Corporate Governance

and the Role of the Board

To examine the theoretical and practical aspects of issues of governance and the role of the board of directors in the way business firms operate in the UK. The theoretical underpinnings of governance are explored from the viewpoint of agency theory and the many voluntary codes that are used to enforce governance on UK businesses.

At the end of the topic you should be able to:

Identify the role that agency theory plays in the study of governance,

Understand how the study of governance can help managers in their decision making,

Discuss how the different codes of governance affect the organisation of firms,

Critically assess the role of the board of directors in shaping organisational governance,

Discuss the circumstances under which issues of governance fail and assess some of the consequences.

 

The formal study requirements for this topic are:

Chapter 4: The Corporation as Stakeholder

Chapter 4: in particular see section 4.5 The Corporation as Moral Regulator

1. Cadbury, A. (1993) Thoughts on Corporate Governance; Corporate Governance An International Review, Vol. 1, No. 1, pp. 5-10.

2. Clarke, R N., Coynon, M.J. and Peck, S.I. (1998) Corporate Governance and Directors’ Remuneration: A View from the Top; Business Strategy Review , Vol. 9, No. 4, pp.21-30.

3. Gedajlovic, E.R. and Shapiro, D. M. (1998) Management and Owenership Effects: Evidence from Five Countries; Strategic Management Journal , Vol. 19, pp. 533-553.

4. Hilmer, F. G. (1993) A Governance Research Agenda: A Practitioner’s Perspective; Corporate Governance An International Review, Vol. 1, No. 1, pp. 26-33.

5. O’Neal, D. and Thomas, H. (1996) Developing the Strategic Board; Long Range Planning ; Vol.29, No. 3, pp.314-327.

6. Stiles, P and Taylor, B. (1993) Maxwell - The Failure of Corporate Governance; Corporate Governance An International Review, Vol. 1, No. 1, pp. 34-45.

Corporate Governance has become an important topic in business life over the last decade or so. There have been a number of reasons for this, prime among them were the business excesses of the late 1980s and the issues of ‘sleaze’, ‘fat-cats’, executive pay rises and the use of share options for top managers with redundancies, closures and poor customer service occurring at the same time. Shareholders felt that they had been frozen out while top managers were running the company for their own ends. Reform had to be constituted to control this developing situation.

Prior to the 1980s the study of corporate governance was relatively unknown and certainly not widely disseminated in the public media . By the end of the decade and into the 1990s, corporate governance became well established in the mainstream of business and public life. We can trace its origins from the pioneering work done by Berle and Means in the1930s when they described the changes in the means of control in large firms away from the ‘owners’ to that of ‘managers’. This study coincided with the rise of corporate America and the creation of large diversified firms.

The cornerstone of micro-economic theory of the firm was that firms were profit maximising systems. In the 1950s and early 1960s this assumption began to be challenged by writers like Herbert Simon. Later the influential work by Cyert and March on the Behavioural Theory of the Firm added to the work done by Baumol, Marris, Williamson and others. Baumol wrote about managerial constraints; Simon argued about bounded rationality limiting managers’ decisions and argued that firms 'satisficed' rather than 'maximized' profits; Marris argued that managers lived in fear of the takeover and Williamson built his work around the concept of managerial utility. These writers collectively re-wrote the traditional theory of the firm and created the alternative theory school. The importance of this historical background is an attempt to show how far the divorce between ownership and control had reached and to explain why managers behave in the way that they do. This in a sense was the precursor to governance issues of the late 1980s and 1990s. In other words we should not have been surprised.

In the European context, in the 1970s we see the rise of the trades unions and the call for representation in corporate decisions. The concept of co-determination, borrowed from the German model and to an extent from the Japanese industrial organisation was seen as a means of removing strife from the workplace. Workers on boards as worker directors, supervisory boards and workers’ representatives co-operating with management seemed a good idea. The Labour government of the 1970s received the Bullock Committee Report on Industrial Democracy and quietly shelved it. A few experiments in industrial democracy were tried but were soon wound up as the firms went into liquidation.

The recession of the early 1980s decimated British industry. The balance of power between labour and capital was reversed. New legislation curbing the power of the unions came into force. In the late 1980s, Britain saw a merger wave. An outcome of this was notable cases of malpractice on a large scale. Shareholders’ rights were often seen to be abused. Cases like the Guinness affair, Blue Arrow, Heron Corporation and others were investigated and litigation and custodial sentences were forthcoming to some of the key actors in these dramas. A need for reform was clearly evident.

In the 1990s and the latter part of the Tory’s 18 years in power saw the issue of ‘sleaze’ come into the public domain. Fat-cats, management share options, shareholders’ rights abused by top executives and of course the infamous Maxwell affair concerning cover-ups and the illegal use of company pension funds to support the share price and other malpractice lead to four reforming reports on governance: Cadbury (1992); Greenbury (1995); Hampel (1998); and Turnbull (2000), all of them voluntary, but having great moral persuasion on company behaviour. Most public companies in the UK have adopted these codes of practice in their governance.

