Corporate Governance Disclosures and Firm performance
Department of Finance, Central Business School, Central University College, Tema, Ghana, West Africa
Abstract
The study examined the effect of corporate governance on the performance of firms in developing economies by using both market- and accounting-based performance measures. The study made use a sample of listed companies from South Africa and Ghana for short descriptive cases, scenarios, and vignettes. It adopted an in-depth, exploratory approach in reviewing the corporate governance issues from the perspectives of principles, regulations, and performance of the top firms.
Results indicate that the direction and the extent of impact of governance are dependent on the performance measure being examined. Specifically, the findings show that large and independent boards enhance firm value and that combining the positions of chief executive officer (CEO) and board chair has a negative impact on corporate performance. The CEO’s tenure in office enhances a firm’s profitability, while board activity intensity affects profitability negatively. The size of audit committees and the frequency of their meetings have positive influence on market-based performance measures and that institutional shareholding enhances market valuation of firms. Finally, results point out that country characteristics influence the impact of governance on corporate performance.
Keywords: corporate governance, ownership structure, developing countries, performance, return on asset, managerial shareholding, board of directors, institution ownership.
Introduction
Corporate governance has become a popular discussion topic in developed and developing countries. Effective corporate governance has been identified to be critical to all economic transactions especially in emerging and transition economies (Dharwardkar et al. 2000). The widely held view that corporate governance determines firm performance and protects the interests of shareholders has led to increasing global attention. However, the way in which corporate governance is organized differs between countries, depending on the economic, political, and social contexts. For example, firms in developed countries have dispersed shareholders and operate within stable political and financial systems, well-developed regulatory frameworks, and effective corporate governance practices. However, firms that operate in developing countries, such as Kenya, may be affected by political instability, resulting in severe economic dislocation and sharp escalation in defense expenditure, which result in a widening fiscal deficit.
Corporate governance could be defined as “ways of bringing the interests of investors and managers into line and ensuring that firms are run for the benefit of investors” (Mayer 1997). The structures and practices of boards differ across national boundaries, as boards have evolved according to each country’s history, culture, laws, and economy. On the African continent, corporate governance matters are driven by countries’ companies codes, securities and exchange commissions, the stock exchange listing requirements, regulations and rules, and other country-specific regulatory agencies. Although corporate governance in Africa is off on a good start, insufficient empirical research limit the basis for comparison of the continent’s corporate governance experiences and outcomes with other continents.
In this chapter, a set of significant case studies based on corporate governance and performance in both South Africa and Ghana is presented. This set of case studies is used to illustrate nature of corporate governance practices and performance that occurs in developing country subject to considerable international scrutiny of its business practices.
The remainder of the chapter proceeds as follows. In the next section, a review of the theories on and benefits of corporate governance are presented. This is followed by the role of internal corporate governance mechanism in an organizational performance. This section ends with capital market and corporate governance. Finally, case studies on both South Africa and Ghana are presented. The chapter ends with a concluding remark that summarizes how corporate governance relates to performance in developing economies. This main objective of this chapter is to explore the relationship between corporate governance disclosures and performance.
Defining Corporate Governance
Corporate governance is a uniquely complex and multifaceted subject. Devoid of a unified or systematic theory, its paradigm, diagnosis, and solutions lie in multidisciplinary fields, i.e., economics, accountancy, and finance among others (Cadbury 2002). As such it is essential that a comprehensive framework be codified in the accounting framework of any organization. In any organization, corporate governance is one of the key factors that determine the health of the system and its ability to survive economic shocks. The health of the organization depends on the underlying soundness of its individual components and the connections between them.
According to Morck, Shleifer, and Vishny (1989), among the main factors that support the stability of any country’s financial system include the following: good corporate governance; effective marketing discipline; strong prudential regulation and supervision; accurate and reliable accounting financial reporting systems; and a sound disclosure regimes and an appropriate savings deposit protection system.
Corporate governance has been looked at and defined variedly by different scholars and practitioners. However, they all have pointed to the same end, hence giving more of a consensus in the definition. Coleman and Nicholas-Biekpe (2006) defined corporate governance as the relationship of the enterprise to shareholders or in the wider sense as the relationship of the enterprise to society as a whole. However, Mayer (1999) offers a definition with a wider outlook and contends that it means the sum of the processes, structures, and information used for directing and overseeing the management of an organization. The Organization for Economic Corporation and Development (OECD) (1999) has also defined corporate governance as a system on the basis of which companies are directed and managed. It is upon this system that specifications are given for the division of competencies and responsibilities between the parties included (board of directors, the supervisory board, the management, and shareholders) and formulate rules and procedures for adopting decisions on corporate matters.
