Ext. Exam.

Question Bank: Corporate Governance

1. What have been the main influences on the development of corporate governance codes and
guidelines?
2. What is corporate governance? Describe briefly the effects of Corporate

Governance on the business and financial markets as a whole.

Ans. Corporate governance comprises of two words, Corporate and Governance.
Corporate
A corporation is an organization created (incorporated) by a group of shareholders who have
ownership of the corporation.
The elected board of directors appoints and oversees management of the corporation.
Governance
Oxford English dictionary defines governance "as the act, manner, fact or function of
governing sway control.
The word has Latin origins that suggest the notion of steering". It deals with the processes
and systems by which an organization or society operates.
Governance can be used with reference to all kind of organizational structure e.g.
Ngo not for profit organization
Municipal corporation /gram panchayat
Central/state government
Partnership firm, etc.
Corporate governance broadly refers to the mechanisms, processes and relations by which
corporations are controlled and directed. Purpose of corporate governance is to have a demonstrable
IMPACT on a corporations FINANCIAL PERFORMANCE.
Governance structures identify the distribution of rights and responsibilities among different
participants in the corporation, such as, the board of directors, Managers, Shareholders, Creditors,
Auditors, regulators, and other stakeholders and include the rules and procedures for making
decisions in corporate affairs.
Effects of CG
provides proper inducement to the owners as well as managers to achieve objectives that are
in THE INTERESTS OF INVESTORS and the ORGANIZATION
ensures improved performance -corporate success, and sustainability
lowers the Capital Cost (interest rates on loans)
creates better access to finance -Positively impact the Share Price, thus enhancing investor
confidence and attracting investment
minimizes wastages, corruption, risks of corporate crisis and scandals, and mismanagement
Employees become accountable to the Management
The Management becomes accountable to the Board of Directors
The Board of Directors becomes accountable to the Investors and the Community
Protects Shareholders Rights
Treats all shareholders including minorities equitably
Provides effective redress for violations
Ensures timely, accurate disclosure on all material matters, including the financial situation,
Performance, ownership and corporate governance
Procedures and structures are in place so as to minimize, or avoid completely conflicts of
interest
Independent Directors and Advisers i.e. free from the influence of others
Independent, totally unrelated Auditors free from influence of the Directors and The
Management
help to ensure that adequate and appropriate system of internal controls operates hence the
assets may be safeguarded
prevent any single individual having too powerful an influence
help to ensure that the company is managed in the best interest of the investors
Establish a framework of sound relationship between the companys management, board of
directors, investors and all stakeholders
Shapes the growth and future of capital market & economy.

Instrument of investors protection.

Protecting the interest of Shareholders and all other stakeholder.
Contributes to the efficiency of the business enterprise.
Creation of wealth.
Enables firm to compete internationally in sustained way.
Keeps an eye on the issues of insider training
Strengthen management oversight functions and accountability.
Balance skills, experience and independence on the board appropriate to the nature and
extent of company operations.
Establish a code to ensure integrity.
Safeguard the integrity of company reporting.
Risk management and internal control.
Disclosure of all relevant and material matters.
Recognition and preservation of needs of shareholders.
3. Critically discuss whether it would be desirable to have one model of corporate governance
applicable to all countries.
4. Describe Roles of Audit Committee, Compensation Committee and Nominating

& Governing Committee.

