What is Corporate Governance?
Corporations are powerful organizations that act as separate entities from its owners. Hence, contemporary views regarding the role of corporations in society recognize that there is a growing importance for regulations on the manners those companies (in particular their board of directors) behave and on their influence on stakeholders, both direct (e.g. shareholders and workers) and indirect (e.g. the general ethical sphere of a country).
Corporate governance, in a narrow sense, is a control mechanism, which aims to govern corporations and their managers to ensure the protection of owners’ interests. Such protection is necessary due to the separation of ownership and management in corporations, in particular in public companies, where holders of minority shares do not have a direct means to influence managerial decisions.
However, it would be false to assume that corporate governance is merely about protecting the shareholders, since their wealth (i.e. the value of their holdings in a company) can be indirectly affected from the relations between the corporation and other stakeholders (e.g. the government) and/or when the company’s ethical behaviour is questionable. The same holds true also for the relations between shareholders and the general environment; that is, changes in shareholders’ wealth affect the society in numerous ways and can bring about material implications on the macroeconomic level. For example, the risk management approach of major US banks, which stood in the heart of the recent credit crisis, is a major corporate governance issue that now receives much attention from the Federal Reserve.
Thus, it can be argued that although the main sphere of corporate governance is to protect the outside investors against contrasting interests of insiders, the meaning of investors can be expanded to include other stakeholders that give the corporation the right to act.
Corporate Governance Theories
The classical thinking about corporate governance concentrates on the means in which investors’ risk can be reduced. In other words, this approach is financial in nature, as it deals with balance mechanisms that should minimize the perceived managerial risk among suppliers of finance and enhancing the probably of return.
However, the emergence of immense corporations in the 20th century has led to a new understanding about a company: Usually known as the systems approach to management, this way of thinking argues that the bigger the company becomes, the more stakeholders influence it and also are affected by it; following Kotler & Keller, in order to thrive, a corporation must manage not only its classical input/output system (e.g. to provide return on investment), but must manage its relations with the social and political environment, its suppliers, customers, etc.
These two economic and ethical standpoints can be observed in three dominating theories of corporate governance, namely, the agency, stakeholder and stewardship theories, which are useful for analysing trends and developments in the field of corporate governance.
The principal-agent is a classical dilemma in microeconomics. The term refers to the situation in which, because of the separation of ownership (the principles) and management (the agents who work on their behalf), managers tend to act for their own interests, which may be different from those of their principals. The dilemma, thus, is to design an incentive system which will encourage managers to work for their owners’ best interest despite their innate selfishness.
The cost of inadequate use of company’s resources by managers and the cost of incentives are called agency costs. Jensen suggested an additional source for agency costs, namely the irrational decision-making manner of agents, which cannot be compensated by traditional incentives.
The stakeholder theory is a managerial approach, which perceives businesses as sets of relationships among groups who share (i.e. have a stake in) the benefits and/or the costs related to a business entity. Unlike the agency theory, which is merely concerned with shareholders’ value, the stakeholder theory expands the concept of value (benefits and costs) to all the related parties. It also stresses the role of ethics in management. Furthermore, this holistic approach urges managers to recognize both primary and secondary stakeholders, while the latter are not to be neglected.
The theory received public attention in R. Edwards Freeman’s 1984 Strategic Management: A Stakeholder Approach. Freeman denies the simplistic view of business as an amoral (or even immoral) entity, arguing that capitalism has thieved because most people are cooperative and honest in most cases.
Broadly speaking, the stewardship theory is the opposite of agency theory; while the latter assumes that people are selfish and managers seek for their own good (unless sufficiently compensated not to do so), “the stewardship theory depict subordinates as collectivists, pro-organizational, and trustworthy”. In the context of corporate governance, stewardship theorists emphasize the ethical roles of the company toward its stakeholders, assuming that by encouraging companies to do so (e.g. thorough “green management” and corporate social responsibility), shareholders will receive the greatest protection and so are the society.
