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Corporate Governance – An Economic Perspective

Rupanjana De, ACS, Director, Nandi Resources Generation Technology Pvt. Ltd.,
Kolkata.

Corporate Governance does not start and end with a set of rules, guidelines and
e-mail : policies to be complied with but has wider implications and impact on the economy
rupanjana_de@yahoo.com of the nation. How, is what this write up seeks to explain.

"In a more globalized, interconnected and competitive world,
the way that environmental, social and corporate governance
issues are managed is part of companies’ overall management
quality needed to compete successfully. Companies that
perform better with regard to these issues can increase
shareholder value by, for example, properly managing risks,
anticipating regulatory action or accessing new markets while
at the same time contributing to the sustainable development
of the societies in which they operate. Moreover these issues
can have a strong impact on reputation and brands, an
increasingly important part of company value.”- reported in
UN Global Compact Financial Sector Initiative, 2004.
There is abundance of information on corporate governance
in various journals and newspapers particularly in the wake of
major corporate frauds and scandals across the past one and
half decades. Conventionally, corporate governance is
understood as the plethora of rules, regulations, customs,
policies, laws and guidelines the compliance of which is vital
as they affect the way of administration of a company to a
great extent. It binds the company in a relationship with the
stakeholders like the shareholders, directors, employees,
customers, creditors, suppliers and the society at large. Because
the directors and officers of a company are bound by their
fiduciary duty towards the stakeholders in general, in
controlling the management of the company they need to use
good business practices and have accountability and integrity.
However, while the above is the traditional practice of defining
corporate governance, a large many other viewpoints of
corporate governance is also available and a lot of research
work has been involved on the same over the years. In the
following paragraph a different view of the concept is expressed
while analyzing good corporate governance as an indicator of
economic efficiency.
Economic theories of Corporate Governance
Ideally, to narrow down the meaning of the term ‘corporate
governance’ into a bunch of mere rules, regulations, policies
and laws would be doing injustice to this much researched
concept. The boundary of this topic is vast. An economic
analysis of it has led to a great debate between two conflicting
notions of corporate governance and accordingly two theories
have evolved; the shareholder theory and the stakeholder
theory. While the former is a narrower version, the latter is
much wide in scope. As per the restricted shareholder theory
the main aim of an organisation is to maximise the wealth of
shareholder who are the real owners of it. This theory stems
from the traditional economic concept of ‘principal-agent’ or
‘Agency contract’ as the source of existence of companies. A
‘principal-agent’ relationship arises when the owner of an
organisation does not manage it himself. In case of companies
the owners or shareholders appoint persons to manage and
control the affairs. Here the shareholders are the principals
and they appoint directors as agents to run the company on
their behalf. The arrangement is mutually beneficial.
Shareholders in general lack specialized business knowledge
that goes behind generating large returns on their investment
and maximising their wealth, and managers may lack the fund
which the former provide them with. For maximisation of
shareholder net wealth what is required is the optimum
allocation of resources, putting them to most productive uses,
etc. Hence, it is the duty of the directors and management of
the company to see that the organisation is run on the best

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possible manner in the interest of shareholders. However, due
to this separation of ownership and control, shareholders who
are the true owners of a company, do not control it, the control
rather lies in the hands of the managers and directors who do
not own the organization. Under this theory, the main problem
in corporate governance is this separation that fuels divergence
of interests and the directors may divert from the profit
maximising aim and be rather interested in maximising their
self interest like increasing their perks and salaries, their
reputation (which may be at the cost of shareholder benefit),
diversion of company assets for personal uses etc. Such a
divergence of interest can be the root cause of bad corporate
governance.
While the shareholder theory of corporate governance attaches
supreme importance to the shareholders as owners of the
company, the much wider view presented by the stakeholder
theory takes into account all the formal and informal, written
and unwritten relations of a company viz., creditors, employees,
suppliers, customers, other contractual parties, members of
the society, institutions with various interests like those for
environmental health hazards, governments and so on. This
theory takes a broader notion of corporate governance and
holds companies to be “socially responsible” organisations that
are typically to be managed in the interest of the public. Thus,
the performance of a company is not only to be judged by the
increase in shareholder value but also from timely creditor
payments, enhancement of employee salaries and betterment
of job conditions, increase in market share, better relations
with suppliers, customers, the government (which would
encompass the better compliance with rules and regulations
part) etc. Therefore, companies with better corporate
governance are those that have dedicated and long standing
suppliers, customers, creditors and employees, and those with
good compliance record and little or no litigation against.