Ans. Not all matters are deliberated by the full board. Some are delegated to subcommittees.
Committees may be standing or ad hoc, depending on the issue at hand. All boards are
required to have -audit committee, compensation committee, nominating and governing
committee. On important matters, the recommendations of the committees are brought
before the full board for a vote.
ROLE OF AUDIT COMMITTE
Oversight of financial reporting and disclosure
Monitor the choice of accounting policies
Oversight of external auditor
Oversight of regulatory compliance
Monitor internal control processes
Oversight of performance of internal audit function
Discuss risk management policies
Example of Best Practice about the Audit Committee engagement-Audit committees meet on
average 7 times per year, for 3.2 hours each
ROLE OF COMPENSATION COMMITTEE
Set the compensation for the CEO
Advise the CEO on compensation for other executive officers
Set performance-related goals for the CEO
Determine the appropriate structure of compensation
Monitor the performance of the CEO relative to targets
Hire consultants as necessary
Example of Best Practice about the Compensation Committee engagement -Compensation
committees meet on average 5 times per year, for 2.4 hours each
ROLE OF NOMINATING & GOVERNING COMMITTEE
Identification of qualified individuals to serve on the board
Selection of nominees to be voted on by shareholders
Hiring consultants as necessary
Determine governance standards for the company
Manage the board evaluation process
Manage the CEO evaluation process
Example of Best Practice about the
Nominating and governance Committee engagement - Nominating and governance committees
meet on average 4 times per year, for 1.9 hours each
5. Discuss the specific lessons learnt from various Corporate Scandals.
Ans. Lessons:1. Some Corporate Executives Will Do Almost Anything~
To Meet Earnings expectations, AND

To Keep the Firms Share Price Stable or Rising

2. There is a need for the Top Management to Set the Ethical Climate in a Firm
3. Auditors and their Clients Can Get Too Close ~
An Auditors independence is a necessary condition for a meaningful audit
4. GAAP is subject to significant management discretion
5. There is No Way For Accounting Standards to stop Fraud Auditors and SEC/SEBI may be able to
make some progress in reducing the fraud
6. Over-reliance on a single amount -Earnings Per Share Can be a Disaster
7.Excessive Leverage is usually a High-Risk Strategy Lehman's demise is a case study in the
dangers of excessive leverage
8.For Financial Institutions Adequate Liquidity is A Must (Case of Washington Mutual- Run on The
Bank)..The credit markets were virtually frozen at that time following the bankruptcy of Lehman
Brothers, and the near-collapse of AIG, Fannie Mae and Freddie Mac
9.Fraud Never Pays-With former WorldCom CEO Bernard Ebbers serving a 25-year jail sentence for
fraud and conspiracy as a result of the company's fraudulent accounting and financial reporting, the
lesson here is that fraud never pays
10 Key Lesson for Investors from the Enron Bankruptcy-If you can't understand it, don't invest in it.
Warren Buffets maxim is, "Never invest in a business you cannot understand.
11. Key Lessons for Investors from the Barings Bank Scandal-..
The downfall of Barings Bank was brought about by the actions of one man- Nick Leeson
Nick was able to cover up the losses for number of months
What does it imply..??
~ Lack of Internal Controls
~ Lack of effective supervision by experienced staff with good understanding of the process and
procedures
12. Key Lesson from Parmalat, Madoff and similar scandals..What may happen if the involvement of
investors is suppressed
Elaborated points
Some Corporate Executives will do almost anything to meet 'earnings expectations, and to
Keep the Firms Share Price Stable or Rising. Often the goal is one of personal enrichment
through the executives exercise of options and the sale of company stocks.
C level Executives must establish and demand te integrity of the firms disclosures- Both
Financial and Non Financial
An Auditors independence is a necessary condition for a meaningful audit. Case: Arthur
Andersen---Even though the External Auditing firm may not have fraudulent intentions, close
relationships between the Auditor and the Client Firm cause the Auditors overlooking the
obvious.
The Firms must make their earning more transparent.
No matter how good or how effective the accounting principles are, there is no way for the
Accounting Standards to stop Fraud.
Financial Statements are only a part of the information investors need to evaluate a
companys Past, Present and Future.
Excessive Leverage is usually a High-Risk Strategy. ~Lehman's demise is a case study in the
dangers of excessive leverage. Lehman's big push into the subprime mortgage market initially
provided stellar returns, as it reported record profits every year from 2005 to 2007. But by
2007. Its leverage was reaching dangerously high levels. In that year, Lehman was the leading
underwriter of mortgage-backed securities on Wall Street, accumulating an $85 billion
portfolio. The ratio of total assets to shareholders equity was 31 in 2007, which meant that
each dollar of assets on its balance sheet was backed by only three cents in equity.
For Financial Institutions Adequate Liquidity is A Must (Case of Washington Mutual- Run on The
Bank).The credit markets were virtually frozen at that time following the bankruptcy of
Lehman Brothers, and the near-collapse of AIG, Fannie Mae and Freddie Mac. Massive Deposit
Outflows- Often cash is a drag in a bull market, but cash is king when times are tough.

