Corporate Governance The Concept And Definition

Published Date: 02 Nov 2017

Chapter 2

Theoretical Underpinnings

2. Introduction

The objective of this chapter is to unravel the theoretical underpinnings linked to corporate governance. This chapter is structured in four sections. Section one underscores the concept of a corporation along with defining it. Section two draws our attention to the concept of corporate governance, and divulges its definition from different perspectives. Section three makes a comparative assessment of the different corporate governance systems around the world. The discussion on corporate governance system with their pros and cons allows the researcher to better position the Indian corporate governance system. Section four of this chapter underpins two important corporate governance theories representing the dichotomous governance ideology: the Agency theory and the Stakeholder theory.

2.1 Defining and Understanding Corporation

The concept of a "corporation" is, at least more than two centuries old, and so is that of "Corporate Governance" albeit in a latent form (Singh & Kumar, 2009). Both concepts of t "corporation" and that of "corporate governance" are fully entwined with each other. Therefore, any rationale discussion on corporate governance will not be fruitful, unless one clearly understands the concept of modern day "corporation" and its antecedents. A corporation may be analyzed from different perspectives, and therefore, defined by scholars in their own context. From a legal viewpoint, noted scholars, Jensen and Meckling (1983) view the corporation as "legal entity which serves as a nexus for a very complex set of contracts among human beings" (p. 2). From economic and financial standpoint, Eisenberg (1993) conceives it as "an instrument through which capital is assembled for the activities of producing and distributing goods and services and making investments………. With a view to enhancing the corporation’s profits and gains of the corporation’s owners, that is, the shareholders" (p. 1275). Monks and Minow (2008) present a more comprehensive and descriptive definition of a corporation with governance implications. This definition of a corporation is considered for research in context. According to Monks and Minow:

Corporation is a structure established to allow different parties to contribute capital, expertise, and labour for maximum benefit of all of them. The investor gets the chance to participate in the profits of the enterprise without taking responsibility for the operations. The management gets the chance to run the company without taking the responsibility of personally providing the funds. In order to make both of these possible, the shareholders have limited liability and limited involvement in the company affairs. The involvement includes, at least in theory, the right to elect directors and fiduciary obligation of directors and management to protect their interests (2008, p. 9).

In antecedents to the development of modern-day corporations, Monks and Minow (2008) suggest that corporations have emerged out from a Darwinian development process with each stage of development making them better and resilient. Corporations in their early form emerged in the initial part of the 17th century, when quasi-governmental organizations were established to take up specific commercial activities under Royal Charter. The East India Company, the Dutch East India Company and Hudson’s Bay Company were first few corporations established under such charters. The corporations, however, in essence evolved only in the 19th century with the allowance formation of joint stock companies under the prerogative of the English Joint Stock Companies Act, 1844 (Calder, 2008; Tricker, 2000). The Act permitted the formation of corporations easily, which till then were established only through Parliamentary approval (Sharma, 2011). The English Limited Liability Act of 1855 provided that investors in joint stock companies would be liable for the debts of the company only to the extent of their initial investment (Hickson & Turner, 2005). The concept solved the capital issue for corporations and facilitated them in raising capital from various individuals recognized as shareholders. Corporations were now able to mobilize capital at huge scale for the commercial purposes. This resulted in the establishment of large corporations in the developed countries by beginning 20th century during the industrial revolution era. These corporations were having a separate legal entity with a centralized management, where shareholders have limited liability with ease of transfer of their interest (Monks & Minow, 2008). These initial developments in corporate law on limited liability joint stock companies established the concept of the corporation and shareholder.

2.2 Corporate Governance – The Concept and Definition

The term "Corporate Governance", was first used by Robert Tricker in his article titled "The Independent Director" (Calder, 2008). In 1984, Robert Tricker published his book on corporate governance titled "Corporate Governance- Practices, Procedures and Powers in British Companies and Their Boards of Directors". Corporate governance may have been coined only two decades ago, but as mentioned in the previous section, it has its origin with birth of corporations itself (Singh & Kumar, 2009). The understanding of its underlying concept is also not new and dates back to a couple of centuries (Denis, 2001; Tricker; 2000). Adam Smith (1776) in his book "The Wealth of Nations", raised concern over people’s money to be looked upon by the directors:

The trade of a joint stock company is always managed by a court of directors. This court, indeed, is frequently subject, in many respects, to the control of the general court of proprietors. But the greater part of those proprietors seldom pretend to understand anything of the business of the company, and when the spirit of faction happens not to prevail among them, give themselves no trouble about it, but receive contently such half yearly or yearly dividend as directors think proper to make them. This total exemption from trouble and from risk, beyond a limited sum, encourages many people to become adventures in joint stock companies, who would, upon no account, hazard their fortunes in any private copartnery. Such companies, therefore, commonly draw to themselves much greater stocks than any private copartnery can boast of……… The directors of such companies, being managers of other people’s money rather than their own, it cannot be expected that they should watch over it with the same anxious vigilance with the partners in the private copartnery watch over their own…… Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of a such company ( Smith, 1776, pp. 264-265).

The above phrase clearly signifies that Adam Smith had sound knowledge about corporate governance concepts, and its underlying issue. He clearly noted the incentive problems, when owners are different from managers. In modern times, the governance challenge in limited liability corporation’s on similar lines was observed by Berle and Means (1932) through distinction between ownership and control of corporations. Their seminal work explained that there exists a separation between the owners of the firm (shareholders) and its management, partly due to gargantuan size and scale of firm operation and matched by owner’s inability to participate in day-to-day affairs of firm. Therefore, when ownership and control are separated, particularly in large firms with fragmented ownership, control of the corporation becomes a vital issue (Mintzberg, 1984). The observation by Berle and Means aroused great interest, but it was not until influential work by, Coase (1937), Jensen and Meckling (1976) and Fama (1980) that actually raised concern and enduring discussion on governance issue in the corporations. Jensen and Meckling (1976) carry forward the observation by Berle and Means to formulate the agency theory. This theory to a large extent demystified bottleneck, and significantly influenced the understanding of corporate governance as a concept, and its associated mechanisms.

