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CORPORATE GOVERNANCE AND FIRM PERFORMANCE: AN EMPIRICAL INVESTIGATION
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CORPORATE
GOVERNANCE AND FIRM PERFORMANCE: AN EMPIRICAL INVESTIGATION
Authored By - KARUN ROY,
R GOWRI
PARVATHY
&
NANDHANA MADHU
ABSTRACT
Reducing agency costs is the
principal problem of corporate governance. Although the scope and stringency of
the laws and rules on eliminating agency costs are expanding, there is still
need for the understanding of the supervision and enforcement of these rules.
Enforcement can take the forms of public and/or private. With dispersed and
concentrated ownership patterns, the relevance of public and private
enforcement mechanism may differ; due to the appearance of agency problems
unlikely.
The purpose of this paper is
to provide a conceptual analysis on corporate governance strategies involving
the exercise of control rights, the appointment of independent directors,
auditing, and disclosure. This paper will also include a guideline on the enforcement
mechanism in Turkey and the ways in which they are used to control the agency
problems; between owners and managers, controlling shareholders and
non-controlling shareholders or creditors.
1. Introduction
Although
corporate governance has received worldwide recognition and acceptance, there
is no single code suitable for different organizational structures and thus,
every jurisdiction introduces their national corporate governance rules mostly
founded on comply or explain approach. Based on the principle of comply or
explain, disclosure to the market regarding adherence to the code is required
(OECD, 2017; 22). Governmental authorities, stock exchanges, and private sector
or stakeholder groups share the responsibility of disclosing the adoption of
such codes. In many jurisdictions corporate governance standards are also
included in company and securities law. Therefore, the implementation and
enforcement of these rules vary among countries. National public regulators in
each jurisdiction have the authority to supervise and enforce the corporate
governance practices of public companies. In Turkey the Capital Markets Board
of Turkey; the SPK, is the main public regulator responsible for enforcing the
corporate governance framework for listed companies.
The
aim of this paper is to understand the role of the legal order in India, in
particular to the legal rules and regulations and corporate governance
strategies established for eliminating agency costs. This paper also aims to
provide a conceptual framework of the enforcement of corporate governance
rules.
2. Setting the
Scene: Agency Theory and Corporate Governance
In
organizations where ownership and control is separated, owners delegate the
duty of operating the company to a professional manager. In other words, those
who manage the company and the company’s owners are different. The role of
managers is to direct the company in accordance to the specified objectives set
by its shareholders.
The first
type of agency problem, the so-called classic principal-agent problem, arises
between principals (shareholders) and agents (managers) resulting from the
opportunistic behaviour of managers (Berle and Means, 1932). The incentives of
managers to act opportunistically refer to self-interested behaviour that may
involve conducts such as misrepresentation for pursuing personal benefit or
using company assets for personal use (Solomon, 2004).
When the
ownership and control is separated, through a contract, the owner(s) delegate
decision-making to a professional agent that is manager/director. The contract
between the principal and the agent generally indicates that the agent shall
not engage any activities that may harm the principal, and how the agent will
compensate the principal in case of any harm occurs. This contractual
relationship involves various costs, including transaction costs and monitoring
costs (Jensen and Meckling, 1976; 306). With regard to transaction costs, first
of all, there is the cost of calculating how to deal with all the possible
scenarios that might occur throughout the contractual period. Second, there is
the cost of consultation with others when planning to solve these odds. Third,
in the case of a dispute, there is the cost of writing down the procedures in a
way that a third person (e.g., a court) can interpret (Hart, 1995).
In the
light of all these, the parties will not choose to write a detailed contract.
Instead, the contract will not be fully developed and will be written in
deficiency. In other words, there will be gaps and incomplete provisions in the
contract - in some cases there will be only part of the course to follow, and
even in some circumstances there will be no way to follow.
In any
event, where the contract is incomplete, and there is agency problem to occur,
corporate governance can be seen as a directive mechanism for situations not
explained in the contract. For instance, corporate governance mechanism
clarifies the distribution of rights to use the company’s assets. The use of
these rights in a single-person company will be directly owned by that person.