There are problems with both the theories as also with the
principal-agent concept. In a company, the principal-agent
problem and the divergence of interests would not have arisen
if it were possible to write ‘complete contracts’ at the very
inception of the company. A complete contract in this case
would have meant a contract specifying every contingency
and every single mandatory act for the agents or directors in
every possible situation. The problem is, it is not possible to
foresee every contingency ex-ante, and that is why
contingencies are contingencies and not certainty. A complete
contract could have ensured that there is no divergence of
interests. Hence there would have been no need to worry about
corporate governance problems. We do worry because
complete contracts are not feasible and it is impossible to
predict everything the future holds for us. The incompleteness
provides the scope of ‘residuals’ and the question arises as to
‘how to efficiently allocate those residuals’. It is because of
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this that we need a mechanism that provides for efficient
decision making in situations that were not foreseen at the
inception of the contract. Such efficient decision making would
imply efficient use of discretion and accountability of directors.
Thus good corporate governance is required to reduce the
chances of ex-post opportunistic behaviour by directors and
managers and divergence of their interest from the real owners
of a company so that investors do not shy away their investment
in companies due to non-reliance on directors. This would
result in a hold-up situation and adversely affect the economy.
It is to check the occurrence of such situations that the
shareholder theory of corporate governance has developed.
As in the shareholder theory, even in the stakeholder theory
there are chances that all ‘investors’ (meaning all ‘stakeholders’
here) shy away their investment because they do not get proper
returns on their investment. To take an example, there may be
a non-optimum investment of employees into the human
capital of the company, the suppliers may under-invest in the
form of low quality raw-materials and customers may under-
invest by buying less of the company products. Similarly
creditors may under-invest by unfavourable credit terms, while
underinvestment from distributors may take the form of
inefficient distribution network and so on. The basic idea of
corporate governance is to ensure the most optimum investment
from all stakeholders and optimum allocation of all types of
resources and that there is continuity and sustainability of
efficient business relationship amongst all components of a
company that make firm specific investment.
The right corporate governance strategy suitable for an
enterprise can provide solutions to most of these problems
of divergence of interest, hold-up, inefficient allocation of
financial and other resources, unproductive uses of resources,
diversion of company’s assets for personal use etc.
Meanwhile, before proceeding further into discussing what
will be an ideal corporate governance mechanism, it is
worthwhile to have a quick look at the various methods to
align the directors’ and managers’ interest with those of the
shareholders:
 To give more power to shareholders for overseeing and
controlling management activity. This can take the form
of certain legal protection in the form of minority rights,
prohibitions of insider-dealing, increase of disclosure
norms etc.
 To try and give incentives to managers for efficient
management and accountability in the form of attractive
perks, stock options, sweat equity etc.
 To make laws stricter with respect to compliances and
norms to be followed (the kind of corporate governance
us professionals are more inclined to think of)
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Corporate Governance – An Economic Perspective
 To use the markets for corporate control like take-overs
etc.
Shareholder theory vs. Stakeholder theory
Both the shareholder and stakeholder theories of corporate
governance have come in for criticisms. The following
criticisms are often labeled against the shareholder theory:
 There is an overemphasized and practically baseless
presumption of strong managers vs. weak shareholders
conflict which has paved the way for all the corporate
governance theories of resolving monitoring and diverse
interest problems. The argument in favour of this is that
widely dispersed ownership in companies is not the
general norm but more like an exception, and it would
be erroneous to think that corporate governance is just
meant for large public listed companies only. Each small
company is a unit in the economy and each make
fractional contribution towards the betterment of the
economy. After all, the sea is made up of millions and
billions of drops of water. One drop of contaminated
water can bring down the quality of water of the entire
sea. Unlike the widely-held companies where managers
enjoy greater control rights vis-a-vis the shareholders,
in closely held companies, the greatest power is generally
in the hands of controlling shareholder, usually some
individuals or a family, or a group of companies. There
is no reason to think that these companies do not need to
put emphasis on corporate governance. Even in such
companies due to dominance of majority shareholders,
the minority shareholders’ rights might suffer.
 The shareholder theory gives a narrow view of corporate
governance in the sense that it overemphasizes
shareholders though they are not the only ones who make
investments in a company. A company is the outcome
of a bundle of people who make specific investments in
their capacity as customers, employees, creditors,
suppliers and distributors apart from shareholders.
Corporate success is thus a team effort. Any good
governance system cannot have optimum output unless
it takes into account all the parties involved, in other
words, all the stakeholders.