In contemporary times, corporate governance is well known and understood by everyone. In spite of widespread acknowledgment and the popularity of the term, when someone contours through literature on corporate governance, he comes across a bewildering variety of perceptions behind available definitions. Still, there is no single, clear and general accepted definition of corporate governance (Solomon & Solomon, 2004). The "absence of any real consensus" on a particular definition of corporate governance reflects its scope and complexity (Keasey, Thompson & Wright, 1997; Rezaee, 2009). Corporate governance is very much interdisciplinary with its scope ranging from, finance, management, economics and law (Aguilera & Jackson, 2010). Definition of corporate governance varies according to the understanding of the observer, the context and from the standpoint of academicians versus corporates (Fernando, 2006).

An effort here is undertaken to analyze the definition of corporate governance from a different perspective. One of the earliest, simple and widely accepted definition (Sharma, 2011) of corporate governance is cited in the Cadbury report (1992, para. 2.5), "the system by which companies are directed and controlled". The report further asserts that the Board of Directors is primarily responsible for governance of the company. The shareholder, on the other hand, is just there to appoint the directors and auditors and assure that a governance structure is in its place in the company.

The economist view of corporate governance focuses on nexuses on the contract between constituents of the firm and their bargaining power over the profit. From economist outlook, corporate governance is "complex set of constraints that shape the ex-post bargaining over the quasi rents generated by the firm" (Zingales, 1998, p. 499). Noted finance scholars, Shleifer and Vishny (1997) characterize corporate governance as return on investment of shareholders. They define corporate governance as "the ways in which suppliers of finance to corporations assure themselves of getting a return on their investments" (p. 737). Legal scholars perceive corporate governance from the point of a publicly listed corporation (Aguilera & Jackson, 2010). J.E. Parkinson (1993 as cited in Aguilera & Jackson, 2010, p. 489) analyzes it as "the rule that sustain and regulate the mode of decision making within the corporation as a mechanism of social choice and in relation to a public interest". Some other legal scholars characterize it more broadly than only constraining it only to the relationship among the parties in the firm. Blair (1995) perceives corporate governance as "the whole set of legal cultural and institutional arrangements that determine what publically traded corporations can do, who controls them, how control is exercised, and how the risk and returns from the activities they undertake is allocated" ( p. 3). Keasey and Wright (1993) define corporate governance "to include the entire paraphernalia of an organisation’s culture, ethos, beliefs, share values and structure that support successful achievement of corporate objectives" (p. 4). They seek to suggest that corporate governance in a corporation is driven by culture, beliefs and ethos of the society, in which it operates. In analyzing corporate governance from a management viewpoint, the role of all the stakeholders and their complex relationship within the corporation is considered. Aguilera and Jackson (2010) improving upon their earlier definition (Aguilera & Jackson, 2003) describe corporate governance as the relationship between the parties with a stake in the firm, and their influence on strategic corporate decision-making.

Some scholars and practitioners have characterized corporate governance from a very wide perspective. Narayana Murthy (2003), contextualizing corporate governance in India, observes that it "includes debate on appropriate management and control structures of a company. Further, it includes the rules relating to the power relations between owners, the Board of Directors, management and, last but not the least stakeholders such as employees, suppliers, customers and the public at large". Rezaee (2009) has also provided a wider corporate governance definition, "the process affected by a set of legislative, regulatory, legal market mechanism, listing standards, best practices and efforts of all corporate governance participants, including legal counsel and financial advisors, which creates a system of checks and balances with the goal of creating and enhancing enduring and sustainable shareholder value, while protecting the interest of the stakeholders". OECD (2004) Principles of Corporate Governance confers a global, broad and objective definition of corporate governance. According to this definition:

Corporate Governance involves a set of relationship between a company’s management, its board, its shareholders, and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set and the means of attaining those objectives and monitoring and performance are determined (OCED Corporate Governance Principles, 2004, p. 11)

There are many other definitions of corporate governance abound arising from the contextualized nature of the subject. From an operational viewpoint of this thesis, whose primary objective is to find the factors of effective corporate governance in India, the study observes corporate governance from three standpoints with respect to in relation to public listed corporations of India.

1. Corporate governance as a framework in which different constituents (board of directors, shareholders, management, stakeholders, auditors) of a corporation have a complex relationship with each other.

2. Corporate governance as a structure through which a corporation is directed and controlled.

3. Corporate governance as a dynamic process in which good practices evolve over time.

2.3 Corporate Governance Systems around the World

In a study like this, the research in hand, it is necessary to find the answer to the essential question, why did different systems of corporate governance developed in different countries from the basic premise of a public corporation? What are the governance challenges in each system? How each system strives to solve these governance problems? This section of the chapter focuses on getting answers to these fundamental questions, and understanding the different corporate governance systems around the world.

The study of comparative corporate governance and development of different systems of corporate governance primarily focuses on the public "corporation". As observed by Aguilera and Jackson (2010), public corporation is a "legal institution, where the rights and the responsibilities of different parties are anchored in law and thereby also created and changed through politics" ( p.492). The public corporation that evolved, perpetually guided the development of the dissimilar governance system in different countries.

In antecedent, critical choice about a given corporate governance system in a country had been steered by the economic efficiency of its corporations’, and political forces devising ways of regulating and controlling the corporation. Roe (1994, 2003), Bebchuk and Roe (1999) based on their path dependence argument give insight on how the political forces in different countries shaped up opposing system of corporate governance. Their thesis showcase that political forces in the US in early 1930s were against the concentrated ownership and or industrial monopolies leading to establishment of dispersed ownership and financing through the stock market. The political forces in 1930s instituted corporate laws, such as Glass-Steagal Act and other regulations, pivotal in establishing a shareholder oriented outsider corporate governance system in the US. In the absence of political determinants that were prevalent in the US, the banks based financial system got prominence in other European countries, particularly in Germany and Japan, with corporate control and the development of a relationship based system (Aguilera & Jackson, 2010). In addition to historical and political developments, social and cultural values (Licht, 2001), institutional arrangement (Aguilera, Filatochev, Gospel & Jackson, 2008; Aguilera & Jackson, 2003) and different legal customs and traditions (La Porta et al., 1998, 1999, 2000) have resulted in different corporate governance system around the world (Carney & Gedajlovic, 2001).

