence of these FID’s or Foreign Independent Directors on the boards of firms has been found to enhance the performance of these firms if the firm has operations in the country from which the FID’s originate. On the other hand, it has been found that there is no significant value addition to the firms if they do not have operations in the countries to which these FID’s belong. On the contrary, it has been proved that there is significant negative correlation between a firm’s performance and the presence of FID’s if the firm does not operate in those countries. Since this report is aimed at firms wishing to internationalize, it is the case that the positive correlation is important and hence having FID’s from the countries in which the firm operates in has a significant impact on the way the firm operates (Masulis & Wang, 2010, 38). The FID’s domiciled in other countries can add value if the firm intends or is operating in those countries. On the other hand, they face potential conflicts of interest if the firm does not operate in those countries. The point here is that the expertise that they bring to the table with their knowledge of the laws and ways of doing things in their home country might be useful if the firm is operating in those countries (Hagendorff & Keasey, 2008, 28). Hence, in order to fully utilize the services of FID’s it is better for international firms to have these FID’s from the countries in which they operate. Finally, the incentives offered to these FID’s might induce blindness to the workings of the firm and hence poor oversight (Nielsen, 2010, 309). This can happen to both firms in the developed countries (due to the disproportionate rewards that FID’s from less developed countries might be getting) and in developing countries as well (due to the tendency of the firms in these countries overcompensating them). Summary of Board Composition and Structural Features Gender Diversity The issue of gender diversity is a bit tricky since the available literature suggests that there is a divergence of views on whether the lack of gender diversity on the boards of many firms is due to the competence gap or because there is an institutional bias against women being on the boards of firms (Dobbin & Jung, 2011, 817). While there can be no argument about the fact that there exist competent women in most of the sectors or industries, there is indeed a lively debate over the existence of the so-called “glass ceiling” that tends to limit the growth of women into senior management positions and hence stunts their progress through the corporate hierarchy (Nielsen, 2010, 97). The issues related to this are beyond the scope of this paper. However, what is very much relevant is the fact that there is significant bias as far as institutional arrangements are concerned because of structural features as well as perceptual issues. The institutional biases are in the form of negative correlations between market signals or share price movements and gender diversity. Further, many conservative firms behave in conventional ways where taking women on to the board seems to be a radical break with the past. However, most of this is changing as there are several firms across the world where women are not only the CEO’s or Chairpersons but also present in the board as directors. The point here is that with the changing times, institutional biases are likely to subside and hence it would be better for the firms to encourage diversity and create a self perpetuating loop between gender inclusivity and performance which in turn lead to sending the right signals to the markets (Dobbin & Jung, 2011, 819). The issues related to competence gaps can be addressed as well if the top down mentoring by the women in senior management of those in the middle and lower tiers is done. The main advantage of having gender diversity is that it can tackle the problem of group think which often is the case with firms in which men make up the entire board. Diversity in any aspect encourages difference of thought and hence must be welcomed for its propagation of alternative viewpoints (Brammer & Millington, 2011, 398). Executive Compensation and Corporate Governance The ongoing global economic crisis has brought to the fore issues related to executive compensation and the role of incentives in determining corporate behaviour and corporate governance. While it has been widely reported that excessive compensation has led to undue risk taking and skewed income levels, it needs to be mentioned that the very system of incentives that are offered to senior management might be the culprit for bad corporate governance (Masulis & Wang, 2010, 64). For instance, an examination of the role of flawed incentives in causing the financial crisis reveals that the system of bonuses that rewarded the bankers for how much profit they made irrespective of the risk involved meant that caution was thrown to the winds and these bankers engaged in irresponsible behaviour. The failure of Lehmann Brothers in 2008 and more recently, the failure of MF Global are examples of how skewed executive compensation can lead to undesirable outcomes for the firm as well as for its shareholders. The passivity with which the boards of many firms accept the high compensation that is paid to the top management is also because the reward system in place for the board members ensures their complaisance. Hence, there should be a mechanism in place that serves as a “check” on runaway compensation and excessive bonuses for employees (Forbes & Watson, 1993, 332). With the number of firms that are showing losses on their balance sheets