The Nature and Extent of Corporate Governance Failure - Essay Example

Introduction The current debate on the failure of financial s extensively discusses the nature and extent of corporate governance failure. The corporate failures of WorldCom and Enron indicated that the overall corporate governance infrastructure within the firms was not effective. It was because of this reason that the regulations such as Sarbanes Oxley were promulgated in order to make it mandatory for the organizations to have a certain degree of corporate governance mechanism within them. The failure of large institutions especially financial services firms reflected on the inability of the managers to ensure that the overall governance mechanism was well placed within the organizations to ensure their stability and compliance with the rules and regulations. Thus normally, the focus is on the managers for corporate governance ignoring the fact that there are various power structures as well as stakeholders within the organization who can effectively dominate the corporate governance process. The role of institutional investors as well as active shareholders has therefore become more prominent after the collapse of large institutions and now they actively take part in the board meetings etc. Large investors such as institutional investors therefore play a critical role also and one of the fundamental questions to be asked as to how to achieve the balance between those two power structures of the organization to ensure corporate governance process to take its deeper roots. Thus “the fundamental issue concerning corporate governance seems to be how to regulate large or active shareholders in order to obtain the right balance between managerial discretion and small shareholder protection.” This paper will therefore attempt to critically discuss the above quoted statement by examining the theoretical implications for separation of ownership and Control. Agency Theory and Corporate Governance In order to properly discuss the above statement, it is critical that a comprehensive overview of the theoretical attempts made so far to discuss and originate the concept of corporate governance is discussed. One of the most potent theories that outline the potential conflict between the roles of managers and shareholders is agency theory. The birth of the modern corporate required that there must be separation between the ownership and control of the organization. This was done with fundamental aim of taking advantage of the skill level of others who can perform the job of managing the corporate in better manner as compared to the owners.(Igor& Deborah,2010). Agency theory basically attempts to study the nexus of different resource holders of the firm. Accordingly, a firm is just viewed as a contract between the different resource holders of the firm however, the arrangement of agency arises when principal (mostly shareholders) delegate some power and duties to their agents (Managers) to perform them on the behalf of the principals. Such relationship however, requires that the principals must pay to their agents in return to their services rendered while executing the job. This delegation of work is often done in order to take advantage of the division of labor and utilize the resources of the organization in most efficient manner. What is however, also critical to understand that such delegation of powers by the principals also requires a certain degree of trust to be placed in the managers while they execute various jobs assigned to them as a part of the overall delegation process. Managers therefore are considered as accountable to shareholders for their actions. (LAN,& LOIZOS,2010). In its simplest form, agency theory therefore attempts to discuss the potential conflicts that can arise between the managers and the owners of the firm. However, since managers manage the whole organization, it is often the case that information asymmetries arise between principals and agents. The basis of theory is fundamentally rooted into the information asymmetries between the managers as well as the shareholders. The self interest of managers and shareholders therefore can collide due to such information asymmetries and managers may take actions which can exclusively benefit them rather than increasing the value for shareholders. As such shareholders always take actions which align the interests of shareholders and the managers through incorporating an effective corporate governance mechanism which can ensure that scope of information asymmetries is reduced and the chances of engaging into opportunistic activities are minimized.(Clarke,2004). The primary motive for such behavior by the agents may be the opportunity to earn higher financial rewards, exploit the labor market conditions to their own maximum benefit as well as taking such actions which can directly benefit them. This also means that the managers may be too optimistic about the economic performance of the entity and ignore the ground realities.(Monks & Minow, 2008). Ignoring the ground realities of doing business as well as their risk biasness may allow managers to deliberately engage into bias into information flows and principals as well as agents may not have the access to same level of information. Principals can effectively overcome such principals by offering higher and more lucrative benefits and compensation to the managers besides offering them an opportunity to earn higher based on their performance. What is also critical to understand that the shareholders often exercise other methods such as enforcing strong corporate control as well as retaining the power to cease the Board of Directors will therefore give more balancing power to the shareholders also.