Therefore, it makes sense to have adequate liquidity at all times, in order to meet
contingencies and unexpected expenses.
With former WorldCom CEO Bernard Ebbers serving a 25-year jail sentence for fraud and
conspiracy as a result of the company's fraudulent accounting and financial reporting, the
lesson here is that fraud never pays. WorldCom was by no means the only company to indulge
in accounting fraud other perpetrators to be caught in 2002 alone included Tyco, Enron and
Adelphia Communications. There have also been numerous other forms of corporate fraud in
recent years, from multi-billion Ponzi schemes run by Bernie Madoff and Allen Stanford to
insider trading and options-backdating scandals. Many of the executives who were involved in
these frauds ended up serving time in jail and/or paying very stiff fines.
Key Lesson for Investors from the Enron Bankruptcy-..If you can't understand it, don't invest in
it Warren Buffets maxim is, "Never invest in a business you cannot understand. Enron
succeeded in deceiving the "smart money," such as pension funds and other institutional
investors for years, through Lack of Transparency, and Accounting Gimmickry.

6. List the SEBI mandate regarding the Audit Committee and its Role, and the

criteria to be independent director.

Ans. SEBI mandate regarding the Audit Committee and its Role
A Sub-Committee of Board of Directors of the Company constituted under provisions of Listing
agreement and Companies Act, 2013
Members should be Financially Literate
Chairman of Audit Committee to be Independent
Company Secretary to be the Secretary to the Committee
Audit Committee Meeting Frequency: Four Times a Year with Maximum Gap of 4 months
Role

Overview Financials Statements Quarterly and Annual

Review performance of the company
Appoint & re-appoint Statutory and Internal Auditors
Approval of appointment of CFO

Criteria to be independent director.

No pecuniary material relationship with Company, Promoters, Directors, Senior Management,

Holding, subsidiary or associate Company

Is not a relative of any of the Directors

Is/was not an employee of the company or was partner of audit firm or legal firm which has
pecuniary interest in the past 3 years

Is not a substantial shareholder, i.e. not more than 2% shareholding

Is at least 21 years old

Strength of Board of Directors
If Chairman is Non - Executive Director, then 1/3 of Directors should be Independent Directors.
If Chairman is Executive Director, then the Directors should be Independent Directors.
If Chairman is Non - Executive promoter Director, then also the Directors of the Board should be
Independent Directors
Board of Directors
Board Meeting Frequency:
Four times a year
Maximum gap of Four Months only

 No. of Directorships/Chairmanships:
Member of not more than 10 Committees and cannot be Chairman of more than 5 committees
Code of Conduct:
Board shall draft a Code of Conduct and shall be applicable to all Board Members and Senior
Management
It shall be posted on the Website of the Company
7. What are the main problems that may arise in a principal-agent relationship
and how might these be dealt with.
Ans. MAIN PROBLEMS:
The principal agent problem arises when one party (agent) agrees to work in favor of another party
(principal) in return for some incentives. Such an agreement may incur huge costs for the agent,
thereby leading to the problems of moral hazard and conflict of interest.
Moral Hazard occurs when the agent acts on behalf of the principal, and is supposed to meet the
principals goals. The objectives of the agent and principal however are different. The principal
cannot easily determine whether the agents actions are actually self-interested misbehavior or not.
Thus moral hazard characterizes many principle-agent situations.
Conflict of interest occurs when costs incurred by agent start rising and agent presumes it will be an
unprofitable relationship for him. Owing to the costs incurred, the agent might begin to pursue his
own agenda and ignore the best interest of the principal, thereby causing the principal agent
problem to occur.
DEALING WITH THE PROBLEMS:
There are 3 contractual forms to solve the agent-principal problem:
1. Incentive
2. Monitoring
3. Co-operative
1. INCENTIVE: As agents effort is not public information and it is costly and difficult to monitor
actual effort of each salesperson. The best solution is payment based on the outcome determined
by certain conditions as follows:
i. When the agent is risk neutral the optimal contract is one in which the agent bears all risks,
making a fixed payment to principal.
ii. When the agent is risk averse and effort averse, the second best solution is efficient-risk
sharing. It forces the agent to bear some risk and his payment depends, to some extent, on
the risky outcome.
2. MONITORING: Since the source of principal-agent problem is information asymmetry, a natural
remedy is to invest resources into monitoring of actions. Monitoring leads to complicated
hierarchical and bureaucratic organizational culture. Monitoring creates additional authority that
eventually leads to complicated bureaucracy system bound with mutual rules. This system is
inefficient to react quickly to changes in its operating environment.
3. CO-OPERATIVE: This is possible only when there are potential synergies for working in a team.
Team members must either be acquired at low cost (to the organization), the relevant specific
knowledge for making good decisions. The organization must be able to control the free-rider
problems of teams at a relatively low cost. The team payments must be done based on:
a. Profit sharing
b. Forcing contract
c. efficiency wages
8. What functions does a board perform and how does this contribute to the

