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INTRODUCTION One of the most vital key ingredients for a company if its wants to survive is to have a clean good corporate governance, where all the role and the rights of corporate elements are well presented and run as it should to guarantee that the company is able to maximize the return to the owners as it is the main purpose of a corporation. However though, not all of the companies out there in this world run their activities based on this idea, not to mention the obstacles found by them who intended to implement it. This corporate governance often put a company into a crisis where it seems that a company lost on their way to achieve their purpose as I mentioned above. Due to the purpose of doubling the owner’s profit, managers as the executives of one company could sometimes do anything they could to achieve an acknowledgement of their good work and further higher bonuses and promotions as a concrete for of those acknowledgments. Meantime, many researchers, and practitioners are all trying to see this situation with a deeper perspective, trying to define what corporate governance really means, what are the elements included in this concept, and what would be the impact for one company if they implement this idea and what would it be if they’re not. Many comes with definitions, and approaches, anomalies to study, and many other problem solving materials, found by years of research and real life cases and evidences. 1

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One of the most vital key ingredients for a company if its wants to survive is to have a clean

good corporate governance, where all the role and the rights of corporate elements are well

presented and run as it should to guarantee that the company is able to maximize the return to

the owners as it is the main purpose of a corporation. However though, not all of the

companies out there in this world run their activities based on this idea, not to mention the

obstacles found by them who intended to implement it.

This corporate governance often put a company into a crisis where it seems that a company lost

on their way to achieve their purpose as I mentioned above. Due to the purpose of doubling the

owner’s profit, managers as the executives of one company could sometimes do anything they

could to achieve an acknowledgement of their good work and further higher bonuses and

promotions as a concrete for of those acknowledgments.

Meantime, many researchers, and practitioners are all trying to see this situation with a deeper

perspective, trying to define what corporate governance really means, what are the elements

included in this concept, and what would be the impact for one company if they implement this

idea and what would it be if they’re not. Many comes with definitions, and approaches,

anomalies to study, and many other problem solving materials, found by years of research and

real life cases and evidences.

This paper made and aimed to compile some of those definitions, and perspectives, so that we

can all see this idea of corporate governance in many point of views. This paper is also including

one real example how a company would deal with this concept when by nature, it operates on

places where culture values have making it hard to do in a most possibly the right way to do it.


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One of the good examples where we can actually see how a company in such a great need to

implement an idea of good corporate governance and yet struggling with some nasty situation

related to the fact that it is operated in a place where internal situations like the fact that it is a

family corporations and external situations like socio-political aspect really affecting the stand

ground of one company is the example of what was happening to south-east Asia and the

nations of that region during and after the Asian financial crisis in 1997.

In 1998, the Asian Development Bank (ADB), launched a study to assist countries that were

most affected by the crisis and determine what factors resulted in the extent of damage

suffered by this countries. The findings show “that poor corporate governance was one of the

major contributors to the building up vulnerabilities that finally led to the crisis in 1997”.

One feature that considered responsible of this situation is the fact that in East Asia is

controlled by large families. This featured are marked by the characteristic of a significant

family control and interlocking shareholdings among affiliated firms. This clearly has a potential

to create problems for the companies’ corporate governance, because the ownership

structures give insiders excessive power to pursue their own interests. The ADB stated that this

problem was one that could be solved by internal checks on the company structures; at this end

many South-East Asian countries have enacted legislation regulating directors’ duties as well as

guidelines to achieving good corporate governance. A study carried out by the World Bank in

2003 showed that family businesses made up the following proportions of total market

capitalization in these South East Asian countries.

In certain countries where effective legislation is in place, the dominance of family business

structures may be used to promote principles of good corporate governance. Family businesses

have the valuable characteristic of having an incentive to keep in place long-term strategies

that aim ‘to transfer the company to the next generation in better condition than it was when

received from the preceding generation’. This differs significantly from the short-term goals of

most companies aiming to maximize profitability in the current period. By taking initiatives

directed at the long-term improvement in performance, it is submitted that family businesses


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have encouraging prospects of practicing good corporate governance. The family business

structure gives rise to various interesting discussions with regards to corporate governance, and

these are reflected in many South East Asian legal frameworks.


In modern economies, the management and control of companies is increasingly separated

from the ownership. It is in line with the Agency Theory that pointing out the importance on

separating day to day corporate management from the owners to the managers. The purpose

of the separation system is to create efficiency and effectiveness by hiring professional agents

in managing the company. It is happened where the CEOs of public companies have

responsibility to act as agents for the owners. While the owners seek to gain information (by

evaluation), develop incentive systems to ensure agent actions in the owner's interests.