Or, in the event of partnership, decisions will be taken by majority vote on
who will access to assets. Companies may adopt these mechanisms within the
scope of corporate governance.
In almost
any contractual relationship where the agency relationship involved, the
information asymmetry in favour of agents is likely to occur. It is observed
that it is especially the small/minority shareholders who are subjected to
asymmetric information. As a result, it is possible that the agents (managers)
who have access to the information that the principals (owners) do not have,
can gain unfair benefits. This conflict between controlling shareholders and
non-controlling (minority) shareholders comprises the second type of agency
problem. Here the primary concern is the possible exploitation of the rights of
non-controlling shareholders by the majority in the firm. For instance, the
agency problem in Turkish companies often occurs as controlling shareholders? incentives
to exploit the rights of minority shareholders (Yurtoglu, 2000). The efforts of
the owners to reach full information via monitoring on the agent whether the
managers fulfil the terms of the contract is both costly and time consuming.
This refers to the cost of monitoring.
The third
agency problem involves the conflicts that may arise between the firm’s owners
and the other parties with whom the firm contracts, such as creditors,
employees and customers. Here the challenge lies in assuring the firm, as
agent, does not act opportunistically towards principals, such as expropriating
creditors, or exploiting employees, or misleading customers (Kraakman et al.,
2009).
In summary,
the agency problem involves both the costs incurred by the contractual
relationship between the owners and the managers, and the costs of the need to
monitor and control the managers due to the risk of agent’s incentives to
behave opportunistically. In each of three type of agency problems, the
fundamental issue is to eliminate the conflicts between the principal and the
agent, which can take difference forms in each case. Corporate governance can
play an important role in reducing agency costs and can be defined as the
system of directing and controlling the company and making management
accountable not only to shareholders but also to any other groups who have a
stake in the company, including creditors (OECD, 2015). In fact, corporate
governance is not only limited to governing of firms, but it can be adopted to
similar organizations where an agency relationship involves. In relation to the
governance of corporation, corporate governance deals with conflicts including
those between shareholders and top managers, and controlling shareholders and
minority shareholders or creditors.
This paper
will continue with presenting the conceptual framework of corporate governance
strategies in reducing agency costs. However, at first, it is necessary to
introduce the legal strategies set for the protection of principals. These can
be classified under two main categorizations: financial market and company law
regulations.
3. Legal
Strategies: Financial Market and Company Law Regulations
Corporate
governance is primarily related to the managers on behalf of the company itself
and its shareholders. Therefore, corporate governance, in general is a concern
of company law. In addition, when a company issues its securities in the
securities markets, investors and other third parties are also involved in this
setting. The relationship between investors and public company is regulated by
financial markets law.
3.1. Financial Market Regulations
Companies
operating in financial markets are obliged to follow certain governance rules.
In India, this is done in accordance with the Companies Act, 2013. The ultimate
objective of financial services regulation is to ensure that investor
protection is secured and market confidence is maintained with reduced
financial crime rates and other form of exploitation cases, such as insider
trading (Baron and Besanko; 1984; Gerner-Beuerle, 2009). The motivation of
financial markets regulation is usually justified to mitigate the aftermath of
the crises and to reassure confidence in the market (Jackman, 2004). It is also
beyond doubt that political intentions are involved in regulation e.g. to
strengthen the political position and/or power (Baldwin and Cave, 2012;
41).
3.2. Company Law
Regulations
The company
law regulations primarily aim to provide a company structure forming under a
legal entity so that the company can fulfil some of the basic functions under
this separate legal personality. Under the form of a company structure, first,
the shares of the company can be transferred. This will ensure that the
company’s activities will continue without interruption even if the
shareholders change. This also allows the shareholders to create a diversified
investment portfolio. Secondly, a delegated management elected and appointed by
the shareholders is formed under a board of directors (Kraakman et al., 2009).