In another perspective, Arun and Turner (2002) contend that there exists a narrow approach to corporate governance, which views the subject as the mechanism through which shareholders are assured that managers will act in their interests. However, Shleifer and Vishny (1997); Vives (2000); and Oman (2001) observed that there is a broader approach that views the subject as the methods by which suppliers of finance control managers in order to ensure that their capital cannot be expropriated and that they can earn a return on their investment. There is a consensus, however, that the broader view of corporate governance should be adopted in the case of banking institutions because of the peculiar contractual form of banking, which demands that corporate governance mechanisms for banks should encapsulate depositors as well as shareholders (Macey and O’Hara 2001). Arun and Turner (2002) supported the consensus by arguing that the special nature of banking requires not only a broader view of corporate governance but also government intervention in order to restrain the behavior of bank management. They further argued that the unique nature of the banking firm, whether in the developed or developing world, requires that a broad view of corporate governance, which encapsulates both shareholders and depositors, be adopted for banks. They posit that, in particular, the nature of the banking firm is such that regulation is necessary to protect depositors as well as the overall financial system (Arun and Turner 2002).
Theories of Corporate Governance
Corporate governance is of growing importance, particularly with regard to the monitoring role of the board of directors. As a result, these theoretical perspectives based on the governance structures and reporting practices affect the value of the firms. This section reviews the theoretical perspectives of a board’s accountability. It draws on agency theory, stewardship theory, stakeholder theory, social contract theory, legitimacy theory, and resource dependency theory.
Agency Theory
Much of the research into corporate governance derives from agency theory. Since the early work of Berle and Means (1932), corporate governance has focused upon the separation of ownership and control, which results in principal–agent problems arising from the dispersed ownership in the modern corporation. They viewed corporate governance as a mechanism where a board of directors is an essential monitoring device to minimize the problems brought about by the principal–agent relationship. In this context, agents are the managers, principals are the owners, and the board of directors act as the monitoring mechanism (Mallin 2004). Furthermore, literature on corporate governance attributes two factors to agency theory. The first factor is that corporations are reduced to two participants, managers and shareholders whose interests are assumed to be both clear and consistent. A second notion is that humans are self-interested and unwilling to sacrifice their personal interests for the interests of the others (Daily, Dalton, and Cannella 2003).
Firms can be described as a nexus of contracts among individual factors of production resulting in the emergence of the agency theory. The firm is not an individual but a legal fiction, where conflicting objectives of individuals are brought into equilibrium within a framework of contractual relationships. These contractual relationships are not only with employees, but with suppliers, customers, and creditors (Jensen and Meckling 1976). The intention of these contracts is that all the parties acting in their self-interest are motivated to maximize the value of the firm, reducing the agency costs and adopting accounting methods that most efficiently reflect their own performance.
The focus of agency theory on the principal and agent relationship (e.g., shareholders and corporate managers) has created uncertainty due to various information asymmetries. The separation of ownership from management can lead to managers of firms taking action that may not maximize shareholders wealth, due to their firm-specific knowledge and expertise, which would benefit them and not the owners; hence, a monitoring mechanism is designed to protect the shareholder interest (Jensen and Meckling 1976). This emphasizes the role of accounting in reducing the agency cost in an organization, effectively through written contracts tied to the accounting systems as a crucial component of corporate governance structures, because if a manager is rewarded for their performance such as accounting profits, they will attempt to increase profits, which will lead to an increase in bonus or remuneration through the selection of a particular accounting method that will increase profit.
Arising from the aforementioned point is the agency problem on how to induce the agent to act in the best interests of the principal. This results in agency costs, for example, monitoring costs and disciplining the agent to prevent abuse (Shleifer and Vishny 1997). Jensen and Meckling (1976) define agency cost as follows: the sum of monitoring expenditure by the principal to limit the aberrant activities of the agent; bonding expenditure by the agent that will guarantee that certain actions of the agent will not harm the principal or to ensure the principal is compensated if such actions occur; and the residual loss that is the dollar equivalent to the reduction of welfare as a result of the divergence between the agent’s decisions and those decisions that would maximize the welfare of the principal. However, the agency problem depends on the ownership characteristics of each country. In countries where ownership structures are dispersed, if the investors disagree with the management or are disappointed with the performance of the company, they use the exit options, which will be signaled through reduction in share prices. However, countries with concentrated ownership structures and large dominant shareholders tend to control the managers and expropriate minority shareholders in order to gain private control benefits (Spanos 2005).
