MODELS & THEORIES OF

CORPORATE GOVERNANCE
Course Instructor: Prof. V. Shyam Kishore
VIT School of Law, VIT University, Chennai.
MODELS OF CORPORATE GOVERNANCE:

• Primarily two models – insider and outsider models based on the difference
in structure of ownership and control.

The Outsider (US/UK Model):

• Characterised by a clear separation of management control and shareholder
ownership.

Prof. V. Shyam Kishore VIT School of Law

 Board of Directors
Appoints
Executive Directors
including CEO

Manage Monitors
Shareholders

Company

Owns

Prof. V. Shyam Kishore VIT School of Law

STRUCTURE:
• Three organs – shareholders, board of directors and management.
DIRECTORS:
• Elected by shareholders
• There is a chairman (if he is also a CEO and otherwise)
• Functions are dual in nature: managerial and monitoring.
• Conflict hence NEDs
• Owe a duty of care to the company, but usually protected like BJ rule.

Prof. V. Shyam Kishore VIT School of Law

SHAREHOLDERS:
• Widely diffused and institutional shareholders.
• Focus is on short-term gains as opposed to long-term value of the
company
• Individual shareholders also look at it as an investment vehicle rather
than as an ownership stake. Hence spread risk across diverse holdings.
• Therefore lack incentive to monitor the company also due to free-rider
problem. Hence ‘vote by their feet’ or ‘wall street walk’.
Basis is the market for corporate control.
Prof. V. Shyam Kishore VIT School of Law
WEAKNESS:
• Board culture is one of passivity. Directors don’t have expertise
or time. Even IDs are CEOs in their own Cos. Hence monitoring
not independent.
• Theory of Market for Corporate Control not accurate.
• Securities market does not truly reflect the long term value of the
company. The focus is misplaced.

Prof. V. Shyam Kishore VIT School of Law

INSIDER MODEL – GERMAN MODEL:

• Two types of firms that can issue shares:

• AG – stock corpn.
• KgaA – a partnership limited by shares.
• Only these can be listed

Prof. V. Shyam Kishore VIT School of Law

 Appoints ½
Supervisory Board Employees

Appoints
& Reports Appoints ½
Monitors

Management Board Shareholders

Manages Owns
Company

Prof. V. Shyam Kishore VIT School of Law

STRUCTURE:
• Must have a Supervisory Board (SB) comprising representatives of shareholders and
employees
• Small Cos, employees 1/3rd if more than 2000, then ½.
• Shareholders representatives elected for 5 years at general meetings.
• Employees representatives elected by employees but can be dismissed by 75% majority
vote in shareholders general meeting.
• Chairman will have to be a shareholders’ representative. Has a casting vote.
• SB appoint the members of the management board (MB)

Prof. V. Shyam Kishore VIT School of Law

FEATURES:
• Most German shares are unregistered bearer shares hence deposited with
banks with a proxy rights given to them for typically 15 months.
• Banks intimate to the shareholders as to how they intend to vote and do so
unless shareholder requests otherwise.
• Shareholders are passive thus banks become powerful.
• Hence they are elected to SB and often chair.
• Large cross-holdings. Three of the major banks hold shares of a majority of
the Cos.

Prof. V. Shyam Kishore VIT School of Law

STRENGTHS:

• Consensus based system – rarely proxy fights – no hostile

takeovers

• Helps nurture a firm hence BMW, Thyssen-Krupp, Daimler-

Chrysler etc…

Prof. V. Shyam Kishore VIT School of Law

WEAKNESS:
• Presence of SB does not necessarily indicate effective monitoring.
• Members not integrated with the strategic planning hence find it difficult to
decide on issues and therefore decide to go with the recommendations of the MB.
• Hence SB cannot pretend to perform the role of NEDs or IDs in the outsider
model.
• Common for SB members to serve on boards of competing Cos. Thus creating a
conflicts of interests.
• Practice of elevating past CEOs to SB also not healthy.

Prof. V. Shyam Kishore VIT School of Law

INSIDER MODEL – JAPANESE MODEL:

• The concept of main bank. Help Cos by being their principal

shareholder and lender.
• Expected to play a lead role in distress as well.
• Monitoring in three stages: ex ante, interim and ex post

Prof. V. Shyam Kishore VIT School of Law

 Appoint
Board of Directors
Shareholders
Executive Directors
including CEOs

Manage Monitor

Main Bank

Owns
Company

Loans

Prof. V. Shyam Kishore VIT School of Law

STRENGTHS:
• Had the strong support of the govt. Bodies like the finance ministry and the bank of japan
• Cross-shareholdings and thus a weak market for corporate control gives security for Cos to grow
and also for managers’ tenure.
WEAKNESS:
• Cross-shareholdings also leads to insulation from external interference but at the cost of profit
and productivity.
• Banks are powerful not truly representing the other shareholders.
• Disregard for shareholder value – often dividends small. Excessive cash retained by the company.
• Appoint themselves to the board – large – avg members 30.6

Prof. V. Shyam Kishore VIT School of Law

 Indian System?

