Introduction Importance Of Corporate Governance

Published Date: 02 Nov 2017

As a result of the increasing globalization trend and the complexity of business, the private sector at this time plays a key role in economic growth both in developing and developed countries. Corporations are being produced by law in the effort to provide an efficient form of organization from which the society will benefit.

Corporations participate to economic growth by combining capital, raw material, labor, and management expertise to create goods and services appealing to members of society. By doing that, corporations purchase goods and services, produce jobs and income, distribute profits, pay taxes, and contribute to foreign exchange. This participation to economic growth will automatically improve standards of living, relieve poverty and hence lead to more stable political systems.

Corporate governance is essential because its quality impacts:

the efficiency with which a corporation employs assets

Its ability to draw low – cost capital;

Its ability to meet societal expectations

Its overall performance.

1) Corporations that have verified to have good corporate governance system are more likely able to attract debt and equity capital. This is due to their efficient manner of utilizing resources and investing them in the making of goods and services mostly in demand and generating the highest return. Good corporate governance in this sense would assist in the best use of scarce resources to the best interest of the society. Other corporations that do not make full use of resources and in the most efficient way (without mentioning corruption) are subject to being out of market or searching for a replacement of their management.

2) Once more effective corporate governance should help corporations in attracting low capital whether it is equity or debt. This is due to the fact that good governance must only give confidence to shareholders that their investments are used to their best interests; hence, managers must be able to provide innovative ideas with constant changing circumstances. This is best reflected when we have an independent monitoring system for management; transparency as to corporate performance, ownership and control; and contribution in certain fundamental decisions by shareholders -- in other words, corporate governance.

3) Corporate governance deals also with the societal issues that are applicable to any country. To be successful, corporations in the long run should display a good and healthy performance that is useful to every society and not only seek pure profit. Some of the issues to be looked after are the agreement of corporations to the country’s laws and regulations such as the prevention of child labor, the support in creating a better and healthier environment… Corporations disregarding such societal issues are more likely incapable of surviving over the long run and in most cases demonstrate government failures or possibly even government corruption.

4) Good corporate governance, as illustrated above, means only efficient use of resources, at low cost capital, in compliance of all societal needs and interests in the existence of responsible and accountable managers and boards. All of this can only be translated into a enhanced performance on the level of the corporation.

Good corporate governance has also an impact on reducing corruption in business practices. It will definitely not prevent firms from any corruptive act, though, it is certain that an effective corporate governance system will classify and remove any corrupt practice at an early stage.

1. Problem Definition

A lack of corporate governance can result in large-scale economic collapse, as was the case of Korea in 1997. In Lebanon, because the commercial credit market is so strong that it really carries the Lebanese economy, if it must collapse, it would have tremendous implications for the country. Therefore, this study attempts to consider any weakness in the corporate governance part of this sector in order to reduce this risk.

2. Research Objectives

First, this study aims at showing whether commercial banks in Lebanon are monitoring their clients enough with special emphasis on the impact of such monitoring on corporate governance. The study shows the importance of auditing in banks, especially in reducing the risk of financial distress of corporate clients and showing the constraints facing such monitoring. Furthermore, one of the objectives of this research is to encourage bankers to increase monitoring, as it has shown to be very beneficial for banks as per several international studies. In addition to this, this research aims to demonstrate how relationship banking is important for the bank and for its corporate clients and how it helps the bank in its monitoring process.

3. Outlines

Chapter 1

1.1 REVIEW OF LITERATURE

Theories Relevant to Corporate Governance

Most of the studies into corporate governance came from the English speaking countries and specifically from the US. It was only until the 1990’s that scholars started recognizing the need for advance research in different economies like Japan, Germany or Europe as a whole instead of assuming that these traditional economies should follow the American developments in this field. This theory emerged from the fact that the US was considered to be the most powerful economy in the entire world and for this reason was the best candidate for being the role model for other countries.