The reason for this historical summary is to place in context the fact that corporate governance is not a new topic. The study of how firms work has evolved. The divorce between ownership and control leads to the question of how we govern firms and control the behaviour of managers. This issue becomes even more sharply focused when we see the creation of large cross-border corporations and firms with extensive alliance relationships.

Corporate governance is essentially a re-affirmation of shareholders’ rights and an attempt to make top managers in firms more accountable for their actions to the owners of the firms, who after all are the shareholders. So how can we model what is happening?

A working definition for the term Corporate Governance would refer to the mechanisms by which companies are controlled, directed and made accountable.

Key questions in Corporate Governance:

The role and legitimacy of the corporation.

Complexity of company structures - the need for checks and balances

To whom is the company responsible ?

Is the 19th century notion of the joint stock company outdated?

What is the role of the modern corporation - is the profit maximising goal realistic?

The divorce between ownership and control, as we have seen created more questions than it answered. At the heart of any capitalist economy the legitimacy of the corporation is not in question, but, increasingly, to some, its role is. Handy argues that the corporation as defined by the prevailing 19^th century definition of a joint stock company may be too restrictive. Firms he argues are motivated by longevity and gain their legitimacy from the society in which they are located. The narrow definition of primacy to shareholder interests, the stakeholder school argues, distorts the role and responsibility of the company. They would argue for a wider definition of responsibility.

While we have seen from the alternative theory of the firm, anomalies exist in terms of how managers behave and how they tend to maximize their own utility, yet firms will create structures to approximate to the owner-manager model of early capitalism. As the number of shareholders increases and the complexity of the firm rises, owners are further divorced from the strategic decisions of the managers they employ. By the late 1990s more checks and balances have emerged to rectify this imbalance of power. So how can we conceive of corporate governance as a model?

There are two basic Corporate Governance Models - The Stakeholder Model and the Agency Model.

The stakeholder model of governance is quite well known and proponents argue from the standpoint of extended responsibility to actors other than the shareholders. For the explanation of the stakeholder model see the workbook for module MB420. In Weiss this concept is adequately explained in Chapter 4. Also for an interesting debate on this issue readers are advised to go to the special issue of Long Range Planning; Vol. 31, No. 3, 1998. Furthermore, a number of scholars have argued that the stakeholder model is dead. Among these is (Beaver 1999) who writes that 'it looks like the people who hold the shares are still number one in the mind of corporate America'. However, there are others who argue very cogently for the stakeholder model. See the work of Moore(1999) and Froom (1999) and Jones and Wicks (1999). Indeed, Wicks argues that 'unlike other theories of organization, it demonstrates how managers can create ways of doing business that are both moral and workable.' ( Wicks: 206)

It is the Agency Model that most western companies and governments base governance upon. In the Agency Model, we have a number of key actors - The shareholders are the 'Principals' or owners of the company, they delegate authority to their 'Agents' or managers who act as stewards to the owners' assets. The actions of the 'Agents' are thus seen in this light. The role of the 'Board' is to ensure that the interests of the 'Principals' are maintained. Figure 1 below depicts the agency model of governance.

On the right hand side of the model we see actions of the 'Principals' and the 'Agents' being mediated by motivations, behaviors and external market constraints on both the 'Principals' and the 'Agents'. Indeed the Alternative Theory, (see the work of Baumol, Marris, Simon, Williamson, Cyert and March), of the firm focuses on these issues and looks at the tensions that arise when the division between 'Ownership' and 'Control' widens and becomes more diffuse. Governance is in one sense an assertion of shareholders' rights, and in a wider sense, covers aspects of social responsibility. Figure 1, below shows the agency model.

Figure 1 The Agency Model of Corporate Governance

In company law, the primacy of the shareholders' interest is unequivocally recognised. Indeed directors of a company have to take shareholders' interest above other parties in their deliberations. We will see later in this topic how this view has been interpreted by the Hampel code.

The traditional role of the board of directors is to ensure that the owners' interests are respected and that the paid managers are behaving with propriety and observing their obligations under the law. Their expanded role is to ensure that due process in governance is observed. In recent years, we have witnessed a number of situations where the behaviour of boards and of directors have been called into question. This has led to the adoption, by companies, of a number of codes of conduct. The most famous being the Cadbury code.

Cadbury called for the splitting of the roles of chief executive and chairman and recommended an expanded role for the non-executive director who would be specifically charged with looking after owner's interests. Cadbury also made other sweeping recommendations that have largely been adopted by large public UK companies.