(Sheath,2010). Along with compensation, there are also other steps that are undertaken in order to bring a balance between the powers of the shareholders as well as the managers. Such steps include more active role of Board of Directors, independent audit committees etc are some of the institutional checks that ensure that the managers do not transgress their powers and take actions which may hamper the interests of the shareholders.(McDonald & Westphal,2010). However, more active of shareholders and especially large shareholders can be effectively harmful for the small shareholder also. More dominant role of shareholders and especially institutional investors may create the potential disbalance between the powers of managers and shareholders besides compromising the rights of small investors. The debate therefore also indicates the relative influence and role of small and large shareholders in bringing in the balance of power within the organization.(Odded & Wang, 2010). Role of Large Investors It is argued that the increasing complexity of doing business, increasing stake as well as the financial crisis are some of the reasons as to why the large and institutional shareholders play active role in the affairs of large corporations. With the de-regulation of the financial markets and their liberalization, the flow of capital and finance has become easier and investors can now invest into international organizations. Such mobility of capital however, also gave rise to the typical risks that arise with the investment into international corporations. Recurring corporate failures as well as consistent episodes of financial crisis indicate towards the need for having more active role of the shareholders and large investors, being the most dominated lot, often demand more active role in the overall affairs of the firm. (Shleifer & Vishny, 1986) Since the de-regulation of the financial markets, the number of institutional investors have increased manifold with main concentration in pension funds as well as insurance companies. This change in the balance of individual shareholders and the institutional investors therefore gave more powers to the large shareholders to influence. Cadbury Report published in 1992 specially mentioned the role of large institutional shareholders to influence the firms and make it compulsory on the firms to implement the recommendations of the report in their true spirit. Such significance of institutional shareholders therefore reflected the overall power they have started to wield on the overall corporate governance process within the organizations for firm level compliance.(Allen, 2007). It is critical to note that the role and influence of institutional shareholders has been mainly signified under the various reports published under the direct instructions of the government. Especially in case of UK, Cadbury Report, Greenbury Report as well as Hampel Report specially focused and encourage the greater role of large shareholders in ensuring that best practices are followed by the firm. Combined Code (2003) also specifically as to how large shareholders can effectively influence the outcomes within the organization. Large and institutional investors however are given the special task of evaluating the governance disclosures made by the firm and recommended for open dialogue between the firm and the shareholders. (Cope, 1997) Such significance to the large shareholders therefore made them more powerful and brought them into a position of dominance. This also resulted into the more shareholder activitism under which large institutional investors set their own terms of references and forced the firms to adapt certain corporate governance codes of their own. The practice also emerged wherein it was necessitated for the institutional shareholders to provide a clear description of as to how they will discharge their duties and responsibilities and what will be the actual modus operandi under which they will perform their job of corporate oversight. (Salisbury,2010). It is also critical to understand that the overall role of institutional investors is not legally defined and it was because of this reason that many institutional investors attempted to micro-manage the firms despite the fact that the micro-management of the firm remained the prerogative of the managers. Public Interest and Large shareholders More active role of large shareholders is also viewed as a proxy of the public interest also as pension funds- one of the largest chunk of institutional shareholders, often manage public money and invest on their behalf into organizations. It therefore becomes an implicit responsibility of the large shareholders to ensure that the public investment is prudently managed by the managers and managers must not act irrationally and under their own self interest. Since the ultimate strategic objectives a firm and a pension fund is optimization of the value therefore the overall purpose and aims of corporate coincide with that of the large institutional shareholders. As such there occurs a fiduciary relationship between the pension funds and corporate. (Dana,2009). The above discussion therefore indicates that the role of institutional shareholders and institutional investors is more prominent now. The increasing complexity and increase of public interest therefore make it