The Benefits of Corporate Governance
Investors and shareholders consider good corporate governance practices as an important factor when making investment decisions. Organizations that implement good corporate governance practices enjoy an increase in their market valuation. Scandals and crises affected the activities of economies; corporate governance practices were seen as a resolution to these scandals and paved a safeguard path for the economy.
Both institutional and private investors perceive good corporate governance practices as a crucial indicator of a company’s performance and strength when making investment decisions: according to a study by Coombes & Watson, institutional investors view corporate governance practices as important as the company’s financial statements and 60% of institutional investors will steer clear of companies with weak corporate governance practices.
In addition, in 2001 a study by McKinsey & Company, looked at 188 companies in 6 emerging markets- India, Malaysia, Mexico, South Korea, Taiwan and Turkey- stated that companies that adopted good corporate governance practices generate approximately 10-12% increase in their value over those with low corporate governance standards.
On the other hand, Companies with low corporate governance standards are considered as more risky. There is a clear correlation between weak boards and corporate scandals, and therefore the press is highly interested in the functioning of boards, as this factor may provide an indicator for the future of the corporation.
OECD Main Principles of Corporate Governance
The Organisation for Economic Co-operation and Development (OECD), which focuses on promoting democratic and free-market economies, provide a set of proposed corporate governance standards. These standards, which are being updated every several years, provide a benchmark for governments and companies to evaluate their level of corporate governance standards. The last version of the Principles, issued in 2004, contains six parts, numbered I-VI. Its main components are:
I. Ensuring the Basis for an Effective Corporate Governance Framework:
This part provides some general guidelines for transparency and efficiency of markets, stressing the importance of coordination between the difference authorities within and among countries, while understanding that the rules cannot be uniform because of differences among countries and markets.
II. The Rights of Shareholders and Key Ownership Functions:
This section focuses on the rights of shareholders (property rights) that need to be protected.
The main rights are:
- To have a safe and reliable way to register and transfer ownership rights.
- To receive relevant and timely information on the company’s state of affairs, such as financial results and any material decisions
- To influence the company’s management though voting in the shareholders’ meeting
- To share the company’s profits
III. The Equitable Treatment of Shareholders:
This chapter deals with protecting the rights of minority and foreign shareholders. In addition, it provides a clear resistance to any form of insider trading and demands board members and other managers to disclose conflict of interests.
IV. The Role of Stakeholders in Corporate Governance:
Following the responsibility of corporations for a wider group of stakeholders, the OECD gives a lot of attention to the role of employees as major stakeholders in a company. Following this approach, employees receive rather similar rights to those of shareholders, in particular regarding receiving timely information (e.g. before insolvency) and communication with the board of directors.
V. Disclosure and Transparency:
Managers are committed to a system of accurate and timely reporting standards.
These reports include:
- Financial operating results (after external auditing)
- Company objectives
- Ownership structure
- Disclosure on the board of directors – remuneration policy, members and their qualifications, selection process and so on
- Related party transactions
- Foreseeable risk factors, issues regarding employees and corporate governance structures and policies.
Furthermore, the OECD suggests that market transparency can be improved through support mechanisms such as rating agency and the press, with whom the companies should cooperate and publish their findings under normal investor relations operations.
VI. The Responsibilities of the Board:
This chapter is the main bulk of the Principles. It deals with the structures, the ways of conduct and the accountability of boards, which are the main function in a corporation responsible for corporate governance policies and implementation.
Corporate Governance Implementation in Kuwait
The regulatory framework in Kuwait is based on laws and resolutions established by the Council of Ministers as well as the Amiri Decrees. Similar to what has happened in many modern economies, the recent financial crisis has uncovered the weak side of the current Kuwaiti regulatory system. It is presumable, thus, that some needed changes are expected to take place in the near future.