As against the above, the stakeholder theory is also not free
from criticisms. The following are some criticisms labeled
against it:
 This theory is criticized by many as being too wide for
companies to ensure compliance with. It is difficult to
consider the incentives and disincentives of all
stakeholders involved. It is equally difficult to set the
efficient levels of investment by all stakeholders.
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 The stakeholder theory leaves scope for the directors or
managers of a company to take shelter under the wider
coverage of the term stakeholder to avoid questions about
company’s bad results.
The right approach
What follows from the above is that both theories have
drawbacks, but both equally have benefits. The shareholder
theory helps directors and managers fix the target for efficiency
levels to be reached based upon single criteria of shareholder
wealth maximisation while the stakeholder theory helps them
avoid underinvestment from a number of business components
and thereby aids long-term growth of the company and
ultimately paces up economic growth. However considering
the greater economic benefits to the nation, the stakeholder
theory definitely gains an edge over the shareholder theory.
In order to make the stakeholder theory more suitable, a new
stakeholder approach has developed and this new approach
narrows down the meaning of a stakeholder and considers
only those parties as stakeholders who have direct firm specific
investment in the company. The contributions of all
stakeholders are important and go hand in hand to increase
shareholder net wealth. Hence the shareholders have incentive
to take into account other interest groups in overall corporate
governance and the importance of developing long term
relations with various components by companies. In this way
not only is wealth maximized, but also jobs are secured and
business becomes more sustainable.
As the views on corporate governance differ, for making
effective policy recommendations for corporate governance
best practices, the proponents need to have an insight into the
various theories developed and their relative merits and
demerits. It is only then that we can have the best corporate
governance structure. It is not just about having a fixed set of
rules and regulations and making proper compliances with
them, it is much more. It is about putting the economy forward
in the path of growth.
Competition vs. Corporate Governance
While discussing corporate governance and its wider
implications for the economy and the right approach to
corporate governance, a question that arises is whether
corporate governance is at all necessary in the presence of
appropriate competition in the product market. Such
competition would provide positive incentives for
companies to take care that it has the best governance
structure in place. Companies that are uncompetitive
because of bad cost structure would automatically be wiped
out of the market. This would mean that no external
regulatory intervention would be necessary. Things like
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market for corporate control, managerial stock options, etc.
are some recent developments that are fueled by this idea.
Nonetheless, good corporate governance mechanism is a
combination of many things including competition in the
product, capital and labour market, economic efficiency,
and the legal set up. These together provide a systematic
approach to corporate governance. However, the problem
with such a systemic approach is that it is not a very easy
task to develop such a mechanism after taking into
consideration so many aspects.
How bad corporate governance affects the economy
While discussing corporate governance as a contributor to
economic efficiency, it is worthwhile to take up the point
raised by Professors Merritt B. Fox and Michael A. Heller, of
the Columbia Law School in their much referred to study
“Corporate Governance Lessons from Russian Enterprise
Fiascoes” published in the New York University Law Review
in 2000. In analyzing the connection between economic
efficiency and corporate governance, these researchers took
up the example of Russian economy immediately after its
transition into privatization. Researching into the poor
performance of the Russian corporate sector and the fall of
the Russian economy after its transition while most authors
and researchers noted such causes like unwanted bureaucratic
interference and poor economic policies, they noted bad
corporate governance in the corporations as the reason and
linked it with the failure of the economy. In their view, an in-
depth knowledge of the circumstances that arose in Russia
does not only give an idea of the transition policy, it also
sheds important light on the theory of corporate governance
in general.
The crash of communism in Russia saw a rapid privatization
of erstwhile state owned enterprises following. This was
accompanied by creation of the Russian stock markets and
formulation of major business, corporate and labour laws. In
the opinion of these authors, the low stock price showed poor
corporate governance and was an indicator of the fact that the
assets of the enterprises were being mismanaged and misutilised
and put to less productive uses for the sole benefit of insiders.
Rather than elaborating on good corporate governance
practices, the authors have identified how ‘bad corporate
governance’ by a company can adversely affect the economy
of a country.
The authors have raised two pertinent questions: The one as
to what are the consequences of corporate governance
problems for the economy of a country and the second as to
why these problems are so widespread. They have identified
two economic functions of the firm, namely, maximising
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the firm’s wealth and in case of enterprises owned by
shareholders, distributing the wealth so gained on a pro rata
basis to them. In their view, companies will have good
corporate governance if they are characterised by both the
aim of maximising shareholders’ wealth and making a pro
rata distribution of that wealth amongst the shareholders.