However there is a problem in this separation of corporate management and ownership as

well. Managers may seek to maximize their own-self interest at the expense of shareholders.

Furthermore this separation may lead to a lack of transparency in the use of funds in the

company and in the proper balancing of the interests of, for instance, shareholders and

managers and of controlling and minority shareholders.

Corporate governance is not a new issue to discuss, for years researches been trying to

understand what corporate governance is, and how a company would implement this

mechanism on how it operates. This leads to various definitions stated by these researches,

including what are the roles of stakeholders, and the theories tagged along the definitions. And

along the way, they also develop a concept of ‘good corporate governance’, which basically

means corporate governance that is done in the right way.

Much of the confusion concerning corporate governance likely occurs because discussions of

governance issues typically assume implicitly governance is out of equilibrium. That is, unlike

other economic activity, commentators often talk as if the invisible hand has yet to guide the

governance to an equilibrium point, with such a mindset, “reforms”, which consist of requiring


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all firms to adopt what seems to be a good idea or has been shown historically to be a trait

associated with the good-performing firms, can seem a sensible course of action.

The OECD Principles of Corporate Governance states:

"Corporate governance involves a set of relationships 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 performance are determined."

While the conventional definition of corporate governance and acknowledges the existence and

importance of 'other stakeholders' they still focus on the traditional debate on the relationship

between disconnected owners (shareholders) and often self-serving managers. Indeed it has

been said, rather ponderously, that corporate governance consists of two elements:

1. The long term relationship which has to deal with checks and balances, incentives for

manager and communications between management and investors;

2. The transactional relationship which involves dealing with disclosure and authority.

This implies an adversarial relationship between management and investors, and an attitude of

mutual suspicion. This was the basis for much of the rationale of the Cadbury Report, and is one

of the reasons why it prescribed in some detail the way in which the board should conduct

itself: consistency and transparency towards shareholders are its watchwords.

The concept of corporate governance can be defined as a set of mechanisms for directing and

controlling and enterprise for the company operational in accordance with the expectations of

stakeholders. The concept of CG has a narrow or broad perspective. Narrowly, the concept of

Corporate Governance is a concept that focuses on the harmonious relationship organs of the

company (shareholders, board of commissioners and board of directors who manage the

company.). Corporate governance is known as the shareholder’s model of governance.


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In the shareholder model of governance, the concept of Corporate Governance faced with two

main issues:

1. Agency Problems

According to Monks and Minow (1995), the company is a mechanism that provides the

opportunity for several participants to contribute to the capital, expertise and

manpower in order to maximize profits in the long term. Participants who contributed

to the capital known as the owner (the principal), whereas participants who contribute

the expertise and labor is called the agent (management company). The existence of

two participants (the owner and agent), causing the problems concerning the

mechanism should be established to harmonize the different interests between

them. After making the placement of the capital owned, the owner will leave the

company without an assurance that the capital that has been placed will not be

channeled to investments or projects that are not profitable.

Chandler and Bratton said that until the year 1970, the agency issues related to the

legitimate use of power by the dichotomy between capital owners and agents became a

central element that dominates the research in the company. The direct effect of this

idea can still be felt today, especially among practitioners and decision makers that

specifically discuss the company's shareholders as owners and GCG as a problem which

basically related to the separation of ownership and control of the company

(Learmount, 2002).

2. The Problems of Incomplete Contracts

After 1970 came a new economic theories of the firm. These theories put forward by

Alchian and Demset'z (1972) and Jensen and Meckling (1976). Alchian and Demset'z and

Jensen and Meckling introduced the idea that the company is a nexus of contracts

(Learmount, 2002). The company is a nexus of contracts means that within the company

there is a set of contractual reciprocity (quid pro quo contract) that facilitates the

relationship between company owners, employees, suppliers, and various other


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participants associated with the company (Fan, 2004). Maher and Andersson (2000)

states that it is impossible to create a complete contract between the investors and

agents who can detail the division of profits between capital owners and agents, and

also to describe the appropriate actions in all situations possible. The cause of the

absence of complete contracts are not to be expected every possibility that happen in

the future due to cost constraints or to anticipate every possibility. The absence of

complete contracts has led to the emergence of numerous conditions that require

control measures in the management of companies that are not explicitly stated in the

contract. Grossman and Hart (1986) describes this as residual control rights, namely the

right to make decisions in situations not described in the contract, for example the right

to make decisions in the management of an investment deal with conditions that are

different from what was planned. In fact, even if capital owners also receive control

rights in order to decide something unexpected, the allocation of residual control for

capital owners are often not effective because most of the capital owners often do not

have the ability or do not have enough information to know what to do.