Prof. V. Shyam Kishore VIT School of Law

THEORIES OF CORPORATE GOVERNANCE
The general necessity is we need a high performing board that
can create a high performance business.
But what is the role of the Board?
What is high performance?
Different companies have different ideas about these
questions.

Prof. V. Shyam Kishore VIT School of Law

The narrow investor driven view: Board’s work driven by
shareholder’s demand for good financial performance and compliance
with governance codes.

The broader strategy driven view: Board’s primary role is in terms of

setting long term objectives of the company and monitoring of
executive performance through a wide range of metrics in relation to
these.

Prof. V. Shyam Kishore VIT School of Law

AGENCY THEORY
Debate about CG traced back to 1930s Bearle and Means – “The
Modern Corporation and Private Property”.

With the separation of ownership and control and the wide

dispersion of ownership, there was effectively no check upon the
executive autonomy of corporate managers.

Prof. V. Shyam Kishore VIT School of Law

The theory seeks to address the question as to how the shareholders
(the principal) of a company can assure themselves that once they
invest their funds, the management (the agents) will act in a manner
that protects the former’s interest.

The root assumption is that the agent is likely to be self-interested and

opportunistic.

Prof. V. Shyam Kishore VIT School of Law

To counter this principal will have to incur agency costs – costs that
arise from the necessity to align the interests of the executives with
those of the shareholders and from putting in mechanisms for
monitoring executive conduct.

Self-interested and opportunistic behaviour is assumed hence the object

was how to make executive self-interest serve shareholder interest.

Prof. V. Shyam Kishore VIT School of Law

External Mechanism:
• Market for corporate control
• Managerial labour market
• External monitoring – by shareholders in AGMs (direct) and other
intermediaries (indirect).
Internal Mechanism:
• Board reforms
• Board constitution – NEDs and IDs
• ESOPS, and other performance based incentives etc…

Prof. V. Shyam Kishore VIT School of Law

STEWARDSHIP THEORY:
Built on the premise that “a steward protects and maximises
shareholders wealth through firm performance, because by so doing,
the steward’s utility functions are maximised”.
Presupposes that left on their own, the managers will act as
responsible stewards of the assets they control.
Suggests that stewards are satisfied and motivated when organizational
success is attained!

Prof. V. Shyam Kishore VIT School of Law

In order to protect their reputations as decision makers in
organizations, executives and directors are inclined to operate the firm
to maximize financial performance as well as shareholders’ profits.
Negative investor assumption may inadvertently distort or weaken the
leadership of the company and hence questions the pessimistic
assumptions of the Agency Theory!!!
Control thus will be counter-productive because it undermines the pro-
organisational behaviour of the steward by lowering his / her
motivation.

Prof. V. Shyam Kishore VIT School of Law

STAKEHOLDER THEORY:
Stakeholder Theory challenges agency assumptions about the primacy
of shareholder interests. Instead it argues that a company should be
managed in the interests of all its stakeholders.
Unlike agency theory in which the managers are working and serving
for the shareholders, stakeholder theorists suggest that managers in
organizations have a network of relationships to serve – this include
the suppliers, employees and business partners.

Prof. V. Shyam Kishore VIT School of Law

Hard to operationalise – if executives are to be answerable to all the
stakeholders they would in effect be answerable to none.

However the key contribution – profusion of interests in business

ethics. CSR, and highlighting of issues like use of child labour,
environmental damage, corruption etc…

Prof. V. Shyam Kishore VIT School of Law

RESOURCE DEPENDENCE THEORY:
Resource Dependency Theory concentrates on the role of board
directors in providing access to resources needed by the firm.
Resource Dependency theorists provide focus on the appointment of
representatives of independent organizations as a means for gaining
access in resources critical to firm success.
Seeing the board as a source of resources opens up a very different way
to think about the board’s role in creating high performance.

Prof. V. Shyam Kishore VIT School of Law

Various types of resources:
Start ups – cheap source of part-time legal, financial or operational
management skills.
Mid-level: not only a source of expertise but networks that gives access
to new markets and finance.
Established businesses: source of market and managerial experience
and hence board composition is looked from the perspective of board
experience than formal independence.

Prof. V. Shyam Kishore VIT School of Law

Thus while Agency theory emphasises the policing role of NEDs for
the investors, the Resource Dependency theory views NEDs as a
context specific resource to support performance.

Prof. V. Shyam Kishore VIT School of Law

SOCIOLOGICAL THEORY:
Focus on composition of the board, transparency of the financial
reporting, disclosure and auditing are considered central to realizing
the socio-economic objectives.
Strengths / weaknesses:
• Based on fair distribution of wealth in society
• The challenge is that the board should not have absolute powers
• Government control, interference may increase leading to constraints
and red tape

Prof. V. Shyam Kishore VIT School of Law