MODULE 1

Ethical Reasoning, Values and Virtues

Outline Introduction to corporate governance; governance and

management; purpose of good governance; Agency theory, transaction cost theory, stakeholder theory; Stakeholder value approach, enlightened stakeholder approach, stakeholder approach.

Governance, risk and financial stability;

– The balancing of conflicting objectives…

– Governance and ethics, corporate ethics, corporate codes of ethics, professional ethics KEY issues in corporate governance

– Role and composition of the board…

– Applying best practice in governance.

– Governance problems for global companies and groups

– Governance issues in the public sector

Introduction to Corporate Governance Corporate governance refers to the system of structures, rights, duties, and obligations by which corporations are directed and controlled. The governance structure specifies the distribution of rights and responsibilities among different participants in the corporation (such as the board of directors, managers, shareholders, creditors, auditors, regulators, and other stakeholders) and specifies the rules and procedures for making decisions in corporate affairs. To achieve the corporate governance‘s objective there is need to employ the Best Practice which is defined as any improvement over existing systems (Bragg 1999).

OECD 2014 define corporate governance as a set of relationships between a company management, its board, shareholder‘s and other stakeholders. Corporate governance is meant to provide the structure through which the objectives of the company are set and the means of attaining those objectives and monitoring performance are determined.

Purpose of Good Governance Corporate governance is the framework companies use to outline the specific operations and guidelines for their employees. Corporate governance is often a unique framework built around the organization‘s mission and values. Large corporations and publicly held companies often use corporate governance to create internal business policies due to the layers of management involved in the company.

1. Facts

Although corporate governance is usually unique to each company, it has a few universal elements. Corporate governance controls the internal and external actions of managers, employees and outside business stakeholders. This framework also outlines the duties, privileges and roles of board members or directors to ensure these individuals do not take advantage of the company‘s resources. Companies may also include information on the role of shareholders in the organization and their responsibilities for voting on corporate issues.

2. Features

Corporate governance usually outlines the goals and objectives of each business contract. The rate of return, length of the contract, individuals who can approve contracts and other obligations are usually included in the corporate governance framework. Corporate governance also creates a checks and balances system to govern internal business departments. This system ensures no one individual or department dominates business decisions or operates outside the company‘s mission and values.

3. Considerations

Publicly held corporations may require shareholder approval when setting up their corporate governance framework. Shareholders are the individuals who have invested money into the business and expect a significant return on their capital. Rather than allowing the board of directors or executive officers the ability to create and implement corporate governance, shareholder approval may be required to ensure that these individuals understand how the company expects to generate financial returns.

4. Benefits

Companies using corporate governance may be able to streamline business operations and increase the potential for maximizing profits. Creating guidelines that must be followed by individuals working in the business can help companies ensure a minimum set of operating standards exists in the company. Organizations may also be able to discipline employees or correct inappropriate workplace situations using the rules or procedures outlined in the company‘s corporate governance framework.

5. Expert Insight

Management consultants, public accounting firms, law firms or other professional organizations may be used by a company creating corporate governance. These individuals or groups can help companies ensure that the corporate governance design for the company meets the expectations of all parties involved. Law firms may be used to ensure that the company‘s corporate governance framework meets all legal requirements regarding its business operations.

Agency Theory The agency theory stems from the existence of agency relationships in corporate environments where there exists a fiduciary relationship between two individuals described as the principal and agent. The Institute of Chartered Accountants of England and Wales (2005), explains that an agency relationship arises when one or more principals (e.g. an owner) engage another person as their agent (or steward) to perform a service on their behalf.

Drawing from the above assertions, it is expedient that a principal engages in a contract with an agent based on trust and interest in achievement of overall organisational goals and objectives. This suggests that though the principal may have personal goals, loyalty and dedication lies in the ability to place corporate goals ahead of personal goals.

In corporate governance debates, the agency theory appears to be the foremost and the most emphasised because it borders on the cost of agency. Agency costs include monitoring expenditures by the principal such as auditing, budgeting, control and compensation systems, bonding expenditures by the agent and residual loss due to divergence of interests between the principal and the agent (Kyereboah Coleman, 2007).

Assumptions of Agency Theory

Jensen & Meckling (1976) opine that typical of the assumptions of agency theory is uncertainty and imperfect monitoring. Uncertainty is usually experienced by the principal in terms of not been able to ascertain the return on investment or the maximisation of shareholders wealth. The principal is expected to undergo a constraint of not been be able to perfectly monitor the activities of the agent. It is believed that there is also a distorted flow of communication between the principal and agent resulting in information asymmetry. Also, both parties (principal and agent) are utility maximises which mostly results in divergence of interest.

Transaction Cost Theory Transaction cost theory is part of corporate governance and agency theory. It is based on the principle that costs will arise when you get someone else to do something for you .e.g. directors to run the business you own.

Transaction cost theory is an alternative variant of the agency understanding of governance assumptions. It describes governance frameworks as being based on the net effects of internal and external transactions, rather than as contractual relationships outside the firm (i.e. with shareholders).