Tersa Barger, Director of IFC/World Bank Corporate Governance Department, on her opening

speech for 2004 Vietnam OECD/World Bank Asia International Roundtable Meeting on

Corporate Governance, pointed why corporate governance is such an important thing to secure

the investor's interests, as well as the wealth of the Government, as quoted of her speech


“As this is the first meeting, I would like to give you IFC’s point of view on why

corporate governance is important, not just for us as outside investors, but for

the Government of Vietnam, for Vietnam's long-term economic success, and for

the benefit of individual companies themselves. Good corporate governance in a

business enterprise promotes operational efficiency, professional management,

clear lines of authority and good risk management, all of which promote

business success and improved profitability. Companies, who turn to outside

sources of capital, as some of you no doubt are currently contemplating, will


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need to demonstrate sound governance to investors and lenders. Outside

investors, like IFC, equate good corporate governance with operational success

and lower investment risk, and therefore are more likely to work with companies

that have made strides in this area. Governments, and the people they serve,

benefit from better corporate governance by increased transparency, leading to

a more fair collection of tax revenues, and the development of a level playing

field for fair competition. Fair competition leads, ultimately, to faster economic

growth as individuals and companies see that their investments will be

protected, allowing them to invest in increased productive capacity. Investment

in production leads to better technologies, better products, increased

employment and a growing economy better able to support an improving social

infrastructure. So corporate governance and investment are part of a virtuous


Corporate governance principles and codes have been developed in different countries and

issued from stock exchanges, corporations, institutional investors, or associations (institutes) of

directors and managers with the support of governments and international organizations. As a

rule, compliance with these governance recommendations is not mandated by law, although

the codes linked to stock exchange listing requirements may have a coercive effect. For

example, companies quoted on the London, Toronto and Australian Stock Exchanges formally

need not follow the recommendations of their respective codes. However, they must disclose

whether they follow the recommendations in those documents and, where not, they should

provide explanations concerning divergent practices. Such disclosure requirements exert a

significant pressure on listed companies for compliance.

Furthermore, widely Corporate Governance concept is a concept that focuses on the

responsibility a company to a number of stakeholders, in addition to owners or

shareholders. The interested parties include the creditors and social constituencies such as

members of the community where the company is located, the environment, as well as local

government and central government. Corporate Governance concept like this is known as

stakeholder model of governance. Within the framework of his analysis, stakeholder model of


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governance emphasizes the company’s presence as an intuition that should be socially

responsible and as an institution that must be managed for public purposes (Maher and

Anderson, 2000).


The primary elements of Corporate Governance are: (1) the shareholders, (2) the management

(led by the chief executive officer), and (3) the board of directors.

The boards of directors are the elected representatives of the shareholders. They are charged

with ensuring that the interests and motives of management are aligned with those of owners.

Recently, there has been much criticism as well as cynicism by both citizens and the business

press about the poor job that management and the BODs of large corporations are doing. We

only have to look at the recent scandals at firms such as Arthur Andersen, WorldCom, Enron,

Tyco, and ImClone Systems. Such malfeasance has led to the erosion of the public’s trust in the

governance of corporations.

There is a popular tendency to view shareholders as the owners of public corporations which

affects some "definitions" of corporate governance. For example, the report of India's SEBI

Committee on Corporate Governance defines corporate governance as the "acceptance by

management of the inalienable rights of shareholders as the true owners of the corporation

and of their own role as trustees on behalf of the shareholders. It is about commitment to

values, about ethical business conduct and about making a distinction between personal &

corporate funds in the management of a company." It has been suggested that the Indian

approach is drawn from the Gandhian principle of trusteeship and the Directive Principles of

the Indian Constitution, but this conceptualization of corporate objectives is also prevalent in

Anglo-American and most other jurisdictions.

Laws and standards defining the responsibilities of boards of directors vary from country to

country. For example, board members in Ontario, Canada face more than 100 provincial and

federal laws governing director liability. The United States, however, has no clear national

standards or federal laws, specific requirements of director vary, depending on the state in

which the corporate charter issued. There is, nevertheless, a developing worldwide consensus


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concerning the major responsibilities of a board. Interview with 200 directors from eight

countries (Canada, France, Germany, Finland, Switzerland, the Netherlands, the United

Kingdom, and Venezuela) revealed strong agreement in following board of director

responsibilities, listed in order of importance:

1. Setting corporate strategy, overall direction, mission, or vision

2. Hiring and firing the CEO and top management

3. Controlling, monitoring, or supervising top management

4. Reviewing and approving use of resources

5. Caring for shareholder interests’

How does a board of directors fulfill these many responsibilities? The role of board directors in

strategic management is to carry out these basic tasks:

1. Monitor: by acting through its committees, a board can keep abreast of developments

inside and outside the corporation, bringing to management’s attention developments it

might have overlooked. A boar should at least carry out this task.

