286 Separation of ownership and control: A need for corporate governance

Separation of ownership and control: A need for corporate governance


The principal-agent problem

The principal-agent problem lies in different interests of those who have effective control over a firm with the interests of those who supply the firm with external finance. Further an agent is supposed to take instruction from the principal, and the principal must accept the consequences of the agent’s actions. If an agent takes decisions and acts on behalf of the principal, the principal might also want some redress against an agent acting outside his authority.

It is comparable to the relationship between the equity shareholders and directors of a company. The reason is due to the separation of ownership and the control, and of corporate outsiders and insiders.


Conflicts of interests

Arising from the principal-agent problem dealing with the conflicts of interest, or potential conflicts of interest, between shareholders and either the board of directors as a whole or individual board member is the heart of corporate governance. The directors may be tempted to take risks and make decisions aimed at boosting short-term performance. Many shareholders are more concerned about the longer term, the continuing survival of their company and the value of their investment. If a company gets into financial difficulties, professional managers can move on to another company to start all over again, whereas shareholders suffer a financial loss.

Issues in corporate governance where a conflict of interests might be apparent are:

1. Directors’ remuneration made at their own discretion;

2. Financial Reporting irregularities and auditing;

3. Lob-sided decision making powers;

4. Excessive business risk taking and lack of risk control;

5. Bad communication of information to shareholders by directors;

6. Honesty, probity and ethical considerations by directors.


Directors’ remuneration

Directors may reward themselves with huge salaries, fees and other rewards, such as bonuses, a generous pension scheme, share options and other benefits. Institutional shareholders do not object to high remuneration for directors. However, they take the view that rewards should depend largely on the performance of the company and the benefits obtained for the shareholders. The main complaint about excessive directors’ remuneration is that when the company does well, the directors are rewarded well, which is fair enough, but when the company does badly, the directors continue to be paid just as well.


Financial reporting irregularities and auditing

The directors may try to disguise the true financial performance of their company by “dressing up” the published accounts and giving less than honest statements. “Window-dressed” accounts make it difficult for investors to reach a reasoned judgement about the financial position of the company.

Accounting irregularities in a number of companies led to a tightening of accounting standards, although the problems of window dressing are unlikely ever to disappear completely.


Decision-making powers

Most decision-making powers in a company are held by the board of directors. The corporate governance debate has been about the extent to which professional managers, acting as board directors, exercise those powers in the interests of their shareholders and other stakeholders in the company, and whether the powers of directors should be restricted.

Key issues about balancing the board is about structuring the board of directors with a variety of other directors, such as non-executive directors and independent directors. This is important to ensure some for of objectivity and independent views given in decision making.


Excessive business risk taking and lack of risk control

As a general rule, investors expect higher rewards to compensate them for taking higher business risks. If a company makes decisions that increase the scale of the risks it faces, profits and dividends should be expected to go up. Another issue in corporate governance is that the directors of companies might take decisions intended to increase profits, without giving due regard to the risks. In some cases, companies may continue to operate without regard to the changing risk profile of their existing businesses.


Poor communication of information to shareholders by directors

Another issue in corporate governance is communication between the board of directors and the company’s shareholders. Shareholders, particularly those with a large financial investment in the company, should be able to voice their concerns to the directors and expect to have their opinions listened to. Small shareholders should at least be informed about the company, its financial position and its intentions for the future, even if their opinions carry comparatively little weight. Proper communication policy should be implemented by the board of director to provide timely information, particularly those of financial, changes of chief executives, directors and business strategies to shareholders across the board and without discrimination.


Ethical issues and corporate governance

Ethical considerations are at the root of many perceived problems with corporate governance in actual practice by members of the board. Individuals are expected to behave in an ethical way. and ethical issues are more difficult to be regulated. Corporate governance can only provide a system and a procedure that is seen to be “ethical” and fair to shareholders. It is therefore important that companies should be aware of the need to maintain a culture of good corporate ethics, providing a code of conduct that all directors and employees are expected to follow in all aspects of their work and responsibilities to the company. In addition, the perception of ethical issues by external pressure groups may affect the reputation of a company, or the way it is run. An activist external group may regard itself as having a vested interest in the activities and operations of a company, particularly those involved in areas of advanced scientific research.


BCS 202/05 Corporate Compliance Management Copyright © 2011 by Wawasan Open University. All Rights Reserved.


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