US scholars were also dominant in developing the theory of the firm based on the assumption that in the beginning there were markets and those firms exist because markets fail. The assumption of the firm, on the other hand, was less relevant in economies tied with cultural priorities, business related social, associations and political systems. Though, this theory proved to be relevant in cultures where competition is greatly effective supported by strong anti-trust laws and large scale publicly traded firms.

These economies prevailed in continental Europe, Japan and other Asian countries.

This resulted in the lack of a theoretical scope for comparing corporate governance systems between different cultures.

The following section will clarify the four models of corporate governance that have been identified by Hawley and Williams (1996) for the OECD (Organization for Economic Co-operation and Development) while taking the US as a worldwide reference. These models do not consider the non-capitalist ownership firms such as the cooperatives, and other non-profit organizations. Instead, Hawley and Williams study focuses on firms with shares publicly traded and thus have rights of continuous succession, limited liability, and unitary boards.

These models are:

1- The Simple Finance Model.

2- The Stakeholder Model.

3- The Stewardship Model.

4- The Political Model.

The Simple Finance Model

This model is a all about setting the appropriate rules and incentives that would motivate managers to act in the best interest of investors. Hawley and Williams "Rules and incentives are defined only by the firm and do not incorporate any legal, political, regulatory or cultural framework".

In the Anglo countries like the US, UK and Canada, publicly traded firms are owned in majority by institutional investors distinct other countries. The problem with institutional ownership is that we end up with managers working as agents to investors and hence compiling the organization problem. The managers will undertake decisions that will more expand their own interests before shareholders. In this case, investors will have to incur the cost of monitoring management, furthermore bonding the agent to the principal.

To beat this agency problem it would look ideal to have a contract that indicates all managers’ decisions and actions under different states.

However, complete contracts are highly expensive and almost unachievable. Thus, it is more expected that managers will end up with situation where decisions are to be taken and again we are face to face with the agency problem.

The agency problem is particularly obvious in Anglo countries due to the dispersed ownership they have with the lack of a supervisory board or any "relationship investor" as described by Monks (1994).

The law next to dispersed ownership also plays a role in limiting the capability of shareholders of forming together a voting power that could have an impact on the management. Laws protect managers from shareholders interventions.

The Stakeholder Model

Clarkson (1994), a reference of stakeholder model stated that "the firm is a system of stakeholders operating within the larger system of the host society that provides the necessary legal and market infrastructure for the firm’s activities. The purpose of the firm is to create wealth or value for its stakeholders by converting their stakes into goods and services".

Moreover, Blair (1995, 322) "the goal of directors and management should be maximizing 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".

Furthermore, Porter (1992, 16-17) raised a recommendation to both, policy makers and corporations as well to adopt for use long-term employee ownership and to have significant board representation by suppliers, customers, employees, financial advisers as well as community representatives.

The result of all these suggestions will be the foundation of trade networks, business alliances and strategic associations that mostly exist in continental Europe, Japan and to a much lesser extent in the US. This is why Porter is giving his suggestion illustrated above as to raise the competitiveness of the US economy instead of relying on markets and hierarchy.

Tax incentives could be established to provide higher profits to shareholders in exchange of waving some of their property rights to strategic stakeholders. Multiple boards could also be encouraged to reduce any conflict of interest and consequently agency costs.

The Stewardship Model

According to this model, managers are driven by their sense of responsibility and need for achievement. In this context, Donaldson and Davis (1994), managers are considered to be "Good stewards of the corporations and carefully work to achieve high levels of corporate profit and shareholders returns". Hence, the need for independent non-executive director boards is no more valid.

Other sources also favored this concept like the Council of Institutional Investors in the US, Cadbury (1992) in the UK…

However, people willing to invest their money in nonprofit organizations just to be selected as directors act as a supporting argument to the stewardship theory.

Hawley and Williams believed that this theory could be expanded towards an executive dominated board or no board at all.

Boards in some instances could be developed just as a result of a cultural habit or to emphasize the idea that some family owned business or government looks more practical.