2. Evaluate and influence: a board can give examine management’s proposals, decisions,

and actions; agree or disagree with them; give advice and offer suggestions, and outline

alternatives. More active boards perform this task in addition to monitoring.

3. Initiate and determine: a board can delineate a corporation’s mission and specify

strategic options to its management. Only the most active boards take on this task in

addition to the previous ones.

Another explanation of Board of Director’s involvement can be seen on Board of Directors

Continuum, which shows the possible degree of involvement (from low to high) in strategic

management process. Boards can range from being phantom boards with no real involvement

to catalyst boards with a very high degree of involvement. Research suggests that active board

involvement in strategic management is positively related to corporation’s financial

performance and its credit rating.


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Highly involved boards tend to be very active. They take their tasks of monitoring, evaluating,

influencing, initiating, and determining very seriously; they provide advice when necessary and

keep management alert. Their heavy involvement in the strategic management process places

them in active participation or even catalyst position. For example in a survey of directors of

large U.S. corporations conducted by Korn/Ferry International, more than 60% indicated that

they were deeply involved in the strategy-setting process. In the same survey, 54% of the

respondents indicated that their boards participate in an annual retreat or special planning

session to discuss company strategy. Nevertheless, only slightly more than 32% of the boards

help develop the strategy. More than two-thirds of the boards review only after it has first been

developed by management. Another 1% admits playing no role in strategy. This and other

studies suggest that most large corporation s have boards that operate at some point between

nominal and active participation.

Generally, the smaller the corporation, the less active its board of directors. In an

entrepreneurial venture, for example, the privately held corporation may be 100% owned by

the founders-who also manage the company. In this case, there is no need for an active bard to

protect the interests of the owner-manager shareholders-the interests of the owners and

managers are identical.

The boards of most publicly owned corporations are composed of both inside and outside

directors, inside directors (sometimes called management directors) are typically officers or

executives employed by the corporation. Outside directors (sometimes called non-management

directors) may be executives of other firms but are not employees of the board’s corporation.

Although there is yet no clear evidence indicating that a high proportion of outsiders on a board

results in improved financial performance, as measured by return on equity, there is a trend in

United States to increase the number of outsiders on boards. The typical large U.S. fortune

1000 corporation has an average of 11 directors, 2 of whom insiders. Even though outsiders

amount for slightly over 80% of board members in these large U.S. corporations (approximately

the same as in Canada), they account for only 42% of boar membership in small U.S.

companies. Boards in the UK typically have 5 inside and 5 outside directors, whereas in France


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boars usually consist of 3 insiders and 8 outsiders. Japanese boards, in contrast, contain 2

outsiders and 12 insiders.

People who favor a high proportion of outsiders state that outside directors are less biased and

more likely to evaluate management’s performance objectively than are inside directors. This is

the main reason why the U.S. Securities and Exchange Commission (SEC) in 2003 required that a

majority of directors on the board be independent outsiders. The SEC also required that all

listed companies staff their audit, compensation, and nominating/corporate governance

committees entirely with independent, outside members. This view is in agreement with

agency theory, which states that problems arise in corporations because the agents (top

management) are not willing to bear responsibility for their decisions unless they own a

substantial amount of stock in corporation. The theory suggests that a majority of a boar needs

from outside of the firm so that top management is prevented from acting selfishly to

detriment of shareholders. Boards with a larger proportion of outside directors tend to favor

growth through international expansion and innovative venturing activities than do boards with

a smaller proportion of outsiders. Outsiders tend to be more objective and critical of corporate


In contrast those who prefer inside over outside directors contend that outside directors are

less effective than are insiders because the outsiders are less likely to have the necessary

interest, availability, or competency. Stewardship theory proposes that, because of their long

tenure with the corporation, insiders (senior executives) tend to identify with the corporation

and its success. Rather than use the firm for their own ends, these executives are thus most

interested in guaranteeing the continued life of the corporation. Excluding all insiders but the

CEO reduces the opportunity for outside directors to see potential successors in action or to

obtain alternate points of view of management decisions. Outside directors may sometimes

serve on so many boards that they spread their time and interest too thin to activelu fulfill their


Top management responsibilities, especially those of CEO, involving getting things

accomplished through and with others in order to meet the corporate objectives. Top


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management’s job is thus multidimensional and is oriented toward the welfare of the total

organization. Specific top management task vary from firm to firm and are developed from an

analysis of the mission, objectives, and key activities of the corporation. Tasks are typically

among the members of the top management team. A diversity of skills can this very important.

