Introduction to Corporate Governance

A. Agency Theory

The central issue of corporate governance stems from the separation of ownership and control.
Most organizations, whether in public sector, business or non-profit entities, have boards of directors and/or commissioners which oversee the performance of the organization and serve as an intermediary to the owners or other stakeholders.

Boards are in a delicate position of translating expectations of the owners into organisational performance, and in larger organisations, are not involved in the day-to-day management of the organisation. Boards are authorised to make decisions on high-level policies and transactions of a company, and yet must delegate authority to implement policy without jeopardizing accountability.
The common issues boards face in overseeing management were first comprehensively discussed in the Agency Theory[1].
The Agency Theory explains how to best organize relationships in which one party (the principal/ the owners) determines the work, which another party (the agent or board) undertakes. The theory argues that under conditions of incomplete information and uncertainty, which characterize most organisational settings, two agency problems arise: adverse selection and moral hazard. Adverse selection is the condition under which the principal cannot ascertain if the agent accurately represents the work he is being paid to do.
Adverse selection may lead to a lack of transparency in the use of funds or improper balancing of the interests of, for instance, shareholders and managers and of controlling and minority shareholders. Moral hazard is the condition under which the agents may seek to maximize their own self-interest at the expense of the principal.
Developing good regulations and practices on governance involves aligning the interests and controlling actions of Principal and Agent to avoid moral hazzard and adverse selection.

B. Corporate Governance Principles

The term of "Corporate Governance" is subject to many varying definitions. Broadly viewed, the FCGI defines Corporate Governance as "a set of rules that defines the relationship between shareholders, managers, creditors, the government employees and other internal and external stakeholders in respect to their rights and responsibilities, or the system by which companies are directed and controlled." (taken from Cadbury Committee of United Kingdom) In addition, FCGI also a points out that the objective of Corporate Governance is "to create added value to the stakeholders." More narrowly, the terms of Corporate Governance can be used to describe just the role and practices of the board of executives/the board of directors, the board of commissioners, managers, and shareholders.

There are four essential elements of Corporate Governance elaborated by the OECD (Organization for Economic Co-operation and Development). The elements are:
  1. Fairness. Ensuring the protection of shareholder rights, including the rights of minority and foreign shareholders, and ensuring the enforceability of contracts with resource providers.
  2. Transparency. Requiring timely disclosure of adequate, clear and comparable information concerning corporate financial performance, corporate governance, and corporate ownership.
  3. Accountability. Clarifying governance roles and responsibilities, and supporting voluntary efforts to ensure the alignment of managerial and shareholder interests, as monitored by the boards of directors (or board of commissioners in Two Tiers System, FCGI)
  4. Responsibility. Ensuring corporate compliance with other laws and regulations that reflect the respective society's value.
    (OECD Business Sector Advisory Group on Corporate Governance, 1998)

A corporate governance system specifies the distribution of rights and responsibilities among different participants in the corporation, such as, the Board of Directors and/or Commissioners, shareholders and other internal and external stakeholders (employees, creditors, government) and spells out the rules and procedures for making decisions on corporate affairs[2]. By doing this, a structure for objective setting and monitoring performance is determined.

Recent high profile scandals in the private sector in various countries and more wide-spread financial crises have focused attention on the role of corporate boards in providing direction and oversight, and on the need for robust governance practices and regulations. There are however significant differences in countries’ legal and regulatory frameworks that shape corporate governance systems.

While governance systems differ around the globe, it does not necessarily mean that the companies under the different governance systems perform better or worse. Instead, the returns are disproportionately channeled to insiders, accompanied with expensive expansion into unrelated business, high leverage and risky financial structures[3].

For example, Low corporate transparency, such as non compliance with disclosure requirements and shareholder equality, contributed to extensive group structures and diversification, and risky financial structures
[4].

Consequently, many jurisdictions including Indonesia, new regulations are evolving to increase disclosure of corporate information, in an effort to increase transparency and accountability among publicly listed companies
[5].

C.The Benefits of Corporate Governance

Two recent academic studies further demonstrate the significant positive financial implication good corporate governance has for companies.