In the mid 1990s, business responded to public disquiet on what was seen as excessive pay rises for senior executives and the misuse of share option schemes by setting up the Greenbury Committee on the issues. Greenbury recommended executive remuneration committees and other reforms to protect businesses’ and shareholders' interests.

In the late 1990s, the committee of inquiry under the chairmanship of Sir Ronnie Hampel reported on aspects of boards of directors and their role and responsibility. This was a further effort by the business community to reform its practices and to keep the notion of voluntarism in the way the system works. Government, being aware of public opinion on the topic of 'sleaze' in business, threatened legislation. Hampel argued for a continuation of self regulation or ‘voluntarism’ in governance issues. Building on from Cadbury and Greenbury. Hampel has argued that it is for 'Shareholders and the general public to decide how companies meet these requirements.... Shareholders should demonstrate increasing vigilance.'

If we return to the debate on stakeholder theory and responsibilities in terms of the board of directors we see that directors of firms are responsible for relations with stakeholders; but they are accountable to the shareholders. ( CBI evidence to Hampel see p12, paragraph 1.17). This is not simply a technical point but a practical one. Directors cannot be responsible to the wider stakeholders as this would be impractical and would mean that the directors would be responsible to no one. Thus detracting from good governance. (See Hampel p12 ).

Hampel, on directors and how to make boards effective recommended the following:

Directors should have training

Boards should be evaluated along with individual directors

Non-execs should make up one third of the board

Biographical details of board members be available to shareholders

Separation of roles of CEO and Chairman

Directors who resign should give a statement of reasons

Companies should describe how they are governed and explain why they deviate from ‘best practice’

 

Research into boards and how they work and their effectiveness is a growing literature, especially as new EU directives are attempting to get some cross-Europe uniformity. The prevailing research has always concentrated on boards’ behaviour in large public firms where data is more readily available. We know little as how boards work in small companies, private firms, fast growing entrepreneurial firms and family owned businesses, ( Huse 1998). Figure 2 below sets out the two key roles of the board - performance role and a conformance role.

This model suggests that a board of directors can be seen as having an outward and an inward looking function. Outward to the market and to investor relationships and inward looking to ensure conformance to governance. We can also see the board as having a past/present orientation, in that boards review performance and set objectives and a future orientation, to ensure that the company's strategy to the market place can deliver the firms objectives. Thus we can see the roles of the board as having both conformance and performance roles.

If we expand this matrix and look at the way the board's roles are structured we can get a fuller view of how the board functions. Figure 3 below, sets this out diagrammatically.

Developing the themes from figure 3, we can now see the role of the board is to appoint and work with the chief executive, monitor performance, formulate strategy and be accountable to shareholders for both performance of the business and its governance.

While these roles that we have described may be seen as not being contentious, nevertheless the way that some of these issues are evaluated can differ from different stakeholder perspectives. Factors like size of company, type of industry, composition of the board in terms of the actors' personalities and complexity of the business structure can affect board performance. Boards can be pro-active in that they are participating very strongly to affect the performance of the firm or they can just be a 'rubber-stamp' in sanctioning the actions of the chief executive and the senior managers.

In their analysis of the Maxwell case Stiles and Taylor (1993) identify how Maxwell managed to evade the many constraints on a business' power, for example, regulatory bodies, board structure, investor relations and media influences. For example, the personality of Robert Maxwell overshadowed the board. Many board members were Maxwell ‘placemen’; the board was ineffective and followed the management line. The media also failed in the Maxwell case, as it collectively did not cast a critical eye on Maxwell companies' activities as Maxwell was always prepared to sue. The failure of governance in the Maxwell case was further compounded by a failure of the regulation system to understand the labyrinthine structure of the Maxwell business empire. Investors were also to blame in that they collectively did not do their research effectively into Maxwell's financial situation and continued to lend to Maxwell and to co-operate in many of Maxwell's schemes. This failure of governance is tabulated below.

Source: Stiles and Taylor (1993)

Go to the BOLA site and review the on-line slides on governance. Site address:

http://sol.brunel.ac.uk/%7Ejarvis/bola/ethics/govern/govern.html

Then find out how your organisation has adapted the Cadbury and the Greenbury reports. Has your organisation taken on board the Hampel recommendations on director training and other points in the report's recommendations? (Do these reports apply to non-plc’s or public sector organisations? If not, what can you suggest students from such organisations do instead?)

Consider the concepts such as board responsibilities; non-executive directors and their duties; disclosure of personal information concerning top management pay in your company. Do you think that the adoption of these concepts will make boards more effective?

Are there any other 'best practices' that you would like to add to the Cadbury Code that would improve stakeholder interests? If so what are they?

How could corporate governance models be adapted for public sector organisations? Give examples where you can.

Be prepared to discuss governance failure and the Maxwell case in the class as part of the lecture and seminar session. A copy of the Stiles and Taylor (1993) article will be made available for students for the seminar discussion.