Every country, therefore, has its own unique system of corporate governance with peculiar traits and features. " Together with ownership structure, the legal system and its related corporate law, the development of capital and product market, other political and economic institutions define the myriad varieties of capitalism that ultimately characterize corporate governance systems" (Hall & Soskice, 2001 as cited in Aguilera, Desender & de Castro, 2011 p. 391). Therefore, distinct corporate governance systems predominate in the contemporary world that is explicitly linked to the nature of capitalism (Fig. 2.1). In understanding the comparative taxonomy of corporate governance systems, this research positions itself, and classifies them into three corporate governance systems. While the predominant and dichotomous system classification, the market-oriented and the relationship-oriented system of corporate governance explain variations in the industrialized nations of the world, a third system: emerging (family based system) system fundamentally describes corporate governance in the emerging countries. This system is still in the development process, and currently in the flux state showcasing characteristic of both matured system of corporate governance.

Fig. 2.1 Typology of Corporate Governance Systems of the World

Shareholder Orientation

Alliance

Capitalism

Personal

Capitalism

Managerial

Capitalism

Market based corporate governance system

Stakeholder Orientation

Network based corporate governance system

Emerging (family based) corporate governance system

Source: Adapted from Carney and Gedajlovic (2001, p. 338)

Before proceeding further, it is essential to define a corporate governance system. A comprehensive and well-explained definition of corporate governance system is provided by Carney and Gedajlovic (2001). They define it as "evolving institutional structure designed to exploit the advantages of the corporate form of organization, while mitigating concomitant agency cost in a manner consistent with society’s legal political and social traditions. Through both formal and informal means, a system of corporate governance embodies a particular network of economic incentives and disincentives that shape corporate behavior. Viewed in such manner, a system of corporate governance is itself integral to the context in which corporate decisions are made" (Carney & Gedajlovic, 2001 p. 336).

2.3.1 Market Oriented Corporate Governance System

Market oriented model, is also known as "Anglo-Saxon model" or "shareholder model" and often referred to as outsider system of corporate governance. In this model, the ownership structure of corporations is characterized by diffusion across a plentiful number of shareholders. The model is exemplified by the separation of ownership of the corporation among a large number of arms-length investors, who just provide their capital for investing and are not involved in day-to-day operations of the business. This dispersion of ownership sets the foundation of Berle and Means (1932) argument, where managers control the corporations rather than shareholders (Mintz, 2005). This manifestation of control of the corporation by managers in Anglo-Saxon economies is termed as "Managerial Capitalism" (Carney & Gedajlovic, 2001). The problem due to the separation of ownership and control raises the corporate governance problem, due to conflict between the owners and the managers, where managers may be unresponsive to shareholder concerns, and rather pursue their own interest (Armour, Hansmann & Kraakman, 2009). Outsider system of corporate governance predominates in Anglo-American countries, primarily exemplified by the United States and United Kingdom, while Canada, Australia, New Zealand and Ireland are rapidly imitating it.

In a market centric system of corporate governance, the corporations are fundamentally financed through the equity allocation by thousands of arm’s length investors. Corporation here is premeditated as only property of those, who have invested their capital in pursuit of economic gain, setting aside the commensurate investment from the other stakeholders. In Anglo-American economies, shareholders are the only contemplated stakeholders of the corporations, whose interest maneuvers the managerial decision-making. Firm here functions through legal compulsion between shareholders and the manager that guides managers as an agent of principals (shareholders) to maximize the market price of the corporation and distribute the quasi rent among its shareholders (Denis, 2001; Fisher & Lovel, 2003; Shleifer & Vishny, 1997).

The predominance of the equity financing of the corporations through a large number of investors makes the capital markets of outsider economies like that of the US and UK, highly developed, strong and very liquid (Machold & Vasude,van, 2004). The ownership structure of the corporation in the outsider system necessitates that all the shareholders have equal access to sufficient and timely information, so that, they can make prudent decisions before investing (Franks & Mayer, 1990; Franks, Mayer & Rossi, 2009). Any inefficiency in information disclosure concedes opportunity for unscrupulous managers to create manipulation and take undue advantage. Therefore, these countries have stringent norms for shareholder protection with robust accounting and disclosure standards, that clearly represents the economic position of the firm to the public (Carney & Gedajlovic; 2001; Franks et al., 2009; Machold & Vasudevan, 2004). The common law system followed in these countries accords greater protection to the investors. A well-developed legal framework exists for demarcating the rights and responsibilities of major actor of corporations (management, directors and shareholders), and enforcing the contractual obligation between them (Franks et al., 2009). Public corporations financed predominately through equity capital have very low debt to equity ratio (Nestor & Thompson, 2000). A thriving equity culture prevails in outsider system countries allowing investors and corporations to contribute significantly towards economic growth of these economies (Carney & Gedajlovic; 2001).