corporate governance of the company?

Ans.
The board should exercise compelling and relentless leadership and should not
underestimate the power of leading by example - evidenced by high levels of visibility
and integrity, strong communications, and demanding expectations. This leadership
should be clear to ALL within the organization, as well as shareholders and other
stakeholders
Boardroom Behaviours
A report prepared for Sir David Walker
by the Institute of Chartered Secretaries and Administrators , UK
June 2009

Much of the research on boards ultimately touches on the question what is the role of the board?
Possible answers range from boards being simply legal necessities, to their playing an active part in
the overall management and control of the corporation.

Role Of the Board from a financial perspective:

Duty to maintain proper accounting records
Periodic reporting of financial position, performance
Establishing, monitoring proper internal controls
Ensuring proper external controls and audit
Skills, knowledge required by directors
Director Responsibilities:
The basic responsibility of the Directors is to exercise their business judgment to act in what they
reasonably believe to be in the best interests of the Company and its shareowners. In discharging
that obligation, directors should be entitled to rely on the honesty and integrity of the Companys
senior executives and its outside advisors and auditors. In furtherance of its responsibilities, the
Board of Directors will:
1. Review, evaluate and approve, on a regular basis, long-range plans for the Company.
2. Review, evaluate and approve the Companys budget and forecasts.
3. Review, evaluate and approve major resource allocations and capital investments.
4. Review the financial and operating results of the Company.
5. Review, evaluate and approve the overall corporate organizational structure, the assignment of
senior management responsibilities and plans for senior management development and
succession.
6. Review, evaluate and approve compensation strategy as it relates to senior management of the
Company.
7. Adopt, implement and monitor compliance with the Companys Code of Conduct.
8. Review periodically the Companys corporate objectives and policies relating to social
responsibility.

9. Review and assess the effectiveness of the Companys policies and practices with respect to risk
assessment and risk management.
9. Describe the elements of Good Board Practices and Procedures.
10. In what ways might Stakeholders' conflict with each other?
11. What corporate governance mechanisms might help with representing the views of stakeholder/
12. Why has the influence of institutional investors grown so much in recent years?
13. What are the SEBI Act 49 requirements in respect of 'Subsidiary Companies',

'CEO Certification and Report on Corporate Governance', and 'Disclosures'?

Ans. (Extract from Session 6 PPT)