Possible conclusions from transaction cost theory

• Opportunistic behaviour could have dire consequences on financing and strategy of businesses, hence discouraging potential investors. Businesses therefore organise themselves to minimise the impact of bounded rationality and opportunism as much as possible.

• Governance costs build up including internal controls to monitor management.

• Managers become more risk averse seeking the safe ground of easily governed markets.

Transaction cost theory versus Agency theory

Transaction cost theory and agency theory essentially deal with the same issues and problems. Where agency theory focuses on the individual agent, transaction cost theory focuses on the individual transaction.

• Agency theory looks at the tendency of directors to act in their own best interests, pursuing salary and status. Transaction cost theory considers that managers (or directors) may arrange transactions in an opportunistic way.

• The corporate governance problem of transaction cost theory is, however, not the protection of ownership rights of shareholders (as is the agency theory focus), rather the effective and efficient accomplishment of transactions by firms.

Stakeholder Theory The stakeholder theory has been perceived to be advancement on the agency theory and corroborates the concept of corporate governance in organisations in a more robust manner than the agency theory. This theory recognizes not only the shareholders or owners of the organisation but also the stakeholders. Stakeholders are a combination of those individual or group that influences an organisation and those that are being influenced by the organisation. Stakeholders therefore comprise of the shareholders, creditors, employees, customers, competitors, suppliers and the community.

Stakeholder theory asserts that companies have a social responsibility that requires them to consider the interests of all parties affected by their actions (Branco and Lucia, 2007). This confers more responsibility on the managers in terms of ensuring that no stakeholder is dissatisfied either in the short run or long run.

Put simply by Sternberg (1997), stakeholder theory is the doctrine that businesses should be run not for the financial benefit of their owners, but for the benefit of all stakeholders.

Stakeholder theory otherwise called ―moral minimum‖ requires corporations to treats other stakeholders of the firm below certain minimum moral standard. Corporations in trying to honour their fiduciary duties of maximizing the welfare of their shareholders must also ensure they maintain their moral duties of minimum wellbeing towards other stakeholders to avoid creating social problems that may pose more serious challenges to the organization.

Stakeholders approach has the following drawbacks:

1. Managers may have leverage to exercise too much discretion due to lack of clear direction of how to exercise options of satisfying all stakeholders‘ welfare. This give rooms for managers to manoeuvre and in the process divert resources to satisfy their personal interest.

2. The implementation of the shareholders theory could politicize an organization between groups of stakeholders in trying to advance their various different interests.

Potential consequences of poor corporate governance Weaknesses in corporate governance practices and stakeholder management processes expose a company and its stakeholders to several risks. The reverse scenario is that effective corporate governance and stakeholder management practices can create several benefits for a company and its stakeholders.

Potential Risks

• One stakeholder group may benefit unfairly at the expense of other stakeholder groups due to weaknesses in a company‘s control systems.

• Managers could make poor investment decisions which benefit them but are detrimental to the company‘s shareholders.

• A company‘s exposure to legal, regulatory and reputational risks could become heightened. For example, a company may be subject to an investigation by a regulatory authority due to a violation of laws and regulations. The company could also receive lawsuits from one of its stakeholders due to some form of impropriety. These could potentially damage the reputation of the company and lead to significant legal costs.

• A company‘s ability to honor its debt obligations may become hindered. This exposes it to bankruptcy risk if its creditors decide to take legal action against it.

Potential Benefits

• Operational efficiency could be improved.

• A company‘s control systems may be enhanced due to the proper functioning of its audit committee and the effectiveness of its audit systems.

• Operating and financial performance could be improved which may lead to a reduction in the costs that are associated with weak control systems.

• Business and investment risk may be lowered, thus reducing a company‘s cost of capital and its default risk.

Governance and Ethics Corporate governance is the term used to refer to the policies and processes by which a corporation (or other large, complex institution) is controlled and directed. It refers especially to the way power and accountability flow between shareholders, boards of directors, CEOs, and senior managers.

For most corporations, the basic governance structure is this: shareholders vote for, and hence empower, a board of directors, who then have a fiduciary responsibility to look out for shareholders‘ interests. The board hires a CEO, who is accountable to the board. The CEO (sometimes with input from the board) hires a management team, and so on. At each step, there is a flow of power down the chain (from shareholders through to front-line employees), and a flow of accountability back up that chain. And there are all sorts of rules — including various policies and principles of good governance — that establish how that power and accountability is to be implemented.

There will be internal rules, for example (partly determined by relevant corporate law), about how board elections are to be carried out. There are also governance principles that apply to things like the inclusion of external, ―independent‖ directors on the board.

In an explicit way: corporate governance is out-and-out a matter of ethics. It is about who is responsible to whom, and for what, and under what conditions.

Governance is also legal matter (for example, the Sarbanes-Oxley Act of 2002 includes a number of requirements about corporate governance). Governance is properly a legal matter because (at least arguably) shareholders need protection from unscrupulous or merely lazy boards of directors and executives, and because the public interest is at stake when large companies are misgoverned. But even where the law is silent, governance remains important: regardless of whether one think in terms of a narrow, shareholder-driven, profits-first perspective, or instead in terms of a broader ‗stakeholder‘ approach, one simply have to agree that the way decisions get made, and the interests that corporate policies tell decision-makers to serve, are ethically important matters.