Table 2.1 Strength of Capital Market in Different Corporate Governance Systems

Year 2010

France

Germany

India

Japan

UK

US

Market Capitalization Of Listed Companies ( Mkt Cap) ( in Bn US$)

1926.49

1429.71

1615.86

4099.59

3107.04

17138.98

Gross Domestic Product (GDP) ( In US$)

2560.0

3309.67

1729.01

5497.81

2246.08

14582.40

Mkt Cap /GDP

( In Percentage)

75.25

43.20

93.46

74.57

138.33

117.53

Stock Traded/ GDP

( In Percentage)

32.34

42.45

61.12

77.86

133.86

208.85

(Source: World Bank Database)

Outsider system of corporate governance, despite having significant strength has commensurate weaknesses too. Apart from shareholders, the other stakeholders, in particular the labor and other business suppliers have minimal say in the functioning of the corporation. The distance between controllers, (management) and owners (shareholders) gives rise to myriad of governance problems in the corporations. Managers by virtue of their position are able to extract more information, and pursue own objectives disregarding their principal interest. Information asymmetry creates opportunity for managers to involve in insider trading, a customary practice in market centric governance system. Managers also reward themselves with excessive remuneration, even for non-performance (Bhasa, 2004b). Excessive power to wanton manager creates sufficient apertures to instigate huge fraud like Enron, WorldCom, Maxwell, Tyco, BCCI and many others. Short-term economic horizon of investment by shareholders conditions managers to behave only myopically. Managers perform those activities, which maximize shareholder value in the short-term. The recent financial crisis originated in the US is largely a function of short-termism of market centric governance model.

The shareholder model of corporate governance has devised a variety of governance mechanism to constrain potentially self-serving managers (Carney & Gedajlovic; 2001; Walsh & Seward, 1990). Existence of market for corporate control primarily through takeovers, strong decision internal control system through inclusion of majority of independent directors on the unitary board system, vigorous external monitoring and control by the institutional investors, a ready market for managerial labor and incentive based executive remuneration system are crucial corporate governance mechanism that mitigate governance issues of this model (Bhasa, 2004b; Jeffers, 2005; Soederberg, 2003; Walsh & Seward, 1990). These mechanisms keep checks and balances on deceitful managers.

Market for corporate control is one of the dominant form of external market based governance control mechanism to punish erring or under-performing managers (Bhasa, 2004b; Lazarides & Drimpetas, 2010; Mayer, 1998; Machold & Vasudevan, 2004; Weimer & Pape, 1999). If managers do not perform as per the expectations of the investors, they may discount company share value. Company valuation in that case may plunge to such a level that it easily becomes a target for a hostile takeover by another company. Mergers, acquisitions, tender offers, proxy fight and leveraged buyouts are common the takeover devices and recurring feature of the market centric model (Weimer & Pape, 1999). The single tier board structure is characteristic of outsider system, which abodes both executive and non-executive directors of the corporation. Both decision management (executive directors) and decision control (non-executive directors) functions are combined in a single board. A board with a majority of independent directors upholds stringent internal decision control over the decision management of executive directors (Maassen, 1999; Soederberg, 2003; Weimer & Pape, 1999).

The important peculiarity of the Anglo-Saxon governance model is the prominence of insurance companies, pension funds and mutual funds as the institutional investors. The majority of individual investors in the US and UK invests in companies through these institutional investors (Nestor & Thompson, 2000). Mallin (2008) points that institutional investor holds about 55% and 45% of the US and UK equity at the end of year 2006. They are the principal investors in the US and UK, and play an active role in safeguarding shareholder rights (Mayer, 1998). The national association of pension funds (NAPS) in the UK and CalPERS in the US are such examples, who are actively engaged in fostering governance standard in their invested companies.

Availability of sound managerial labor market in the Anglo-Saxon economies also helps in alleviating the governance problem to a large extent (Bhasa, 2004b). In a corporation, an ill-functioning manager can be easily replaced with outside competent managerial people. Long-term incentive based executive remuneration tools like stock-option have been designed as a governance mechanism in market centric economies in direction to persuade managers think like an owner of the corporation, which may align their interest with shareholders of the corporation (Maassen, 1999; Roe, 2003; Weimer & Pape, 1999).

2.3.2 Network Oriented Corporate Governance System

Network oriented model, is also known as "relationship based model" or "stakeholder model" and often referred to as insider system of corporate governance. Insider system is characterized by confederacy ownership and control of the corporation by relatively closely held identifiable network of insiders (Nestor & Thompson, 2000). Unlike the Anglo-Saxon model based on shareholder primacy, insider system adopts a pluralistic approach of withholding all stakeholder interest (Allen, 2005; Bhasa, 2004b; Deakin & Hughes, 1997; Machold & Vasudevan, 2004). Kester (1992, as cited in Mayer 1998) suggests, corporations in this system are "coordination devices for aligning self interest with collective good of several parties" (p. 147). Insiders, including company stakeholder such family shareholders, banks, allied and affiliated companies and labor through a network of their ties ( including equity, debt and commercial) provide an effective basis for monitoring each other behavior in insider system, referred to as Alliance Capitalism (Carney & Gedajlovic, 2001). Corporations here are controlled through complex network of cross-shareholding between companies, families and banks (Kalpan, 1997). Most of companies reciprocally own and control each other through interlocking shareholding, resulting in network of relationship that has mutual ownership (Franks & Mayer, 1995; Maher & Anderson, 2000). Network oriented system of corporate governance has been embraced by a number of the Continental European countries, and Japan.

Corporation in network-oriented system is conceived as a nexus of contract among multiple stakeholders: bankers, creditors, laborer, customers and shareholders (Bhasa, 2004b). The governance problem featuring in the outsider system is not that important in this system (Nestor & Thompson, 2000). The corporate governance problem arises here due to "the conflict between the firm itself – including, particularly, its owners- and other parties with whom the firm contracts, such as creditors, employees, and customers. Here the difficulty lies in assuring that firm, as agent, does not behave opportunistically towards these various other principles- such by expropriating creditors, exploiting workers, or misleading consumers" (Armour et al., 2009, p. 4). Different stakeholders have their own interest in the corporation that giving rise to a conflict of interest among these stakeholders. Corporate governance mechanism in countries following alliance capitalism lies in harmonizing and safeguarding each of the stakeholder’s interest (Tricker, 1994).