Subsidiary
Two classes
i) A Material Subsidiary - if any of the following conditions are satisfied
In which the current/proposed Investment of the Company exceeds 20% of its consolidated
net worth as per the last audited balance sheet; or
Which have generated at least 20% of the consolidated income of the Company during the
previous financial year
ii) A Material Non-Listed Indian Subsidiary : A Material Subsidiary which is incorporated in
India and is not listed on the Indian Stock Exchanges
At least one independent director of Holding company to be in subsidiary company
The Audit Committee of the Holding Company must examine the financial statements of the
unlisted subsidiary Company, in particular, the investments made by the latter
The Minutes of the Board Meetings of the Unlisted Subsidiary Companies shall be placed
before the Board of the Listed Holding Company
The management must place before the Board of Holding Company a report of all Significant
Transactions and Arrangements entered into by the unlisted subsidiary company
(Significant transaction or arrangement means any individual transaction/arrangement that
exceeds or is likely to exceed 10% of the total revenues/expenses/assets/liabilities, as the
case may be, of the material unlisted subsidiary for the immediately preceding accounting
year.)
Disclosures
The philosophy of disclosure in the securities markets is premised on the idea that
securities represent a bundle of rights that are not visible to a potential buyer of securities
and that
The buyer must know the nature of the bundle of rights before investing.
Disclosure also reduces the possibility of wrongdoing
Even if a disclosure is not read by anyone, the fact that something needs to be disclosed
provides a good prophylactic against wrongdoing
The idiom that sunlight is the best disinfectant succinctly describes a whole philosophy in the
securities market
Basis of Related Party Transactions
Definition of Related Party Transactions - A business deal or arrangement between
two parties who are joined by a special relationship prior to the deal.
For example, a business transaction between a major shareholder and the corporation, such as a
contract for the shareholder's company to perform renovations to the corporation's offices, would be
deemed a related-party transaction.
Disclosure of Accounting Treatment
Board Disclosure Risk Management
Proceeds from Public, Rights, Preferential Issues
Remuneration of Directors
Management
Shareholder
CEO/CFO Certification
CEO- Managing Director and CFO Director/ Head Finance shall submit a certificate to the Board on:
Reviewed financials statement and it contains no untrue or misleading statements
Financial Statements present true and fair view

They accept responsibility for establishing and maintaining Internal control for financial report
and rectifying deficiencies, if any.
14. What are the mandatory requirements relating to the minimum information

that must be made available to the Board of Governors in accordance with the
provisions of clause 49A of the SEBI Act (2003)?

1. Annual operating plans and budgets and any updates.

2. Capital budgets and any updates.

3. Quarterly results for the company and its operating divisions or business segments.
4. Minutes of meetings of audit committee and other committees of the board.
5. The information on recruitment and remuneration of senior officers just below the board level,
including appointment or removal of Chief Financial Officer and the Company Secretary.
6. Show cause, demand, prosecution notices and penalty notices which are materially important
7. Fatal or serious accidents, dangerous occurrences, any material effluent or pollution problems.
8. Any material default in financial obligations to and by the company, or substantial non-payment
for goods sold by the company.
9. Any issue, which involves possible public or product liability claims of substantial nature,
including any judgment or order which, may have passed structure on the conduct of the
company or taken an adverse view regarding another enterprise that can have negative
implications on the company.
10. Details of any joint venture or collaboration agreement.
11. Transactions that involve substantial payment towards goodwill, brand equity, or intellectual
property.
12. Significant labour problems and their proposed solutions. Any significant development in Human
Resources/
Industrial Relations front like signing of wage agreement, implementation of Voluntary
Retirement Scheme etc.
13. Sale of material nature, of investments, subsidiaries, assets, which is not in normal course of
business.
14. Quarterly details of foreign exchange exposures and the steps taken by management to limit the
risks of adverse exchange rate movement, if material.
15. Non-compliance of any regulatory, statutory or listing requirements and shareholders service
such as non- payment of dividend, delay in share transfer etc.
16. The law does not require any agenda for meetings of the Board [Abnash Kaur v. Lord Krishan
Sugar Mills Ltd. (1974) 44 Com Cases 390, 413 (Del)].
17. Board of directors can transact business even without a formal agenda [Sunil Dev v. Delhi &
District Cricket Association, (1994) 80 Com Cases 174 (Del)].
18. It is not necessary that an agenda for directors meeting should be specified [Maharashtra Power
Development Corpn Ltd. v. Dabhol Power Co., (2004) 120 Com Cases 560 (Bom)].