Three main laws govern business activities: the Commercial Companies Law, the Civil Code and the Commercial Code. Moreover, Kuwaiti businesses must conform to three regulatory bodies, whose main objective is to protect the stakeholders of a given business, namely its shareholders of the company and the affected groups of the general public. Those regulating bodies are the Central Bank of Kuwait, the Ministry of Commerce and Industry and the Kuwait Stock Exchange.
Looking closely at the current corporate governance practices in Kuwait, there is a sense of dichotomy between the country’s economic power and the extent to which the OECD Principles are being implemented. One example is the issue of minority shareholders’ protection:
In a recent review on the MENA countries, Naciri recognizes the rather developed corporate governance environment in Kuwait; however, he indicates a significant drawback in the issue of minority protection, relating this problem to the traditional investors’ culture, which is highly centralized and being held by family investments and banks.
On the other hand, the advantage of traditional business methods, in particular religion, may benefit investors and reduce the overall managerial risk. Religious ethics in this sense can replace rigid corporate governance standards. One example is the sense of commitment (which largely corresponds with the Stewardship Theory) of Kuwaiti financial institutions toward the society. Grais & Pellegrini demonstrate this point by comparing two mission statements from two banks, one from Kuwait and the other from the US:
Kuwait Finance House’s mission statement recognizes its stewardship:
“In accordance with the Islamic principles, KFH ensures that while working with the public professionally, the company guarantees an honourable relationship with its client base and the Muslim community as a whole”
While the American statement is one-dimensional, and may be considered as risky in the light of the recent financial crisis:
“Our basic corporate objective (is) maximizing the value of our shareholders’ investment”
The differences are thus so vast, that one should not ignore their implication on everyday business ethics in the two banks.
Recommended Corporate Governance Practices for Kuwait
Since state-of-the-art corporate governance standards are not fully understood in the Kuwaiti market, the regulators should stress on thorough understanding and the adoption of good corporate governance practices. Good corporate governance practices will increase the efficiency of internal supervisory controls, encourage precise financial disclosures, and define the duties of the board of directors and management. The banks and more importantly the investment companies in Kuwait should implement corporate governance practices to complement the functions of the regulating bodies in protecting, stabilizing and developing the financial systems.
The board of directors of any company should be competent, experienced in the particular line of business and responsible, corresponding with corporate governance practices. In many major companies in Kuwait, the BOD or higher level of administration did not adhere to the declared policies of the company and the aim for which the company was formed; to state one example, companies in the industrial field of business invested their funds in the stock exchange and lost a major percentage of their capital.
A necessary step towards better functioning BODs is to promote a mechanism of annual evaluations of their work, which should be reported to the shareholders of the company. In case of a breach of their duties or a bankruptcy due to negligent acts by the directors, they should be liable for the losses of the shareholders.
Disclosure and transparency is the revelation of a material fact on a financial statement or document. The notion behind disclosures and transparency is that information is available to everyone instead of a certain group, giving each individual equal opportunity in making decisions.
During the financial crisis, some investment companies as well as a prominent bank were involved in a scandal due to disclosure and transparency issues. Preferential treatment was given to certain clients in the bank, who were also their major shareholders/ directors, to invest in risky financial instruments without the necessary collateral to cover the losses. This news was disturbing to minority investors and customers, regarding it as fraud and illegal actions.
The investment companies, company funds were used for purposes other than what it is intended for, in the aim of obtaining short-term profits for the mother company. However, with the stock market crash the companies incurred losses and their wrongful activities were revealed to the public.
“Private benefit of control” is another challenge that faces investors in Kuwait, through insider dealings by related parties, transfer pricing and appointment or employment of incompetent relatives. Financial disclosures and transparency standards are a solution to this problem.
There are, however, several fields in which the Kuwaiti corporate governance norms excel over many other markets in region. For example, in a recent survey by Naciri, Kuwait was found to provide the most comprehensive corporate governance framework for protection of minority shareholders in the MENA region. This strength of the Kuwaiti market can be used to leverage other issues of corporate governance, as any other sort of competitive advantage.
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