Table 2.2 Comparison between Market based And Network based System of Corporate Governance

Corporate Governance systems

Market Oriented Corporate Governance System

Network Oriented Corporate Governance System

Countries

US, UK, Australia, Canada, Ireland

Continental Europe ( Germany, France, Italy, Netherlands) and Japan

Ownership structure

Dispersed equity ownership, most of the shares are in hands of dispersed group of individuals and particularly institutional investors

Concentration of ownership with interlocking and pyramidal structure

Control of Corporation

Separation of ownership and control by management

Control of corporation by reciprocal ownership by companies and families

Shareholder/Stakeholder

Recognizes primacy of shareholders in the company

Recognizes the role of all the stakeholder (including employees)

Transparency and disclosure

High transparency and disclosure standards

Low level of transparency and disclosure standards

Finance to corporations

Preference to use equity capital as a means of financing

Preference to use debt capital (Bank) as a means of financing, high debt to equity ratio

Strength of Capital Markets

Fully developed and liquid capital market

Comparatively weak and illiquid capital

Legal System

Common law system

Civil law system

Board Structure

Unitary board structure

Predominately dual board structure (unitary structure optional)

Market for corporate Control

Large and active market for corporate control

Weak market for corporate control

Relationship Orientation

Short term relationship orientation

Long term relationship orientation

Labor relationship

Ready market for external managerial labor

Strong internal labor market with long term relationship

Engagement with Financers

Active role of institutional investors

Active role of banks

Legal Protection

Strong protection of shareholders in equity market regulation

Comparatively weak protection to shareholders but strong protection to creditors

The economies with network-oriented system of corporate governance characterize by corporations with a concentrated ownership structure having substantial entwined crossholdings (Machold & Vasudevan, 2004; Maher & Anderson, 2000). The centrality of this system is the network of relationship that facilities corporation functioning, but some differences are also observed in this governance paradigm that includes: the German model; the Latin model and the Japanese model. In German relationship based system – commercial banks play a dominant role and a major actor of corporate control, in a relatively less developed capital market. Apart from holding equity ownership of themselves, they are in a leadership position of monitoring the management as representative of all the shareholders (Nester & Thompson, 2000). Many other European countries, such as the Netherlands, Austria, Switzerland and other Scandinavian countries imitate the German based governance model. The Latin and Japanese system are recognized by interlocking of share ownership among the bank and other group companies. The French system is the epitome of the Latin system with Italy, Spain and Belgium being other economies displaying characteristics of this model (Weimer & Pape, 1999). In this system, the state is the dominant shareholder and companies mutually control each other through a web of complex cross holding known as "verrouillage". The state plays a central monitoring role through its direct or indirect control over the French entities commonly referred as "dirigisme" . In Japanese model, ownership and control of the corporations is through "Keiretsu" system, where bank and other financial companies playing the apex role (Bhasa, 2004a). Here also, banks take a leadership role and performing monitoring role in guiding the firm activities (Bhasa, 2004b).

Banks are axis for corporate financing for corporations in the insider system (Mayer, 1998). Corporations are generally dependent on the corporate financing by banks for their requirements and show debt equity ratio. Banks have a complex relationship with a corporation with long-term commitment of the capital driven by sustained firm growth rather than myopic market returns (Bhasa, 2004b; Carney & Gedajlovic, 2001; Nestor & Thompson, 2000). The capital markets are generally less developed and illiquid with low market capitalization of corporations as compared to market centric governance model (Table 2.1). The transparency and disclosure norms are low, insiders can have selective exchange of inside information (Nestor & Thompson, 2000). Insider oriented economies largely endorse the civil law system, but grant less protection to investors as compared to market centric economies (La Port et al., 2000). France has a weakest investor protection and least developed capital market ( as per study by La Porta et al., 1997).

All the stakeholders have mutual trust and commitment that helps them in forging long-term and stable relationship with each other (Carney & Gedajlovic, 2001; Mayer, 1998). The sustainable relationship drives the creation of firm resources and competencies. In spite of the benefit due to the strong relationship between multiple stakeholders, firms in the relationship based system are averse to innovation, entrepreneurship, risky ventures, professionalism of management and restructuring in the case of discontinuous change due to culture of reciprocity and ponderous stakeholder consultation (Carney & Gedajlovic, 2001; Machold & Vasudevan, 2004; Malla, 2010). Recurring infringement by state in the governance process, either through its ownership or through regulatory control encumbers efficient functioning of corporations (Malla, 2010). The ownership concentration and illiquid capital market results in condensation of risk to the bank / state that may result in the collapse of an entire economy in case of extreme business contraction or crisis.

In insider system, due to non-institutionalization of ownership among retail and institutional investors like mutual funds, insurance and pension funds, these play a minor role in the governance process (Nestor & Thompson, 2000). Banks on the other hand assume a leadership role in presence of different stakeholders and have significant influence on managerial decision-making (Bhasa, 2004b; Mayer, 1998; Rubach & Sebora, 1998). External market mechanism like market for corporate control through takeovers is absent in this system primarily due to high ownership concentration and strong contractual relationship between management and stakeholders (Fukao, 1995). The system, therefore, entrust internal corporate governance mechanisms family, bank and intertwined corporate relations, alliances and cross-holdings, interlocking directorships and a two-tier board system to monitor the management (Deakin & Hughes, 199; Hoskisson, Yiu, & Kim, 2004; Machold & Vasudevan, 2004). In contrast to outsider system that allow only single tier board structure, relationship based system generally abides to two tier board structure, with option for unitary structure (in France single tier board structure is allowed, in Japan a different board system) (Weimer & Pape, 1999). Supervisory board appoints executive/management and closely monitors its functioning. An important feature of German and Japanese governance model is "relational board structure" that embrace to include the key stakeholders such as labor, lenders, customers and other suppliers, but employee playing a dominant role in board decision making process (Hoskisson et al., 2004; Rubach & Seobora, 1998). Board envises a pluralistic view to safeguard all stakeholder interest (Allen, 2005; Machold & Vasudevan, 2004). Unlike the external market for managerial labor in the Anglo-American economies, network oriented economies have a strong internal labor market. The managers' performance is directly monitored by both by the firm, and the employees executive (through representation on the board) that curtails the moral hazard problem faced by managers in outsider economies, and guide them in establishing long term stable relationship with a corporation (Hoskisson et al., 2004).