A study of 1500 public companies in the United States in the 1990s found that those who received a higher governance rating and stronger shareholder rights also had:
  • higher firm valuations
  • higher profits
  • higher sales growth
  • lower capital expenditures[6]

In a study of debt markets, which analysed 2002 governance data from companies registered with the US Securities and Exchange Commission, found that a hypothetical medium size firm with $934 million of outstanding debt could potentially create savings of USD $74 million (8%) per year, depending on the spread between investment grade and speculative grade on 10-year bonds. At the time of the study, the spread was about 800 basis points.
The study identified the following variables that significantly influenced credit ratings:

  • majority of shareholders own less than 5% of the company;
  • more transparency in financial disclosure;
  • a higher percentage of board directors are deemed to be independent;
  • less CEO power on the Board;
  • more stock ownership among directors; and
  • greater director experience and expertise as measured by the number of appointments to other Boards[7].

Policy makers are also increasingly aware of the contribution good corporate governance makes to financial market stability and efficiency, investment and economic growth. Good corporate governance can contribute to economic development in that it provides efficient intermediation and allocation between an economy’s savings and productive uses of these resources in the corporate sector. Corporate governance rules also ensure that these resources are properly monitored.

To guide countries in the process of developing stronger governance structures, the Organisation for Economic Cooperation and Development (OECD) in 1999 published The OECD Principles of Corporate Governance, which have become the internationally accepted principles for governments to evaluate and improve the legal, institutional and regulatory framework for corporate governance, and provide guidance and suggestions for stock exchanges, investors, corporations and other parties. An updated version was issued in 2004 to reflect further governance developments in OECD countries. The OECD principles have served as a basis for national level governance codes in many countries, including Indonesia.

The latest 2004 revision of the OECD Corporate Principles of Corporate Governance
[8]
Ensuring the basis for an effective corporate governance framework
The corporate governance framework should promote transparent and efficient markets, be consistent with the rule of law and clearly articulate the division of responsibilities among different supervisory, regulatory and enforcement authorities.

The rights of shareholder and key ownership function
The corporate governance framework should protect and facilitate the exercise of shareholders’ rights.

The Equitable Treatment of Shareholders
The corporate governance framework should ensure the equitable treatment of all shareholders, including minority and foreign shareholders. All shareholders should have the opportunity to obtain effective redress for violation of their rights.

The Role of Stakeholders in Corporate Governance
The corporate governance framework should recognise the rights of stakeholders established by law or through mutual agreements and encourage active cooperation between corporations and stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises.

Disclosure and Transparency
The corporate governance framework should ensure that timely and accurate disclosure is made on all material matters regarding the corporation, including the financial situation, performance, ownership, and governance of the company.

The Responsibilities of the Board
The corporate governance framework should ensure the strategic guidance of the company, the effective monitoring of management by the board, and the board’s accountability to the company and the shareholders.


The corporate governance movement is currently developing international government principles that are concerned at the highest and broadest level with holding the balance between economic and social goals and ensuring accountability for the stewardship of those resources.
[9]


[1] Eisenhardt, K. “Control: Organisational and Economic Approached.” ”, (Management Science, vol. 31, no. 2. (., February 1985). pp. 134 – 149.

[2] Definition derived from the Cadbury Committee of the United Kingdom. The Cadbury Committee was set up by the Bank of England and the London Stock Exchange and was chaired by Sir Adrian Cadbury in 1991.
[3] Claessens, Stijn and Joseph Fan. “Corporate Governance in Asia: A Survey.” University of Amsterdam Working Paper. (2003).

[4] Claessens, Djankov and Lang. “Who Controls East Asian Corporations?” World Bank Working Paper. (1999).
[5] Utama, Siddharta. “Corporate Governance, disclosure and its evidence in Indonesia.” Usahawan, No. 5 XXXII. (2003).

[6] Gompers, Paul, Joy Iishi, and Andrew Metrick. “Corporate Governance and Equity Prices.” Quarterly Journal of Economics. 118 (1). (2003), pp. 107-155.

[7] Ashbaugh, Hollis and Daniel Collins and Ryan La Fond. “The Effects of Corporate Governance on Firms’ Credit Ratings.” Journal of Accounting & Economics. (2003).
[8]OECD website: http://www.oecd.org/dataoecd/32/18/31557724.pdf

[9] Speech by Sir Adrian Cadbury and Ira Millstein at the 10th Annual International Corporate Governance Network July 8, 2005.