What is a Corporate Code of Ethics? A corporate code of ethics is a statement of business guidelines meant to inform worker behavior and prevent behavior that does not fall in line with the company's mission and greater objectives. Ethical codes, also called codes of conduct, can vary significantly from one company to another. For example, a company that has a goal of preventing harm to the environment might include a list of rules aimed at limiting behaviors that might negatively affect the environment in its code of conduct. Codes of conduct may also include rules aimed at keeping employees in compliance with laws and regulations.

Can a Code of Ethics Influence Behavior?

A corporate code of ethics cannot prevent unethical behavior, but it can have an impact on employee decisions. If a worker knows that a certain course of action violates his company's ethical code, he is likely to give more thought to whether or not he should pursue that course of action.

Key Issues in Corporate Governance

1) CONFLICTS OF INTEREST

Avoiding conflicts of interest is vital. A conflict of interest within the framework of corporate governance occurs when an officer or other controlling member of a corporation has other financial interests that directly conflict with the objectives of the corporation.

2) OVERSIGHT ISSUES

Effective corporate governance requires the board of directors to have substantial oversight of the company‘s procedures and practices. Oversight is a broad term that encompasses the executive staff reporting to the board and the board‘s awareness of the daily operations of the company and the way in which its objectives are being achieved.

3) ACCOUNTABILITY ISSUES

Accountability is necessary for effective corporate governance. From the top-level executives to lower-tier employees, each level and division of the corporation should report and be accountable to another as a system of checks and balances. Above all else, the actions of each level of the corporation is accountable to the shareholders and the public.

4) TRANSPARENCY

To be transparent, a corporation must accurately report their profits and losses and make those figures available to those who invest in their company.

5) ETHICS VIOLATIONS

Members of the executive board have an ethical duty to make decisions based on the best interests of the stockholders. Further, a corporation has an ethical duty to protect the social welfare of others, including the greater community in which they operate.

Role and composition of the Board The Board of Directors

Governing bodies of all Organizations whether designated as Boards of Directors, Board of Trustees or otherwise called Boards of Directors, should be completely independent directors and these Directors should preferably constitute the majority of all Directors, with the possible exception of privately held companies.

Boards are typically made up of 3 to 15 individuals that collectively have the expertise and experience to help direct a company.

Responsibilities of the Board

• The Board is accountable and responsible for the performance and affairs of the company. It should define the company‘s strategic goals and ensure that its human and financial resources are effectively deployed towards attaining those goals.

• The principal objective of the Board is to ensure that the company is properly managed by overseeing the effective performance of the Management

• The primary responsibility for ensuring good corporate governance in the company lies with the Board.

• The Board shall define a framework for the delegation of its authority or duties to management specifying matters that may be delegated and those reserved for the Board. The delegation of any duty or authority to the Management does not in any way diminish the overall responsibility of the Board and its directors as being accountable and responsible for the affairs and performance of the company.

Officers of the Board include:

1. The Chairman

2. The Chief Executive Officer/Managing Director

3. Executive Directors

4. Non-Executive Directors

5. Independent Directors

Applying best practice in governance:

Approaches to Governance 1. Rules-Based Approach to Corporate Governance A rules-based approach to corporate governance is based on the view that companies must be required by law (or by some other form of compulsory regulation) to comply with established principles of good corporate governance. The rules might apply only to some types of company, such as major stock market companies. However, for the companies to which they apply, the rules must be obeyed and few (if any) exceptions to the rules are allowed.

Advantages

i. Companies do not have the choice of ignoring the rules.

ii. All companies are required to meet the same minimum standards of corporate governance.

iii. Investor confidence in the stock market might be improved if all the stock market companies are required to comply with recognised corporate governance rules.

Disadvantages

i. The same rules might not be suitable for every company, because the circumstances of each company are different. A system of corporate governance is too rigid if the same rules are applied to all companies.

ii. There are some aspects of corporate governance that cannot be regulated easily, such as negotiating the remuneration of directors, deciding the most suitable range of skills and experience for the board of directors, and assessing the performance of the board and its directors.

2. Principles-Based Approach to Corporate Governance

A principles-based approach to corporate governance is an alternative to a rules-based approach. It is based on the view that a single set of rules is inappropriate for every company. Circumstances and situations differ between companies. The circumstances of the same company can change over time. This means that:

- the most suitable corporate governance practices can differ between companies, and

- the best corporate governance practices for a company might change over time, as its circumstances change.

It is therefore argued that a corporate governance code should be applied to all major companies, but this code should consist of principles, not rules.

This approach is sometimes called “comply or explain”. It applies in the UK, for example. With a comply or explain approach, stock market companies should be required to present a corporate governance statement to their shareholders, in which they state that:

i. they apply the principles in the code of corporate governance (the code that applies to companies in that stock market), and

ii. either the company has:

- complied with all the provisions or guidelines in the code for applying the principles in practice, or

- explain their non-compliance with any specific provision or guideline