Hence, the corporate structure formed by company law regulations serve to
facilitate a business environment that allows a more efficient operations of
business firms. In order to fulfil the efficiency objective, the other main
function of company law is to control conflict of interest among corporate
participants, including the three type of
agency problems? or „principal-agent? problems; (i) shareholders and
managers, (ii) controlling shareholders and non-controlling shareholders, and
(iii) shareholders/directors and creditors (See also section 2 above). For
example, company law regulations set mechanisms that impose constraints on
agent’s ability to exploit their principals, as well as on the ability of
controlling shareholders to exploit the rights of minority shareholders.
Similarly, in the case of agency problem between the company itself and the
creditors, the rules of law protect creditors from opportunistic behaviour of
firms.
It may be
concluded that regulatory strategies are used to constrain the agent’s
opportunistic behaviours in order to protect principals; e.g. shareholders,
minority shareholders, creditors, investors and alike. In this respect, under
regulatory rules agents are prohibited specific behaviour, such as making
decisions or undertaking any transactions what would not in the best interest
of the shareholders or the company itself. Regulatory rules depend on the
ability of regulatory body in determination of agent’s compliance with the
rules (Kraakman et al., 2009).
3. Corporate Governance Strategies and Methods of
Enforcement
As the
first part of this paper outlined, corporate governance can reduce agency
problems and the costs associated to them. The availability of good quality
regulations is important for good conduct of governance of corporations yet
more important is their compliance and enforcement. Easterbrook and Fischel
(1984; 678) described it smoothly as
“The world of inadequate enforcement, is
similar to the world of no enforcement.”
The
supervision and enforcement of corporate governance rules can take place
through public and private means (Jackson and Roe, 2009). Public enforcement
includes criminal and civil law suits brought by public authorities. In
addition to these, public enforcement also covers continuous monitoring of the
disclosed information by the securities authorities. For instance, the SPK as a
regulatory authority, has the ability to monitor compliance with the corporate
governance rules and also is able to impose sanctions for any violations. In
the form of private enforcement, a shareholder lawsuit may be taken to the
court. Although private enforcement mostly embraces civil lawsuits brought by
private parties, public actors may also be involved in these initiatives,
particularly in cases where state owns major shares in a public company.
The next
part will provide a conceptual analysis on the following corporate governance
strategies in reducing agency costs; namely, (i) control rights, (ii)
appointment of independent directors, (iii) auditing and (iv) disclosure. In
addition, enforcement methods for each of these strategies will be
outlined.
4.1. Control Rights and Enforcement
Control
rights (or managerial shareholder rights1) include the right to
participate in the general shareholder meeting, right to obtain information and
examination, right to request for a special audit, right to proceed, and right
to vote to select the board members. These rights require shareholders to
participate in decision-making process and to be included in identifying firm’s
strategies and objectives. As already explained, under the agency relationship,
shareholders delegate decision-making power to the board of directors. Giving
instructions regarding day-to-day management is the board of directors? duty.2
However, various measures may be taken against the possibility of loss or
damage created on the part of shareholders. The ultimate objective of these
measures is to strengthen the principals (primarily, the shareholders) against
opportunistic behaviour of agents. The enforcement of these measures can take
different forms.
a.
Shareholders’ right to call a general assembly meeting
The request
of the shareholder to call a general assembly meeting from the board of
directors is one of these measures.3 this course of action is
particularly important to non-controlling shareholders because it introduces
them an opportunity to determine the agenda of the meeting and make their
voices heard by the board members. In case the board of directors rejects the
request of the shareholders to call a meeting or do not respond within seven
days, the shareholders may apply to the court (TCC, art. 412/1). The court may
decide to call the general assembly to the meeting and may appoint a trustee to
organize the agenda.
b.
The principle of equal treatment of the shareholders
of the same type
The
principle of equality of corporate governance, stipulates that all shareholders
is treated in a fair manner and that all shareholders in the same conditions
are treated equally. This principle also refers to the equal treatment of the
shareholders of the same type. Accordingly, shares in any type of shares must
have the same rights and investors should be informed of the rights associated
with the shares before purchasing them (OECD, 2015; 20).