Research indicates that top management teams with a diversity of functional and educational

backgrounds and length of time with the company tend to be significantly related to

improvements in corporate market share and profitability. In addition, highly diverse teams

with some international experience tend to emphasize international growth strategies and

strategic innovation especially in uncertain environment, to boost financial performance. The

CEO, with the support of the rest of the top management team, most successfully handle two

primary responsibilities that are crucial to the effective strategic management of the

corporation: (1) provide executive leadership and strategic vision and (2) manage the strategic

palling process.

Successful CEOs are noted for having a clear strategic vision, a strong passion for their

company, and an ability to communicate with others. They are often perceived to be dynamic

and charismatic leaders-which is especially important for high firm performance and investor

confidence in uncertain environment

One view is that the conflict of interest between owners and managers would be substantially

reduced if executive compensation plans more tightly related to performance. The view is

widely held that executive compensation is not closely linked to performance measured by

changes in the value of the firm. Jensen and Murphy (1990) found that executive pay changes

by only $3 for a $1.000 change in the wealth of the firm, an elasticity of 0.003, or 0.3%. this is

argued to demonstrate that executive pay is not linked to performance. However, this

relationship may be least partially explained by large value of the firm in relation to executive


A large impact on executive wealth position could have strong motivational influences.

Haubrich (1994), using some reasonable parameter assumptions, derived Jensen and Murphy

results from some leading models of principal-agent theory.


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Core, Holthousen, and Larcker (1999), examined the association between firm’s corporate

governance structure and level of CEO compensation and the future performance of the firm.

The sample consisted of 495 observations for 205 publicly traded U.S firms over the period

1982 to 1984. The compensation data were collected by a major consulting firm using mail


The cross-sectional regression, controlling for the economic factors, showed that board of

director characteristics and ownership structure were significantly related to the level of CEO

compensation. With regard to board of director variables, CEO compensation was higher when

side directors appointed by the CEO, there were more outside directors considered “gray” (the

pay), and outside directors were older and served on more than three other boards. CEO

compensation was lower the greater percentage of inside directors that sat in the board. With

respect to ownership’s variables, CEO compensation was lower when the CEO’s ownership was

higher and when the large blockholders were present (either non-CEO internal board members

or external blockholders who owned at least 5% of the equity).

Core, Holthousen, and Larcker used a second set of regressions between the compensation

predicted by the board and ownership variables and the subsequent operating and market

performance of the firm. They found a significant negative relationship. This result suggested

that the board and ownership variables were proxies for the effectiveness of the firm’s

governance structure controlling agency problems and not the determinants of the CEO’s

equilibrium wage. The board and ownership structures affected the extent to which CEOs

obtained compensation in excess of level implied by the economic determinants. Thus, firms

with weaker governance structures had greater agency problems. CEOs of firms with greater

agency problems were able to obtain a higher compensation. Firms with greater agency

problems did not perform as well.


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These are some proposal to improve pay for performance policies have been made in recent


1. Limit the base salaries of top executives

2. Base bonus and stock option plans on stock appreciation

3. Stock appreciation benchmarks shoul consider:

a. Close competitors

b. A wider peer group

c. Broader stock market indexes

4. Base stock options on a premium of 10% to 20% over the current market and do not

prerace them if the shares of the firm fall below the original exercise prices

5. Institute company loan programs that enable top executives to buy substantially impact

the wealth position of the top executives

6. Pay directors mainly in stock of the corporation with minimum specified holding periods

to heighten their sensitivity to firm performance.

Despite the primacy of generating shareholder value, managers who focus solely on the

interest of the owners of business will often make poor decisions that lead to negative

unanticipated outcomes. For example decisions such as mass layoffs to increase profits,

ignoring issues related to conservation of natural environment to save money, and exerting

excessive pressure on suppliers to lower prices can certainly harm the firm in the long run. Such

actions would likely lead to negative outcomes such as alienated employees, increased

governmental oversight and fines, and disloyal suppliers.

Clearly, in addition to shareholders, there are other stakeholders (e.g. suppliers, customers)

who must be explicitly taken into account in the strategic management process. A stakeholder

can be determined as an individual or group inside or outside the organization’s performance.