increasing by the day, it is indeed time to relook at the compensation and reward systems in these firms. The point here is that the gap between the lowest paid worker and the highest paid management figure must not be unreasonably large and this must serve as a yardstick to judge the prevailing compensation system in these firms (Cornett et al, 2008, 367). Role of Institutional Investors Ample literature and research studies exist on the effect that large shareholders or institutional investors have on corporate performance and corporate governance. The theories under which these studies have been done are the agency problem theory and the resource dependency theory. The agency problem theory states that the incentives for value maximisation and utility seeking behaviour are more for managers who are not owners and who do not hold significant equity. Hence, there tends to be a tendency on the part of these managers to indulge in self serving and self interested behaviour. This implies that there has to be some sort of control over this kind of behaviour and since minority shareholders do not have the kind of clout that large shareholders have, they might not be in a position to question the managerial practices in firms where they hold equity. On the other hand, large investors or the institutional investors by virtue of having more votes and a chance to be on the board can do away with the agency problems and the asymmetries of information along with issues arising out of the resource dependency theory. They have access to information which they have obtained from management, which can be passed on to other shareholders at no additional cost. In this way, the overall shareholder value to the firm increases since this process benefits all the shareholders. In this way the agency problems of managerial actions and asymmetries of information can be tackled by the presence of institutional investors on the boards of firms. There are numerous studies that have been done which indicate a positive correlation between the presence of institutional investors on the boards of firms and the level of corporate performance (Bauwhede, 2009, 511). Conclusion and Recommendations To improve firm performance, good corporate governance is a must. It is recommended for firms wishing to internationalize that they encourage diversity in the board by including women, FID’s and institutional investors apart from abiding with the voluntary codes of corporate governance (Aguilera & Cuervo-Cazurra, 2009, 380). A measure of how good corporate governance can lead to greater shareholder value and all round benefits to stakeholders can be seen in the way firms that practice such governance are able to do well internationally. In the globalized world economy, the business imperatives are all about seizing the opportunities and connecting the dots between the various steps in the global supply chain. To do this, the firm must have expertise and comply with global regulations. Hence, it is more than ever that firms need to have foreign independent directors, members of the board who are well versed in the various laws and regulations in the countries in which the firm operates and finally, have institutional investors in the board by which they can control agency problems (Koh & Laplante, 2007, 315). It is a fact that international firms tend to have problems with managers since international operations are often handled by professional managers. These managers might indulge in value maximizing and utility enhancing behaviour that is self interested and self serving. Hence, the issue of CEO Chairperson Duality must be looked at in this respect (Bektas & Kaymak, 2009, 25). Overall, firms can do well if they incorporate some of these suggestions and in particular, those related to diversity. It is nobody’s case that international firms restrict themselves to a specific set of board members and it is indeed the case that they would be better off with the expertise and knowledge that they can gain from a wide range of opinions that comes with board diversity. Finally, the issues of conflicts of interests and insider trading that have bedevilled many global firms in addition to issues related to lack of knowledge of the local laws and regulations must be addressed through proper corporate governance. This can only come through exercise of adequate oversight and control by the board of directors whose main purpose must be to establish a system of checks and balances. In conclusion, with the recent emphasis on good corporate governance in view of the growing tendencies of many firms to be embroiled in scandals, the time is now for the various regulators and corporates themselves to enforce the laws as well as to voluntarily comply with the laws in a consensual and transparent manner so as to maximize stakeholder value. References 1. Aguilera, R. and Cuervo-Cazurra, A. (2009) Codes of Good Governance, Corporate Governance: An International Review, 17(3), p.376–387. 2. Bektas, E. and Kaymak, T. (2009) Governance Mechanisms and Ownership in an Emerging Market: The Case of Turkish Banks, Emerging Markets Finance & Trade, 45(6), p.20–32. 3. Brammer, S. and Millington, A. (2011) Gender and Ethnic Diversity Among UK Corporate Boards, CORPORATE GOVERNANCE, 15(2), p.393-403. 4. 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(2004) Remuneration, Retention, and Reputation Incentives for Outside Directors, THE JOURNAL OF FINANCE, 59(5), p.2281-2308. 17. Ying Kwok, J. (1998) Does CEO Duality Matter: An Integrative Approach, Virginia Polytechnic Institute and State Un, 1(1), p.1-140. Read More