4.2. Appointment of Independent Directors
and Its Enforcement
In
principle, the governing bodies of a company (managers and executives) are
expected to serve in the best interest of the companies they manage. However,
in practice, in companies (mainly in group of companies) the governing bodies
are left in a situation where they have no choice but to follow the
instructions of a dominant group, namely family members holding the majority of
the capital. As a result, there is a risk of exploitation of small shareholders
in companies in which managerial decision process take into consideration the
interests of the dominant shareholders.
The
appointment of independent members in the board of directors is suggested in
order to protect small shareholders and set a monitoring system on the
managerial decision process. In this respect, it is suggested that the majority
of the board members must be compromised of non-executive members.
Non-executive members may consist of persons who do not have any administrative
duties in the company or they do not have a unit operating under their control
and they are not involved in the company’s ordinary and day-to-day business
activities. Within the non-executive members, there must also be independent
members capable of performing their duties in exclusive of any influence (SPK
Corporate Governance Principles, art. 4.3.6, 4.3.7, and 4.3.8).
The
functionality of the appointment of independent directors is questioned
especially in firms with a controlling shareholder where in the controlling
owner can both hire and fire board members (Berglöf and Claessens, 2006; 139).
Hence, enforcement plays an essential role in ensuring that this rule serves
its purpose.
4.3. Auditing and Its Enforcement
It is
evident from the notorious case of Enron in the U.S., financial reports were
used to mislead shareholders and investors (Coffee, 2002). The incentive of
Enron?s managers was to overstate the earnings to increase the share prices.
So, Enron represents a typical first type of agency problem (see section 2
above); where in the managers do not act in the best interest of the company.
The role of auditing here is to function as a monitoring mechanism over the
opportunistic behaviors of managers (Watts and Zimmerman, 1983).
On the
other hand, where the controlling shareholder have enough motivation and power
to monitor management, incentives to commit fraud take different forms. Here,
the controlling shareholder acts to extract private benefits through illegally
transferring assets to other corporations (i.e. tunneling) as experienced in
Imar Bank case in Turkey (Aktan et al., 2009). In such case, it is possible that
the exploitation remains undiscovered for a long term, depending on the
controlling shareholder?s power. Also, the risk of exploitation is both on part
of minority shareholders and creditors. The role of auditing with such
ownership patterns is to provide assurance on the accuracy of the company?s
financial statements. In these companies, auditing serves an important
governance function in such way that high-quality audits are used to convince
outside investors and that the ability to exploit is limited thus the company
could attract external finance (Jensen and Meckling, 1976; 323-325).
The role of
auditing as a governance strategy is in fact comparable to the role of
independent board members (see section 4.2 above). In both, the company relies
on the judgement of a non-interested party on the approval of some certain
transactions. In addition, auditors can be held liable, if found faulty, for
participation in corporate fraud, or for failure to disclose fraudulent conduct
(TCC, art. 554). In addition to civil liability, the SPK is authorized to issue
a number of sanctions on audit firms, for example administrative and judicial
fines, and cancellation of licenses for issuing false or misleading audit
reports with intention or without taking reasonable care (Kandemir, 2015;
726-732).
4.4. Disclosure and Its Enforcement
The other
corporate governance strategy in reducing agency costs is to provide a timely
and accurate disclosure mechanism that ensures transparency regarding the
corporation including the financial situation, performance, ownership, and
governance of the company (OCED, 2015; 41).
a. Disclosure of related-party-transactions
With
concentrated ownership structures, it is generally the case that controlling
shareholders pursue to increase their personal benefits through
related-partytransactions.6 This opportunism will likely to be
successful where the controlling shareholders have the power to influence or,
in most cases, to determine the outcome of a managerial decision. To overcome
this kind of opportunistic behaviors, it is suggested that a non-interested
party, who will not benefit from his/her decision, i.e. the independent board
members, to approve the related-party transactions.
The law in
Turkey requires the disclosure of related-party-transactions of public
companies. Accordingly, independent directors? approval is necessary for all
relatedparty transactions of public companies and if the independent members do
not approve the transaction, this shall be publicly disclosed and shall be
submitted to the general assembly for approval (SPK Corporate Governance
Principles, art. 4.4.7). By disclosing the related party transactions, it is
aimed to ensure that minority shareholders and other investors are informed in
advance of potential conflicts of interests generated by such transactions.