15. What are the main developments in Corporate Governance Codes?

The First Phase of Indias Corporate Governance Reforms: 1996-2008 Indias corporate governance
reform efforts were initiated by corporate industry groups, many of which were instrumental in
advocating for and drafting corporate governance guidelines. Following vigorous advocacy by
industry groups, SEBI proceeded to adopt considerable corporate governance reforms. The first
phase of Indias corporate governance reforms were aimed at making boards and audit committees
more independent, powerful and focused monitors of management as well as aiding shareholders,
including institutional and foreign investors, in monitoring management.9 These reform efforts were
channeled through a number of different paths with both SEBI and the MCA playing important roles.
SEBI-appointed committees and the adoption of Clause 49 Shortly after introduction of the CII Code,
SEBI appointed the Committee on Corporate Governance (the Birla Committee). In 1999, the Birla
Committee submitted a report to SEBI to promote and raise the standard of Corporate Governance
for listed companies.12 The Birla Committees recommendations were primarily focused on two
fundamental goalsimproving the function and structure of company boards and increasing
disclosure to shareholders. With respect to company boards, the committee made specific
recommendations regarding board representation and independence that have persisted to date in
Clause 49.13 The committee also recognized the importance of audit committees and made many
specific recommendations regarding the function and constitution of board audit committees.
The Second Phase of Reform: Corporate Governance: After Satyam Indias corporate community
experienced a significant shock in January 2009 with damaging revelations about board failure and
colossal fraud in the financials of Satyam. The Satyam scandal also served as a catalyst for the
Indian government to rethink the corporate governance, disclosure, accountability and enforcement
mechanisms in place.
MCA actions Inspired by industry recommendations, including the influential CII recommendations, in
late 2009 the MCA released a set of voluntary guidelines for corporate governance. The Voluntary
Guidelines address a myriad of corporate governance matters including:
independence of the boards of directors;
responsibilities of the board, the audit committee, auditors, secretarial audits; and
mechanisms to encourage and protect whistleblowing.
Important provisions include:
i.
Issuance of a formal appointment letter to directors.
ii.
Separation of the office of chairman and the CEO.
iii.
Institution of a nomination committee for selection of directors.
iv.
Limiting the number of companies in which an individual can become a director.
v.
Tenure and remuneration of directors.
vi.
Training of directors.
vii.
Performance evaluation of directors.
viii.
Additional provisions for statutory auditors.
SEBI actions In September 2009 the SEBI Committee on Disclosure and Accounting Standards issued
a discussion paper that considered proposals for:
appointment of the chief financial officer (CFO) by the audit committee after assessing the
qualifications, experience and background of the candidate;

 rotation of audit partners every five years;

voluntary adoption of International Financial Reporting Standards (IFRS);
interim disclosure of balance sheets (audited figures of major heads) on a half-yearly basis
16. What are the main sub-committees of the board and what role does each of these subcommittees play?
17. Describe Salient Features of Anglo-American-, German-, Japanese-, and Indian

Corporate Governance Models

Ans. Anglo American Model

This model is also called an Anglo-Saxon model and is used as basis of corporate governance
in U.S.A, U.K, Canada, Australia, and some common wealth countries
The shareholders appoint directors who in turn appoint the managers to manage the business
Thus there is separation of ownership and control
The board usually consist of executive directors and few independent directors
The board often has limited ownership stakes in the company
Moreover, a single individual holds both the position of CEO and chairman of the board
The Anglo-American Model relies on effective communication between shareholders, board and
management with all important decisions taken after getting approval of shareholders (by
voting)
GERMAN Model
This is also called as 2 tier board model as there are 2 boards viz.
The supervisory board and the management board.
It is used in countries like Germany, Holland, France, etc.
Usually a large majority of shareholders are banks and financial institutions
The shareholder can appoint only 50% of members to constitute the supervisory board
The rest is appointed by employees and labor unions
Japanese Model
This model is also called as the business network model, usually shareholders are
banks/financial institutions, large family shareholders, corporate with cross-shareholding
There is supervisory board which is made up of board of directors and a president, who are
jointly appointed by shareholder and banks/financial institutions.
This is rejection of the Japanese keiretsu- a form of cultural relationship among family
controlled corporate and groups of complex interlocking business relationship, where cross
shareholding is common most of the directors are heads of different divisions of the company.
Outside director or independent directors are rarely found of the board
Indian Model
The model of corporate governances found in India is a mix of the Anglo-American and
German models.
This is because in India, there are three types of Corporation viz. private companies, public
companies and public sectors undertakings (which includes statutory companies, government
companies, banks and other kinds of financial institutions).
Each of this corporation have a distinct pattern of shareholding.
For e.g. in case of companies, the promoter and his family have almost complete control over
the company. They depend less on outside equity capital. Hence in private companies the
German model of corporate governance is followed.
18. What would Good Corporate Governance entail, and what would it achieve?
19. How are different theories of corporate governance more appropriate to

different types of ownership structures?