2.3.3 Emerging Market Corporate Governance System

In orchestrate of global corporate governance system, where most of the mature economies emulate either market based or relationship based system, a third paradigm is steadfastly emanating, known as "emerging market corporate governance system", representing all economies that are swiftly entering into a global business order (Berglöf & von Thadden, 1999; Bhasa, 2004b; Claessens & Fan, 2002; Millar, Eldomiaty, Choi, & Hilton, 2005). The system is predominately exemplified by East Asian countries, also spans to some East European countries (La Porta et al., 1999; Millar et al., 2005) and many other developing and transition countries like China, India, Brazil and Mexico (Berglof and Von Thadden, 1999; Bhasa, 2004b; Carney & Gedajlovic, 2001; Claessens & Fan, 2002; Millar et al., 2005; Stijin & Yurtogulu, 2012). The emerging market system is manifested by personal capitalism, that is characterized as "firms managed by individuals or by small number of associates, often members of founders’ families, assisted by only a few salaried managers, or they ( are) federations of such firms" ( Chandler, 1990 p. 236 as cited in Carney & Gedajlovic, 2001). The founding entrepreneur typically instigates firms in this system, which gradually become befitting part of a large business group in later stages of development, as a founding family diversifies into several businesses to spread their concentration of risk from a single entity (Bhasa, 2004b; Carney & Gedajlovic, 2001).

The corporations in the emerging market system in early stages of development are financed by internal capital of the business group (Claessens & Yurtoglu, 2012). In later stages of development, corporation incapable of fulfilling the capital requirements through internal funds looks for external financing. The emerging market system is currently in a state of flux, where it is constantly moving between the market centric system for equity financing through stock exchanges and the network based system for debt financing through the banking system (See Fig 2.1). This system in the contemporary state is between two polarized extremes of insider and outsider corporate governance systems, displaying features of both matured system of corporate governance (Bhasa, 2004b). Furthermore, governance characteristics in the economies are tilted towards any of the two matured systems that is linked to their colonial past.

Emerging market economies show a replica of relationship based model, where the corporation is owned and controlled by families or financial institutions through pyramidal crossholdings (Bhasa, 2004b; Millar et al., 2005; Nestor & Thompson, 2000), whilst they also have acquiesced to market based mechanism thorough listing on stock exchanges (Bhasa, 2004b). Ownership of corporations in the emerging market system generally lies in the hand of huge financial and business groups or conglomerate. Relationship through cross-holding in the emerging market system, however, is significantly different from that one existing in network oriented economies. While, the symmetric entwined inter-firm cross-holding facilitates governance process in the alliance capitalist economies, cross-holdings in emerging markets are not symmetric, and result into pyramidal group structure, controlled by a single owner that do not facilitate effective governance (Carney & Gedajlovic, 2001). Claessens and Yurtoglu (2012) in their recent study on emerging market system point that largest direct shareholding often by family (in some economies, by state and financial institutions) is generally more than 50 %. In addition to direct control over the corporation, it is further facilitated either by crossholding, and pyramid ownership structure (particularly in East Asian countries and India), or through legal structures like nonvoting stocks and dual class shares (countries of Latin America) (Claessens & Yurtoglu, 2012; Millar et al. 2005).

The coupling of ownership and control in emerging market system averts the typical agency problem articulated in Berle and Mean firms of market centric system due managers - shareholders conflict. The agency problem that prevails in the emerging market system is due to conflict of interest between the owner / manager that have either majority interest or controlling the corporation and other minority shareholders (Armour et al., 2009; Claessens & Yurtoglu, 2012; Hansmann & Kraakman, 2004; Millar et al., 2005; Young, Peng,, Ahlstrom, Garry & Jang, 2008). Here, governance problem arises as majority shareholder with control on management has power to pursue decisions of the firms on the behalf of all shareholders that may expropriate minority shareholder (Armour et al., 2009). The governance mechanism in the emerging market system are aimed that minority shareholder are not expropriated by majority shareholder actions, and giving them adequate safeguard.

Family managed business groups and conglomerates, whereas create an internal channel for financing group firms, it also besets corporate governance problems. Family controlled group often control the appointment of all the directors to the board (Nam et al., 1999) and instigate a relative at the top management position than a professional manager (Carney & Gedajlovic, 2001). Corporations here are often plummeted by the poor transparency, vague management structures and owner/ manager discretionary decisions that often result in minority shareholder expropriation (Claessens & Yurtoglu, 2012). Inadequate safeguards to minority shareholders, make investors averse in investing family owned companies (La Porta et al., 1999). Empirical evidence from research on emerging markets (East Asian Economies) has shown that companies affiliated with a business group have less stock market capitalization (Claessens, Djankov, Larry & Lang, 2002). Therefore, corporations in emerging market find difficulty in raising equity on favorable terms and have a high cost. As a result, the capital markets of emerging markets are still quite immature as compared outsider economies, and outside financing for corporations vastly through bank financing.

In addition to family business groups, state has significant credence in the political economy of emerging markets. A number of corporations in the heavy industry and the whole banking system is under control of the state in emerging markets. Ownership by institutional investors is also of not much substance in the emerging market system, but are growing steadfastly due to the attractiveness of these markets. However, rather than playing an active role in the governance process of corporations, they are guided by dominant shareholder/owner behavior. They prefer to exit the corporations in order save themselves from expropriation by the management rather than changing their decisions (Claessens & Yurtoglu, 2012; Millar et al., 2005).

The economies of the emerging market system after the crisis in Asia (East Asian economies) and Brazil in 1998 are embracing market based corporate governance mechanism, focusing on more transparency and disclosure and protection of investors' rights. They are instigating changes in order to attract foreign capital and build a strong and successful developed economy. A detailed discussion on corporate governance and its various mechanisms applicable to emerging market with special reference to India is put forth in the Chapter 4.