This disclosure may also discourage the controlling shareholder from tunneling
the company assets to other sources (Schouten, 2009; 23) since the monitoring
over the management will be more scrutinized.
However, in
companies with a powerful shareholder, the functionality of disclosing
related-party-transactions might be impaired. It is mainly because in these
companies, shareholder pressure on the management may remain weak owing to the
poor incentive to collect information and to monitor management (Sheifer and
Vishny, 1997). Therefore, for ensuring that the board acts and decides in the
best interest of the company and discouraging intensives for self-dealing,
enforcement power of regulatory authorities plays an important role. With
regards to disclosure obligations of public companies in Turkey, the screening
on compliance is carried out through public supervision by the SPK. The SPK, if
deemed necessary, may require the disclosure of any partnership and subsidiary
relation and their related-part-transactions (SPK Communiqué, art. 9/9).
SPK
monitoring can be launched as a regular inspection routine or following an
investor complaint. If an abusive related-party transaction is identified, the
SPK issues a legal warning containing possible penalties to be charged if the
losses are not compensated by the company. The SPK has also the authority to
apply sanctions including the cancellation of licenses or issuing a criminal
report to the Chief Public Prosecutor?s Office (Cumhuriyet Ba?savc?l???), as a
last resort.
b. Disclosure of information about large ownership
Public
disclosure of shareholders who have a significant share in a company, in other
words, who reach or exceed a certain threshold, is important in terms of
identifying potential conflicts of interests. It also helps to discover
deceitful transactions that the company potentially to be engaged with the
related parties. Therefore, the information about large ownerships in a company
should be disclosed (OECD, 2015; 43) to perceive who control the company or who
wants to take control. In this respect, corporate governance rules require the
disclosure of the information of the ownership structure of public companies in
their websites as means to show the names, shares, and proportions of the real
person shareholders who hold more than 5% of the shares (SPK Corporate
Governance Principles, art. 2.2.3).
5. Conclusion
This paper
has showed on the one hand, corporate strategies alongside with regulatory
rules are used as tools for constraining agents for their opportunistic
behaviors. These governance strategies, on the other hand, help to facilitate
practices to increase the power of principals. This include the ability of the
principals to intervene in the firm?s management, e.g. through the exercise of
control rights, the appointment of independent board members and auditors, and
public disclosure of material information.
In a
classic agency problem, corporate governance strategies may serve the purpose
of controlling managers, which is the basis of the first agency problem. With
concentrated ownership model, however, the problem is more on the risk of
exploitation of minority shareholders and that is the second agency problem.
For non-controlling shareholders, corporate governance strategies may be less
effective, due to the comparatively adverse position in the firm. Thus, there
is need for regulatory strategies; i.e. well-drafted financial market
regulation, through for example investor protection rules.
This paper
also concluded that corporate governance strategies largely rely upon public
enforcement through specialized courts and monitoring activities of the public
securities regulator, i.e. in Turkey, the SPK. Due to the concentrated
ownership pattern, the corporate governance strategies alone are less
effective. Public enforcement via the SPK screening and monitoring plays a
fundamental role in the exercise of governance. However, this should not imply
that private enforcement plays no such role. Private enforcement mainly relies
on initiatives by principals (i.e. shareholders and creditors). For instance,
it is possible to take action for shareholders to bring a liability claim
against auditors or to fulfill an annulment action against general assembly
decisions. Yet, if the coordination and communication among shareholders are
weak, private enforcement activities may remain limited. Furthermore,
litigation success depends on a certain level of development of the
institutions (including courts, judges, and procedural law), and the legal
environment.
Article Information
CORPORATE GOVERNANCE AND FIRM PERFORMANCE: AN EMPIRICAL INVESTIGATION
Authors: KARUN ROY, R GOWRI PARVATHY, NANDHANA MADHU
- Journal IJLRA
- ISSN 2582-6433
- Published 2023/04/05
- Volume 2
- Issue 7
About Journal
International Journal for Legal Research and Analysis
- Abbreviation IJLRA
- ISSN 2582-6433
- Access Open Access
- License CC 4.0
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