Each stakeholder group makes various claims on the company.

A survey of the U.S. general public by Harris Poll revealed that 95% of the respondents felt that

U.S. corporations owe something to their workers and the communities in which they operate

and that they should sometimes sacrifice some profit for the sake of making things better for


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their workers and communities. People were concerned that business executives seemed to be

more interested in making profits and boosting their own pay than were in the safety and

quality of the products made by their companies. These negative feelings receive some support

from a study that revealed that the CEOs at the 50 U.S. companies that outsourced the greatest

number of jobs received a greater increase in pay (up 46%) from 2002 and 2003 than did the

CEOs of 365 U.S firms overall (only 9% increase).

Definitions are vary among these elements of stakeholders, there are arguments saying that

each one of the group of stakeholders holds the position of main stakeholders:

1. Employees: there is widespread argument that they are the prime stakeholder

2. Shareholders: some would say that shareholders are the first stakeholder

3. Management: controversial, but some believe that managers are stakeholders. For

example, Evan and Freeman argue that managers have an additional duty to maintain

the health of the company by keeping stakeholder demands balanced, which makes

them stakeholders

4. Creditors: creditors rights are often protected under contract and backed by collateral

so they are seldom treated as owners, as the shareholders are

5. Trade unions: some argue that this group is redundant with the employee group

6. Customers: most stakeholder models include customers

7. Suppliers: often considered stakeholder

8. The local community: broader definitions of stakeholders widen the concept to include

responsibility to future generations –those who will one day be reliant upon the physical

environment—as a stakeholder group.

There are two opposing ways of looking at the role of stakeholder management in strategic

management process. The first one can be termed ‘zero sum’. In this view, the role of

management is to look upon the various stakeholders as competing for the organization’s

resource. In essence, the gain of one individual or group is the loss of another individual or



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Although there will always be some conflicting demands, there is value in exploring how the

organization can achieve mutual benefit through stakeholder symbiosis, which recognizes that

stakeholders are dependent upon each other for their success and well-being. That is,

managers acknowledge the interdependence among employees, suppliers, customers,

shareholders, and the community at large.

Contractual Theory of the Firm

The contractual theory of the nature of the firm has become widely held (Alchian, 1982; Alchian

and Woodward, 1988; Fama and Jensen, 1983a, 1983b). It vies the firm as a network of

contracts, actual and implicit, that specify the roles of the various participants or stakeholders

(workers, managers, owners, lenders) and defines their rights, obligations, and payoffs under

various conditions. The contractual nature of the firm implies multiple stakeholders. Their

interest must be harmonized to achieve efficiency and value maximation. A basic issue is the

role of market transactions (and their relative costs) versus organization processes as

alternative models of governance (Williamson, 1999).

Although contracts define the rights and responsibilities of each class of stakeholders in a firm,

potential conflicts can occur, contracts are unable to envisage the many changes in conditions

that develop over the passage of time. Also, participants might have personal goals, as well.

Most participants contract for fixed payoffs. Workers receive wages. Creditors receive interest

payments and are promised the repayment of principal at the maturity of debt contracts. The

shareholders hold residual claims on cash flows. In recent years, wage earners have been paid

in part in the common stock of the firm in ESOPs or in return for wage concessions. Warrants

and convertibles add equity options to debt contracts.

In this framework, the literature has expressed concern about the separation of ownership and

control (Berle and Means, 1932). In general, the operations of the firm are conducted and

controlled by its managers without major stock ownership positions. In theory, the managers

are agents of the owners, but in practice they may control the firm in their own interests. Thus,

conflict of interest arises between the owners and managers.


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Jensen and Meckling (1976) developed a number of aspects of the divergence of interest

between owners and management (their agent). They described how the agency problem

results whenever manager owns less than the total common stock of the firm. This functional

ownership can lead managers to work less strenuously and to acquire more perquisites

(luxurious offices, furniture, and rugs; company cars) than if they had to bear all of the costs.

To deal with agency problems, additional monitoring expenditures (agency costs) are required,

Agency costs include (1) auditing systems to its limit this kind of management behavior, (2)

various kinds of bonding assurances by the managers that such abuses will not be practiced,

and (3) change in organization systems to limit the ability of managers to engage in the

undesirable practices.

Agency Theory versus Stewardship Theory in Corporate Governance

Managers of large, modern publiclt held corporations are typically not the owners. In fact, most

of today’s top managers own only nominal amounts of stock in the corporation they manage.

The real owners (shareholders) elect boards of directors who hire managers as their agents to

run the firm’s day-to-day activities.