mandatory for large shareholders to take active part into the management of the affairs of the firm. However, there remains a question of whether such unprecedented influence of large shareholders can compromise the powers of the managers as well as the rights of small shareholders? More dominating role of large institutional shareholders also means that they will force on the firms the decisions which may not be profitable for the firm in long run and may further put into danger the overall stakes of the small and individual shareholders of the firm. Balance between Shareholders and large investors The dominance of institutional investors however, brought forward some of the most important implications for managers. Managers usually view shareholders – no matter whether they are large or small- as just one group of stakeholders. Other stakeholders of the firm include the employees, customers, government, general public etc therefore managers always attempt to bring a balance between the power shared by each group of stakeholders rather than allowing just one group of stakeholders to dominate. (McTaggart & Knotes, 1993). Thus in order to effectively bring the balance, it is therefore important that role of large shareholders shall be balanced with the importance of the managerial discretion and with that of the rights of small shareholders. One common theme that is now being advocated is the assumption that the governing objective of the firm shall not be the maximization of shareholder value but rather it shall be the maximization of customer satisfaction. (LI, MOSHIRIAN, PHAM, & ZEIN, 2010). Maximizing the satisfaction of customers however, require that the managers must have a larger discretion into the affairs of the firm and they must take actions that successfully create value for the customers. It is thus believed that the value maximizing efforts for customers itself translate into value maximizing for the shareholders. This therefore means that the more active role from the large institutional shareholders may hamper their own interests and to bring in back the focus, it is therefore critical that the role of large institutional investors shall be regulated in such a manner to bring more managerial discretion. From corporate governance purposes, it is also advocated that the large institutional shareholding into one company make it more costly for the large institutional shareholders to actively pursue their investments. This may be because of many reasons including free rider problem, risk concentration as well as the liquidity and preference issues. (Cassidy,2003). This therefore means that though large shareholding in the firms may not be wise move by such institutional investors because it can create significant corporate governance issues for them also. This is in-line with the fact that decisions taken by institutional investors to make large shareholding into one company potentially put at risk the interests of the stakeholders of such firms. The more dominating role of large shareholders thus increases the monitoring costs for large institutional shareholders and it is important that the roles must be balanced in such a manner that almost all the key stakeholders are taken care off. (Pergola, T, Verreault, D, 2009) Finally, managers have more information and understanding about their business and it is their professional duty to manage the business. On the other hand, institutional investors held large shareholding just for the purpose of investment therefore they may be enticed by the speculative behavior and may force the changes that can be effectively detrimental for the firm in long run. With more focus on achieving appreciation of the stock value, larger shareholders therefore may effectively put at risk the smaller shareholders by overriding their concerns and rights by taking actions which may not benefit small shareholders. (Crane & Matten, 2007). Since managers have the information, it is therefore can easily be argued that the role of managers must be more active in settings where institutional investors are more active. Actions by the strong CEOs can effectively nullify the impact of large shareholders on the discretion of the managers, if the overall direction of such actions is to create more value for the firm.( Boubakri, Guedhami & Sy,2008). Further, the role of various gatekeepers such as auditors and accountants of the firm can be improved to effectively put check on the managers. From corporate governance perspective, more active role of auditors and their independence in providing the professional opinion may be sufficient enough to satisfy the concerns of the large shareholders. Thus rather than micro-managing the firm, it is more appropriate if managers are allowed to work on their own and a balance must be struck to regulate the behavior of large shareholders. (Zeckhauser & Pound, 1990) Conclusion To regulate the behavior of managers is one aspect of corporate governance whereas to regulate the role of large shareholders is another critical aspect of corporate governance also. The need is to have a fine balance between the two so that not only managerial discretion is maintained but the interests of other stakeholders of the firm are taken care off too. 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Are Large Shareholders Effective Monitors? An Investigation of Share Ownership and Corporate Performance. Retrieved April 18, 2010, from National Bureau of Economic Research: http://www.nber.org/chapters/c11471.pdf?new_window=1 Read More