2.4 Corporate Governance Theorizing

The extant literature on corporate governance reveals several theories to unravel the governance concern in corporations, and their envisageable solutions (Clarke, 2007; Solomon & Solomon, 2004). Theories that give insight to corporate governance are agency theory, transaction cost theory, stewardship theory, resource dependence theory, stakeholder theory, managerial hegemony theory, and class hegemony theory (Clarke, 2007). Each of the theory has its own approach to corporate governance problems, but none of theory succeeds in epitomizing all the concern. It is not possible here to discuss and explain all theories and their approach to corporate governance. Here two important theories: agency theory and the stakeholder theory are explained and discussed here. Other theories will be referred to in forthcoming chapters if required. These two theories are selected as they explain two different ideologies of corporate governance in the functioning of corporations. While agency theory explains the shareholder paradigm of outsider system, the stakeholder theory vindicates the network-oriented model ideology of stakeholder consideration. Both the theories contemplate different conceptual understanding with which a firm is conceived, and rights and responsibilities among different actors are accorded. While agency theory proponents conjure corporation indispensable for fulfilling its only owner’s interests, the stakeholder theorist analyzes corporation as a socially embedded institution for serving interest of multiple stakeholders. These two theories are explained in subsequent sections of this chapter.

2.4.1 Agency Theory

Agency theory employs a simple financial model to observe corporate governance problems in corporations ( Hawley & Williams, 1996; Letza et al., 2004). The agency theory is concerned with understanding the consequences and solutions caused by conflict of interest arising in the Berle and Means corporations due to the separation of ownership and control (decision making authority). Jensen and Meckling (1976) carried forward the concepts put forth by Alchian and Demsetz (1972) and Ross (1973) to examine the relationship between principal and agent in the firm ( Denis, 2001). The firm in this perspective is conceived as a nexus (of contract) between various contracting parties (Jensen & Meckling, 1976). In this relationship model, the financiers of capital (principal) appoint managers (agents) with specialized human capital to look after their funds and generate return on that fund (Shleifer & Vishny, 1997). The principal and agent both sign a contract that specifies what managers can do with funds and how profits generated from these funds will be distributed among the parties (Clarke, 2007).

A contract under which one or more persons (the (principal(s)) engage another person to perform some service on their behalf which involves delegating some decision making authority to the agent. If both parties to the relationship are utility maximizers there is a good reason to believe that the agent will not always act in the best interest of the principal ( Jensen & Meckling, 1976 p. 308)

The problem, however arises because it is not feasible to write a complete feasible contract keeping in view the unforeseen future (Shleifer & Vishny, 1997). This allows principals to grant the agents (managers), the residual control over the firm (Grossman & Hart, 1986). Manager’s control of the firm emanates conflict of interest between the principal and the agents (Shleifer& Vishny, 1997, Turnbull, 2000). This conflict is based on the assumption that agent will not act opportunistically to pursue his/her own objective rather maximizing the shareholder wealth. Managers having better access of information than shareholders, and discretion over investment decisions of finance may not be involved in the activities that give credence to shareholder interest (Turnbull, 2000).

Eisenhardt (1989) argues that under condition of imperfect information asymmetry and uncertainty in the corporation with the separation of ownership and control, two agency problems arise. The first problem that arises is of adverse selection (bounded rationality) because investors (principals) cannot verify whether managers (agents) are good or bad resource allocators, and how actually they have behaved. Another problem is that of moral hazard (opportunism) reflecting proclivity, where managers in their position of resource allocators may pursue their own interest and not necessarily the interest of company principals. Because of these agency problems, companies’ shareholders are unable to write perfect contracts.

Jensen and Meckling (1976) refer that shareholder incur some cost to mitigate against these agency problems due to separation of ownership and control. These costs are referred to as agency cost that can be seen as a loss of shareholder arising partially due to inability of writing completely feasible contracts. Jensen and Meckling (1976) argue that shareholders bear three types of agency cost: monitoring cost, boding cost and the residual loss. Monitoring cost is borne by the principals to monitor the aberrant behavior of the agents due to divergence of interest. These costs are control costs that arise such as for handsomely remunerating managers, and keeping independent directors on the Board. Bonding cost is incurred to align agent interest with that of the principal. This includes cost of information disclosure to the shareholders, and cost of preparing audited financial statements for the company. Apart from these, the cost incurred after above mentioned costs is referred as residual loss that arises as the cost of fully enforcing principal-agent contract far outweighs, the benefits derived from doing so. Agency theory proponents (Eisenhardt, 1989; Fama, 1980; Fama & Jensen; 1983; Jensen & Meckling, 1976) suggest the conflict between principal and agent can be reduced through various mechanisms that align the interest agents with of principal.

Agency theory is directly applicable to corporations of the outsider system with diffuse ownership structures, where shareholder primary is dominant and shareholders are as only residual claimants (Clarke, 2007; Gamble & Kelly, 2001). Shareholders are the only determinants of the corporate functioning as per say of the agency theory. The major limitation and criticism of agency theory is on the account of its ignorance of other important stakeholders of the corporation, and considering it only as property of shareholders (Blair, 1995; Freeman, 1984).

2.4.2 Stakeholder Theory

The stakeholder theory ascendance is a response to the shareholder primacy and rise of institutional investors in Anglo-Saxon countries in the early eighties that hoisted serious concern to stakeholders in the network-oriented countries like Germany and Japan (Gamble & Kelly, 2001). Freeman (1984) first made choice of the word "stakeholder" in place of then traditionally used economic term "stockholder" and loosely defined it as "any group of individual who is affected by or can affect the achievement of an organization’s objectives". The author (Freeman, 2004) further refined stakeholders to "those groups who are vital to the survival of the organization". Stakeholder theory, rather than conceiving the corporation as a bundle of assets that only belongs to the shareholders, construe it as the property of all those who contribute their specific resources to it. Here, the corporation is conceived as institutional arrangement for managing the relationship between all the parties, who have a stake in it (Clarke, 2007).