Agency theory. As suggested in the classic study by Berle and Means, top managers are, in

effect, “hired hands” who may very likely be more interested in their personal welfare than that

of the shareholders. For example, management might emphasize strategies, such as

acquisitions, that increase the size of the firm (to become more powerful and to demand

increased pay and benefits) or that diversify the firm into unrelated businesses (to reduce

short-term risk and to allow them to put less effort into a core product line that may be facing

difficulty) but that result in a reduction in dividends and/or stock price.

Agency theory is concerned with analyzing and resolving two problems that occur in

relationships between principals (owner/shareholders) and their agents (top management):

1. The agency problem that arises when (a) the desires objectives of the owners and the

agents conflict or (b) it is difficult or expensive for the owners to verify what the agent is


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actually doing. One example is when top management is more interested in raising its

own salary than in increasing stock dividends

2. The risk-sharing problem that arises when the owners and the agents have different

attitudes toward risk. Executives may not select risky strategies because they fear of

losing their jobs if the strategy fails.

According to agency theory, the likelihood that these problems will occur increase when stock

is widely held (that is, when no one shareholder owns more than a small percentage of the total

common stock), when the board of directors is composed of people who know little of the

company or who are personal friends of top management, and when a high percentage of

board members are inside (management) directors.

To better align the interest of the agents with those of the owners and to increase the

corporation’s overall performance, agency theory suggests that top management have a

significant degree of ownership in the firm and/or have a strong financial stake in its long-term

performance. In support of this argument, research indicates a positive relationship between

corporate performance and the amount of stock owned by the directors.

Stewardship Theory, in contrast, suggests that executives tend to be more motivated to act in

the best interests of the corporation than in their own self-interests. Whereas agency theory

focuses on extrinsic rewards that serve on lower-level needs, such as pay and security,

stewardship theory argues that senior executives overtime tend to view the corporation as an

extension of them. Rather than use the firm for their own ends, these executives are most

interested in guaranteeing the continued life and success of the corporation. The relationship

between the board and the top management is thus one of the principal and steward, not

principal and agent (hired hand). A diversified investor may care little about risk at the company

level-preferring management to assume extraordinary risk so long as the return is adequate.

Because executives in a firm cannot easily leave their jobs when in difficulty, they more

interested in a merely satisfactory return and put heavy emphasis on the firm’s continued

survival. This, stewardship theory argues that in many instances top management may care

more about a company’s long term success than do more short term oriented shareholders.


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Positive Corporate Governance

James McConville on German Law Journal is explaining a concept named as Positive Corporate

Governance, a one way to see corporate governance in behavioral and motivational point of

view, which derived from a psychological term named positive psychology, a concept that was

developed by Martin Seligman in 2000.

Positive corporate governance represents a movement that views the behavior and motivations

of corporate participants (particularly executives) in a positive light (and is thus a significant

departure from the ‘anti-management’ approach which presently maintains support in law

faculties and management schools), to recognize their personal strengths and virtues, and to

promote the tangible implications that this positive perspective has for corporate governance

(in particular the regulation of internal governance arrangements and the performance of


Positive corporate governance recognizes the dominance of the corporation in modern society

and places enormous faith in the corporation as a facilitator of positive outcomes in society

(strong employment, sustainable environment, healthy relationships on a professional and

personal level). It does this by emphasizing and promoting the positive traits in corporate

participants, how these traits can be materialized through the corporation (as well as how these

traits can be brought to the corporation), and the important implications of this positive

emphasis on the corporation and its performance and sustainability. This provides positive

corporate governance with a solid normative grounding.

In this respect, it could be said that there are close parallels between positive corporate

governance and “virtue ethics”, first advocated by Aristotle in The Nicomachean Ethics, and

which has since been applied in contemporary management literature and thinking to infuse

management with moral accountability and autonomy. Virtue ethics is fundamentally

concerned with the character or attributes of a person that allow that person to “best” perform

their role [as director, executive or otherwise]. There is a focus on character and how it can be

enhanced, rather than emphasizing the utility of rules. Education is considered to have an

important role to play in this systematic development.


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Because of the concentration on human weaknesses inside the corporation rather than

recognizing and fostering strengths, what we have seen in recent years is a change in the

dynamics of regulation in relation to corporate governance – from adherence to internal

‘norms’ to the emergence of external regulatory mechanisms (i.e., formal legal rules) designed

to perform a reward or punishment function in an effort to control the behavior of managers.

Under this approach, the corporation, and the individuals within the corporation, cannot be

trusted to regulate their own internal arrangements without some external oversight and

imposition of external rules.