Stewardship theory :
It sees a strong relationship between managers and the success of the firm, and therefore the
stewards protect and maximise shareholder wealth through firm performance. A steward who
improves performance successfully, satisfies most stakeholder groups in an organization, when
these groups have interests that are well served by increasing organisational wealth (Davis,
Schoorman & Donaldson 1997). When the position of the CEO and Chairman is held by a single
person, the fate of the organization and the power to determine strategy is the responsibility of a
single person. Thus the focus of stewardship theory is on structures that facilitate and empower

rather than monitor and control (Davis, Schoorman & Donaldson 1997). Therefore stewardship
theory takes a more relaxed view of the separation of the role of chairman and CEO, and supports
appointment of a single person for the position of chairman and CEO and a majority of specialist
executive directors rather than non-executive directors (Clarke 2004).
Social Contract Theory:
It sees society as a series of social contracts between members of society and society itself (Gray,
Owen & Adams 1996). There is a school of thought which sees social responsibility as a contractual
obligation the firm owes to society (Donaldson 1983). An integrated social contract theory was
developed by Donaldson and Dunfee (1999) as a way for managers make ethical decision making,
which refers to macrosocial and microsocial contracts. The former refers to the communities and the
expectation from the business to provide support to the local community, and the latter refers to a
specific form of involvement.
Legitimacy Theory:
Traditionally profit maximization was viewed as a measure of corporate performance. But
according to the legitimacy theory, profit is viewed as an all inclusive measure of organizational
legitimacy (Ramanathan 1976). The emphasis of legitimacy theory is that an organization must
consider the rights of the public at large, not merely the rights of the investors. Failure to comply
with societal expectations may result in sanctions being imposed in the form of restrictions on the
firm's operations, resources and demand for its products. Much empirical research has used
legitimacy theory to study social and environmental reporting, and proposes a relationship
between corporate disclosures and community expectations (Deegan 2004).
Political Theory:
Political theory brings the approach of developing voting support from shareholders, rather by
purchasing voting power. Hence having a political influence in corporate governance may direct
corporate governance within the organization. Public interest is much reserved as the government
participates in corporate decision making, taking into consideration cultural challenges (Pound,
1983). The political model highlights the allocation of corporate power, profits and privileges are
determined via the governments favor.
Resource Dependency Theory:
According to the resource dependency rule, the directors bring resources such as information, skills,
key constituents (suppliers, buyers, public policy decision makers, social groups) and legitimacy that
will reduce uncertainty (Gales & Kesner, 1994). Thus, Hillman et al. (2000) consider the potential
results of connecting the firm with external environmental factors and reducing uncertainty is
decrease the transaction cost associated with external association. This theory supports the
appointment of directors to multiple boards because of their opportunities to gather information and
network in various ways.
Stakeholder Theory:
With an original view of the firm the shareholder is the only one recognized by business law in most
countries because they are the owners of the companies. In view of this, the firm has a fiduciary
duty to maximize their returns and put their needs first. In more recent business models, the
institution converts the inputs of investors, employees, and suppliers into forms that are saleable to
customers, hence returns back to its shareholders. This model addresses the needs of investors,
employers, suppliers and customers. Pertaining to the scenario above, stakeholder theory argues
that the parties involved should include governmental bodies, political groups, trade associations,
trade unions, communities, associated corporations, prospective employees and the general public.
In some scenarios competitors and prospective clients can be regarded as stakeholders to help
improve business efficiency in the market place.
Agency theory:
The agency model assumes that individuals have access to complete information and investors
possess significant knowledge of whether or not governance activities conform to their preferences
and the board has knowledge of investors preferences (Smallman, 2004). Therefore according to the
view of the agency theorists, an efficient market is considered a solution to mitigate the agency
problem, which includes an efficient market for corporate control, management labour and corporate
information (Clarke, 2004). According to Johanson and Ostergen (2010) even though agency theory
provides a valuable insight into corporate governance, its applies to countries in the Anglo-Saxon
model of governance as in Malaysia.