This implies that bad corporate governance in a firm at the
micro level might arise from its inability to fulfill any one
or both of these economic functions. While failure to meet
these objectives might be due to a variety of reasons, only
one such reason may be the existing legal set up, quite in
contrary to the more popular viewpoint.
These authors have identified seven symptoms of diseased
corporations which go in to point towards their bad corporate
governance. Out of these the first five relate to maximisation
of wealth and the last two relate to pro rata distribution of
this wealth and according to them these are the seven ways
by which, in their words “loosely constrained and poorly
incentivised managers cause social welfare losses” and all
seven of which can be identified with poor corporate
governance. Accordingly inability of firms to maximise
wealth may be deduced from the following five symptoms
that point towards its inefficient and non-incentivised
managers:
 a firm’s continued operation even though it should be
shut down immediately,
 inefficient capacity utilization by viable firms,
 inefficient investment in negative present value projects,
 failure to implement positive net present value projects
 failure to identify positive net present value projects.
Two symptoms that indicate the firm’s inability to make pro
rata distribution of wealth generated are:
 diversion of claims of the corporation
 diversion of the assets and opportunities belonging to
the firm by the managers.
These seven symptoms go in to show how the economy of a
country suffers due to the bad corporate governance in firms.
Thus, in their study of the state of corporate governance in
Russian enterprises, Professors Fox and Heller have made an
analysis of economic functions of a firm and the various ways
in which poor corporate governance in companies can inflict
damages to the economy of the country. For economically
less developed countries like India the analysis of Professors
Fox and Heller seems to be an eye opening one.
(Contd. on p. 462)
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19. Douglas, P. C., Davidson, R. A. and Schwartz, B. N. (2001)’The effect
of organizational culture and ethical orientation on accountants’ ethical
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21. Dalla Costa, J. (1998)The Ethical Imperative. Why Moral Leadership is
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22. Kanungo, R. N. and Mendonca, M. (1996)Ethical Dimensions of
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of Business Ethics, 20, 217–225.
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Corporate Governance – An Economic Perspective
(Contd. from p. 456)
Does the company secretary fit in to the economic
efficiency theories?
From the above discussion on the point raised by Professors
Fox and Heller, it is easy to link that the company secretary
can make a difference. Non-pro rata distribution of wealth
generated by firms to the shareholders resulting from diversion
of claims of the company by the managers from rightful
claimants can definitely be put to check by the presence of a
company secretary in the organisation. A company secretary
can ensure that managers do not divert claims of the company
by refusing to give effect to share purchases by outsiders, or
by refusing to accept board directors lawfully elected by such
shareholders, or by issuing shares to insiders against inadequate
consideration and so on. It is the job of the company secretary
to ensure that such malpractices do not occur, and he is the
compliance officer of the company charged with ensuring
proper compliance with all legal requirements. These fall
within the purview of his day to day activities. The company
secretary can therefore be instrumental in effecting pro rata
distribution of residuals generated by a firm and thereby make
his contribution towards the economy. Similarly, the company
secretary may also be instrumental in ensuring that the company
has a long lasting relation with all its stakeholders and thereby
increase the sustainability of the organisation for greater
economic benefit.
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26. Trevino, L. K. (1990)’A cultural perspective on changing and developing
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28. Thomas, T., Schermerhorn, J. R. and Dienhart, J. W. (2003)’Strategic
leadership of ethical behavior in business’, Academy of Management
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Conclusion
Developing an all-proof framework for efficient corporate
governance that ensures complete legal compliance, efficient
allocation of resources, optimum level of investment from all
stakeholders in a company, long-lasting business relationship
and sustained business and economic growth and which at the
same time ensures that directors and managers remain
accountable to the shareholders is a herculean task. And if
developed, such a corporate governance mechanism would be
an ideal one. The reason is simple, quite contrary to the popular
belief, corporate governance does not start and end with merely
a set of rules, guidelines and policies to be complied with. It
is much more with much wider implication and good corporate
governance has its positive impact on the economy of the entire
nation. It is not just about directors and managers remaining
accountable to shareholders, or even the wider version that
targets the stakeholders as the beneficiaries of good governance.
It is rather about treating a company as an economic unit at
the minimum and that what it does, does not merely affect its
employees, creditors, investors, competitors, customers and
the government, the impact is on the entire economy. For
economically developing countries like India, this consideration
gains all the more importance and we are compelled to think
that the rightly planned corporate governance structure in
companies that puts due emphasis on economic development
of the country is the demand of the hour. 
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