Researchers have found some discrepancy between both the stewardship and agency theories. Donaldson and Davis have contributed this contrast to some deficiencies in the adopted studies and ultimately the findings supporting both theories.

The stewardship activities of managers could become intended on all firms’ levels. Theories could be valid as supported by the empirical evidence and may be considered as part of the psychological, political, or other broader models.

The contingency may exceed the firm’s level to reach the whole culture as it is in Japan where employer could be ranking the first in terms of employee priority or when the executive resign from job in the event the firm is in a bad situation.

The Political Model

The delegation of authority and power to managers and the relationship to other stakeholders is mainly determined by governments and the corporate sector.

Over the past, this corporate sector proved to use a massive effect on the US legal, political, and regulatory system. Even Felix Frankfurter of the US Supreme Court stressed out that the history of US constitutional law is "the history of the impact of the modern corporation upon the American scene" quoted in Miller (1968).

After the American Revolution, corporations were only granted short life charters that were revocable in case of damage with only limited corporate authority. In the late 19th century, corporations’ role became so essential that they "bought and sold governments" as per Friedman (1973, 456). Different states reacted to this main change in the corporate sector role and as a result many of them brought up the cumulative voting of minority shareholders to select directors.

Hawley and Williams defined the political model from a micro point of view based on Gundfest (1990) and Pound interpretations.

Gundfest, declared that "an understanding of the political marketplace is essential to appreciate the role that capital-market mechanisms can play in corporate governance".

Pound, said that "the political model of governance is an approach in which active investors seek to change corporate policy by developing voting support from dispersed shareholders, rather than by simply purchasing voting power or control…" Accordingly it is a matter of politics and not finance that rules this new form of governance.

Black and Coffe (1993) declare that: According to a new "political" theory of corporate governance, financial institutions are not naturally uninterested, but rather have been regulated into submission by legal rules that sometimes purposely, sometimes inadvertently. Hobble American institutions and elevate the costs of participation in corporate governance.

Hawley and Williams (1996) comment that:

The political model of corporate governance locates the performance-governance issue squarely in a broader political context and places severe limits on the traditional economic analysis of the corporate governance problem.

Emerging Political Issues

From 1974 and on, tax and other incentives have been introduced into the US Congress to promote universal share ownership. This resulted in about 1000 firms out of the 7000 firms listed on American stock exchanges. Whereas in 1998 Japan had more than 90% of the firms listed on their stock markets with an ESOP. In Russia, this is much higher in publicly traded firms. Universal ownership prevents the problems of universal owners. Stakeholder ownership also proved to have a positive effect on the firm’s overall performance.

Other Models of Corporate Governance

Culture

The Culture is an explanation of governance carried out by Hollingsworth, Schmitter and Streeck (1994) from a cultural standing: Transactions are conducted on the basis of mutual trust and confidence sustained by constant, particularistic, preferential, reciprocally obligated. They may be kept together either by value consensus or resource dependency – that is, through "culture" and "community" – or through dominant units imposing dependence on others.

In this framework, the cultural perspective may represent some elements of the stewardship model.

Some of the scholars have found that the type of dominant religion in a culture like Catholicism may have an impact on trust within large firms. However, this has to be further tested in future researches.

It is also obvious that the impact of cultural values on the firm structure and performance should be incorporated in the studies to come.

The Power Perspective of Corporate Governance

Another point that seems to be ignored is the power to be delegated to all willing shareholders, managers or directors to take decisions and actions.

The power given to shareholders, considered as part of the political model, may face hindrances from security laws, to management plan at general meetings, voting arrangements, to proxy procedures, and corporate by-laws.

The effectiveness of the directors’ power depends on their will and knowledge to act and exercise control over management. In most cases, this will is not present either out of loyalty to the management or due to the lack of shareholders support. The later, clearly present in US firms, is caused by the lack of information that is mainly kept at the managers’ level. Perssson, Tabillini and Roland (1996) proved that the welfare of stakeholders may become negative if we do not have an appropriate separation of powers.