Positive corporate governance has some significant implications for the regulation of corporate

governance. This is because the negative ‘agency problem’ is considered the underlying and

ultimate justifying force for external regulation of corporate governance.

In their text, Understanding Company Law (2003), Lipton and Herzberg make it quite clear that

regulation of corporate governance is based entirely on the presumption that directors and

managers of modern public corporations need to be kept accountable.

Corporate governance best practice seeks to provide the mechanisms which align the interests

of management with those of shareholders. The development of increased interest in corporate

governance reflects higher expectations by the public and investment community that greater

efforts be made by listed public companies to develop structures and procedures so as to

ensure management is effective and acts in the interests of shareholders and adopts

appropriate standards of corporate behavior.

One of the areas of corporate governance where positive corporate governance has significant

implications is executive compensation. Positive corporate governance may just be the answer

to the problematic “decoupling” of executive pay from company performance that we have

recently witnessed.

Positive corporate governance contends that for the overwhelming majority of corporate

executives, happiness comes not from money per se, but rather one’s relative position. In

embracing positive corporate governance, the task becomes directing this natural competitive

instinct (with the help of education both in and outside of the corporation) to promote more


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productive endeavors - as opposed to relying on conventional methodologies, such as ‘pay for

performance’ to achieve the same objectives.

Corporate Governance Reform

There is a growing consensus that corporate governance reform should be a matter of global

concern. Although some countries face more serious problems than others, existing governance

mechanisms have failed to effectively protect outside investors in many countries. Among the

other things, reform requires: (1) strengthening the independence of board of directors with

more outsiders (2) enhancing the transparency and disclosure standard of financial statements,

and (3) energizing the regulatory and monitoring the function of stock exchange commission.

However, as we have seen from the experiences of many countries, governance reform is easier

said than done. First of all, the existing governance system is a product of historical evolution of

the county’s economic, legal, and political infrastructure. It is not easy to change historical

legacies. Second, many parties have vested interests in the current system, and they will resist

any attempt to change the status quo. For example, Arthur Levitt, chairman of the SEC during

much of 1990, attempted the use of lobbyists and advertising, in Levitt’s word (The Wall Street

Journal, June 17, 2002, p. C7): “The ferocity of the accounting profession’s opposition to our

attempt to reform the industry in a few years ago is no secret…. They will do everything

possible to protect their franchise, and will do so with little regard for public interest.” This

earlier failure to reform the accounting industry contributed to the breakout scandals in the

United States. It is noted that former executives of WorldCom were indicated allegedly

orchestrating the largest accounting fraud in history, with the help of conniving auditors. In

another example, following the Asian financial crisis, the Korean government led efforts to

reform the country’s chaebol system but met with stiff resistance from the founding families,

which were basically afraid of losing their private benefits of control. Nevertheless, reform

efforts in Korea were partially successful, partly because the weight and prestige of the

government were behind them and partly because public opinion was generally in favor of



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Sarbanes-Oxley Act of 2002

Beginning in 2000, in United States, numerous corporate misdeeds were uncovered and

disclosed by various regulatory bodies. The misdeeds derived from two types of issues: (1) false

disclosures in financial reporting and other information releases, and (2) undisclosed conflicts of

interest between corporations and their analysts, auditors, and attorneys, and between

corporate directors, officers, and shareholders. In response to these fraudulent disclosures and

conflicts of interest, in July 2002 congress passed the Sarbanes-Oxley Act (commonly called


SOX focused on eliminating the many disclosure and conflict of interest problems that had

surfaced it. It did the following: established an oversight board to monitor the accounting

industry; tightened audit regulations and controls; toughened penalties against executives who

commit corporate fraud; strengthened accounting disclosure requirements and ethical

guidelines for corporate officers; established corporate board structure and membership

guidelines; established guidelines with regard to analyst conflicts of interest; mandated instant

disclosure of stock sales by corporate executives; and increased securities regulation authority

and budgets for auditors and investigators.

The major components of SOX are:

1. Accounting regulation – The creation of a public accounting oversight board charged

with overseeing the auditing of public companies, and restricting the consulting services

that auditors can provide to clients

2. Audit committee – The company should appoint independent “financial experts” to

audit its audit committee

3. Internal control assessment – Public companies and their auditors should assess the

effectiveness of internal control of financial record keeping and fraud prevention

4. Executive responsibility – Chief executive and finance officers must sign off on the

company’s quarterly and annual financial statements. If fraud causes an overstatement

of earnings, these officers must return any bonuses.


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