20. Describe

briefly
Governance.

the

Agency

and

Stewardship

theories

of

Corporate

AGENCY THEORY
Agency theory relative to corporate governance assumes a two-tier form of firm control:
managers and owners. Agency theory holds that there will be some friction and mistrust
between these two groups. The basic structure of the corporation, therefore, is the web of
contractual relations among different interest groups with a stake in the company.
Features
In general, there are three sets of interest groups within the firm. Managers, stockholders and
creditors (such as banks). Stockholders often have conflicts with both banks and managers,
since their general priorities are different. Managers seek quick profits that increase their own
wealth, power and reputation, while shareholders are more interested in slow and steady growth
over time.
Function
The purpose of agency theory is to identify points of conflict among corporate interest groups.
Banks want to reduce risk while shareholders want to reasonably maximize profits. Managers are
even more risky with profit maximization, since their own careers are based on the ability to turn
profits to then show the board. The fact that modern corporations are based on these relations
creates costs in that each group is trying to control the others.
Costs
One of the major insights of agency theory is the concept of costs of maintaining the division of
labor among credit holders, shareholders and managers. Managers have the advantage of
information, since they know the firm close up. They can use this to enhance their own
reputations at the expense of shareholders. Limiting the control of managers itself contains costs
(such as reduced profits), while profit seeking in risky ventures might alienate banks and other
financial institutions. Monitoring and limiting managers itself contains sometimes substantial
costs to the firm.
Significance
The agency model of corporate governance holds that firms are basically units of conflict rather
than unitary, profit-seeking machines. This conflict is not aberrant but built directly into the
structure of modern corporations.
Effects
It is possible, if one accepts the premises of agency theory, that corporations are actually groups
of connected fiefs. Each fief has its own specific interest and culture and views the purpose of
the firm differently. In analyzing the function of a corporation, one can assume that managers
will behave in a way to maximize their own profit and reputation, even at the expense of
shareholders. One might even understand the manager's role as one of institutionalized
deceit, where the asymmetry of knowledge permits managers to operate with almost total
independence.
Stewardship Theory
Stewardship theory, however, rejects self-interest.
Motivation
For stewardship theory, managers seek other ends besides financial ones. These include a sense
of worth, altruism, a good reputation, a job well done, a feeling of satisfaction and a sense of
purpose. The stewardship theory holds that managers inherently seek to do a good job,
maximize company profits and bring good returns to stockholders. They do not necessarily do
this for their own financial interest, but because they feel a strong duty to the firm.
The stewardship theory holds that managers inherently seek to do a good job.

Identification
stewardship theory holds that individuals in management positions do not primarily consider
themselves as isolated individuals. Instead, they consider themselves part of the firm. Managers,

according to stewardship theory, merge their ego and sense of worth with the reputation of the
firm.
Policies
If a firm adopts a stewardship mode of governance, certain policies naturally follow. Firms will
spell out in detail the roles and expectations of managers. These expectations will be highly
goal-oriented and designed to evoke the manager's sense of ability and worth. Stewardship
theory advocates managers who are free to pursue their own goals. It naturally follows from this
that managers are naturally "company men" who will put the firm ahead of their own ends.
Freedom will be used for the good of the firm.
Consequences
The consequences of stewardship theory revolve around the sense that the individualistic
agency theory is overdrawn. Trust, all other things being equal, is justified between managers
and board members. In situations where the CEO is not the chairman of the board, the board can
rest assured that a long-term CEO will seek primarily to be a good manager, not a rich man.
Alternatively, having a CEO who is also chairman is not a problem, since there is no good reason
that he will use that position to enrich himself at the expense of the firm. Put differently,
stewardship theory holds that managers do want to be richly rewarded for their efforts, but that
no manager wants this to be at the expense of the firm.