Until now, there was a wide cry for complete disclosure and transparency that would allow shareholders to do the proper monitoring of firms’ actions. This call was based on an implicit assumption that shareholders already possess power and the good will to act. The authority of this assumption is to be considered in all corporate governance studies.

The power model constituting a part of the larger political model should not be disregarded since without the appropriate power, no action can even initiate.

Cybernetic Analysis

The cybernetic approach is based on the mathematics of information theory.

This means that humans like computer have limited capacity to receive, store, process and transmit information. This is why they prefer almost stable systems or slow rate changes.

Another purpose for economizing information is maybe to avoid the problem of "bounded rationality" or in other terms the neurophysiologic limits of humans from one side to their language limits from the other side.

To overcome the capacity issue of humans as it is with computers, it might sound wiser to accomplish the work in team, network or group. This explains the need for designing teams, or multiple boards, or even the setting of external alliances with stakeholders.

1.2 Previous research

1. Japanese Corporate Governance

Unlike large American companies, large Japanese and German companies tend to engage in long term commercial relationships, which have resulted in the famous Japanese keiretsu, or long-term corporate networking. These networks show a number of common business practices within Japan that have important governance functions.

Reciprocal Trade and Relational Contracting:

Japanese keiretsu is mainly characterized by loyalty and stability in affiliation between group members. Unlike the Anglo-American system, Japanese long-term contracts are governed by trading relation-ships. Usually companies sign a long-term "basic agreement" subject to annual renewal. Basic agreements generally contain articles that specify that any disagreement between the parties should be solved kindly through mutual discussion. These agreements are usually done by senior management.

b) Board Composition:

Huge Japanese corporations are controlled by Boards of Directors comprising of managing directors chosen from the top management itself.

Major share-owning stakeholders, such as banks, are often indirectly represented in a Japanese company’s Board of Directors.

c) Management Transfers and Information Sharing:

The effective communication desired to maintain long-term relationships between the different Japanese contracting parties requires management transfers and the development of lines of communication between these parties. Moreover, many Japanese industries have institutionalized networks that promote information sharing.

The company’s main bank closely monitors its business and financial condition and intervenes in times of distress, especially when it is the largest supplier of capital to the company.

d) Selective Intervention:

Generally this intervention is done by the company’s main bank, which does not only intervene at times of distress but also for dispute resolution and negotiations with bank clients.

2. German Corporate Governance

The German corporate governance system is similar to the Japanese system and different from the Anglo-American and French systems. Many Eastern European countries are affected by the German system.

a) Two-Tiered Board Structure:

The two-tier governance system was created in 1870, in order to give bankers a tool to control its investments. They have two boards, a supervisory board and a management board, that meet several times per year. The supervisory board appoints the management board, instead of just appointing the CEO. However no member can sit on both boards. The members of the management board are supposed to run the company by agreement. But it is worth mentioning that on top of appointing the management and setting their compensation, the supervisory board sometimes has more authority in the company.

Technically, shareholders and employees of German companies are equally represented on the supervisory board.

Shareholders’ representatives are often chosen for their relationship with German industry. Insurance companies and banks have significant representation.

b) Special Banks’ Position:

Due to the historical economic situation in Germany, banks own a significant percentage of equity in German corporations and they serve as depositories for stock owned by other shareholders in the company. The banks also have the right to vote on behalf of depositors. In view of this, the corporations’ main banks need to be represented on their supervisory boards as is usually done in Germany. Supervisory board members from such banks are valued for their economic conditions and knowledge of business, as well as for their detailed knowledge of the company.

c) Merger and Acquisition Activity:

"The special position of banks, government anti-trust policy, and the structure of the corporation all discourage unfriendly takeovers." In view of the strong position of banks as equity suppliers and holders, it is very difficult for unfriendly takeovers to occur without a bank’s approval.

3. Conclusive Remarks:

Board differences do appear to separate the systems commonly found among large corporations in different countries such as Germany, Japan and the United States…

Due to globalization, these systems are coming into direct contact and sometimes in conflict with each other. Occasionally they are coming into competition with each other.