Freeman’s (1984) stakeholder theory posits that successful managers must systematically attend to the interests of various stakeholder groups. He suggests that managers must formulate and implement processes that maximize the wealth of not only the shareholders, but all the stakeholders of the business. The main task in this process is to manage and integrate relationships and interests of shareholders, employees, customers, suppliers, communities and other groups in a way that guarantees the long-term success of the firm an organization’s success. The manager’s job is to maintain the support of all of these groups, balancing their interests, while making the organization a place where all stakeholder interests can be maximized over time (Clarkson 1995; Donaldson & Preston 1995).

Donaldson and Preston (1995) construe that stakeholder conceptualization requires more rigorous thinking and analysis for comprehension. They identified three versions of stakeholder theory in their analysis: the descriptive, instrumental and normative stakeholder theory. Corporate governance is linked only to the instrumental and normative stakeholder theory. Instrumental stakeholder theory stresses on studying the organizational consequences of taking into account stakeholders in the management, examining the connections between the practice of stakeholder management, and the achievement of various corporate governance goals. Normative stakeholder theory, on the other hand, focuses on identification of moral or philosophical guidelines linked to the activities or the management of corporations. Donaldson and Preston (1995) consider that normative approach forms the core of the stakeholder theory as it pitches the rightful justification for the existence of theory. Normative stakeholder theory aims, to answer the critical corporate governance question like, "what are the responsibilities of the company in respect of stakeholders?" And "why companies should take care of other interests than the shareholders' interests?"

The stakeholder theory identifies the corporate governance problem of relationship-based system (as prevalent in Germany and Japan) due to absence of stakeholder involvement in governance process where separation of ownership and control is not a contentious issue, and corporate governance propensity is to safeguard all the stakeholders’ interest. Blair (1995) carrying this view, suggest "... the goal of directors and management should be maximizing the total wealth creation by the firm. The key to achieving this is to enhance the voice of and provide ownership-like incentives to those participants in the firm who contribute or control critical, specialized inputs (firm specific human capital) and to align the interests of these critical stakeholders with the interests of outside, passive shareholders" (p. 322).

Stakeholder theory extends the view of agency theory that solely focuses on shareholder to include other stakeholder groups. If the job of the management is to maximize the total wealth of enterprise rather than just the value of the shareholder’s stake, then management must take into account the effect of corporate decisions on all the stakeholders, including the social, environmental and other ethical considerations (Donaldson & Preston, 1995; Freeman, 1984,2004). Taking into account the stakeholder perspective, Porter (1992, p. 17) suggest that corporations should "seek long-term owners and give them a direct voice in governance" (i.e. relationship investors) and to "nominate significant owners, customers, suppliers, employees, and community representatives to the board of directors".

Stakeholder theory, however, too comes with limitations and criticism. Blair (1995) argues that even though it has more practical and intellectual appellation than agency theory, it has not much effect on corporate governance policy making. Philips (1997) contends that identifying and defining stakeholders is both problematic and impractical, and arbitrary discretion deem to happen in different contexts. Sternberg (1997) also captured deficiencies in stakeholder theory, and argues that it is infeasible to good corporate governance, while considering all the stakeholders of the corporations.

2.5 Summary and Conclusions

This chapter analyzed corporate governance basic underlying concepts, definitions, associated system and its peculiarities and concerned theories. In this analysis, it is clearly understood that corporate governance concept is intrinsically linked to the corporation, and thus both have evolved perpetually. The notion of the corporation, and that of corporate governance has a different understanding of scholars from different field like law, economics, finance and management. Each one has analyzed and defined both these concepts from their own perspective. The different standpoint of analysis makes it extremely difficult to any universal definition of corporate governance and corporate.

In analysis of corporate governance systems, it is observed that the way corporations have evolved, guided by historical and political antecedents, and legal customs, culture and institutional arrangement in which it situated determines the corporate governance in that country. While every country has its own system of corporate governance with peculiar traits and features, this research understood corporate governance systems of the world by classifying them into three categories. In this classification, two developed corporate governance system exists. In market centric system, the corporation has an instrumental view with shareholder primacy, while network oriented system has an institutional view to corporation with a focus on all stakeholders. In market centric or outsider system, the governance issues in corporations focus on shareholders, settled through strong protection of their rights, and efficacy of market based mechanism. In the corporations of the network-oriented system, stakeholder concerns are resolved through closed internal alliance and monitoring. The new emerging economies of the world constitute a different corporate governance system and characterized by features of both developed systems. Their institutional arrangements are still weak and in the development stage, and so this system is in a state of flux between two polarized matured systems. The two theories, agency theory and stakeholder theory exemplify ideology of functioning of corporations in the matured dichotomous system of corporate governance. Agency theory adopts the only shareholder perspective while stakeholder theory has a paradigmatic view to include all stakeholders of the corporation. Both theories justify their stance, and oppose each other view.

In recent times, there have some serious debate, which of the corporate governance system is ideal one. There are arguments by some scholars that globalization will lead to convergence to corporate governance, and all systems will primarily converge to a universal system manifested by market centric model (Hansmann & Kraakman, 2004). This study considers that although a corporate system may have moved closer to each other as a consequence of globalization effect, but it is difficult to destabilize the institutional arrangements , and cultural and legal predisposition in which, the corporation is embedded in a given society. The societal view to corporations and the subsequent evolution of corporate governance system suggest that corporate governance framework in each country will be different. In the final analysis and conclusion, researcher observe that for India that is part of emerging market corporate governance system, and still in the process of developing a sound corporate governance framework, it is necessary to take a holistic view. Currently being in a state of flux with type of hybrid system, it is imperative to give due regard to both ideologies and devise its way governance of corporations.