The agency model assumes that individuals have access to complete information and investors possess significant knowledge of whether governance activities confirm to their preferences and the board has knowledge of investors’ preferences (Smallman 2004). Therefore according to the view of the agency theorists, an efficient market is considered a solution to mitigate the agency problem, which includes an efficient market for corporate control, management labor, and corporate information (Clarke 2004).
According to Johanson and Ostergen (2010) even though agency theory provides a valuable insights into corporate governance, its applicability is to countries in the Anglo-Saxon model of governance.
Stewardship Theory
In contrast to agency theory, stewardship theory presents a different model of management, where managers are considered good stewards who will act in the best interest of the owners. The fundamentals of stewardship theory are based on social psychology, which focuses on the behavior of executives. The steward’s behavior is pro-organizational and collectivistic, and has higher utility than individualistic self-serving behavior and the steward’s behavior will not depart from the interest of the organization because the steward seeks to attain the objectives of the organization. According to Smallman (2004) where shareholders wealth is maximized, the steward’s utilities are maximized too, because organizational success will serve most requirements and the stewards will have a clear mission. He also states that stewards balance tensions between different beneficiaries and other interest groups. Therefore, stewardship theory is an argument put forward for firm performance that satisfies the requirements of the interested parties resulting in dynamic performance equilibrium for balanced governance.
Stewardship theory sees a strong relationship between managers and the success of the firm, and therefore the stewards protect and maximize shareholder wealth through firm performance. A steward, who improves performance successfully, satisfies most stakeholder groups in an organization, when these groups have interests that are well served by increasing organizational wealth (Davis, Schoorman, and Donaldson 1997). When the position of the CEO and chairman is held by a single person, the fate of the organization and the power to determine strategy is the responsibility of a single person. Thus, the focus of stewardship theory is on structures that facilitate and empower rather than monitor and control (Davis, Schoorman, and Donaldson 1997). Therefore, stewardship theory takes a more relaxed view of the separation of the role of chairman and CEO, and supports appointment of single person for the position of chairman and CEO and a majority of specialist executive directors rather than nonexecutive directors (Clarke 2004).
Research into corporate governance also discusses the stakeholder theory in relation to firms’ responsibility to the wider community. A stakeholder is any group of individuals who can affect or is affected by the activities of the firm, in achieving the objectives of the firm (Freeman 1984). A similar view has been put forward by the World Business Council for Sustainable Development (1997), which also identifies stakeholders as the representatives from labor organizations, academia, church, indigenous peoples, human rights groups, government and nongovernmental organizations and shareholders, employees, customers/consumers, suppliers, communities, and legislators. A firm’s objective could be achieved through balancing the conflicting interests of these various stakeholders. Therefore, a fundamental aspect of stakeholder theory is to identify the stakeholders an organization is responsible for. Any stakeholder is relevant if their investment is, in some form, subject to risk from the activities of the organization.
Corporate governance systems are in a state of transition due to internationalization of capital markets, resulting in convergence of the shareholder value-based approach to corporate governance and the stakeholder concept of corporate governance toward sustainable business systems (Clarke 1998). It can be seen that stakeholder theory is an extension of the agency perspective, where responsibility of the board of directors is increased from shareholders to other stakeholders’ interests (Smallman 2004). Therefore, a narrow focus on shareholders has undergone a change and is expected to take into account a broader group of stakeholders such as those interest groups linked to social, environmental, and ethical considerations (Freeman, Wicks, and Parmar 2004). As a result, stakeholder theory supports the implementation of Corporate Social Responsibility and endorses risk-management policies to manage diverse interests.
Criticisms that focus on stakeholder theory identify the problem of who constitutes genuine stakeholders. One argument is that meeting stakeholders’ interests also opens up a path for corruption, as it offers agents the opportunity to divert the wealth away from the shareholders to others (Smallman 2004). But the moral perspective of stakeholder theory is that all stakeholders have a right to be treated fairly by an organization, and managers should manage the organization for the benefit of all stakeholders, regardless of whether the stakeholder management leads to better financial performance.
Legitimacy Theory
Another theory reviewed in corporate governance literature is legitimacy theory. Legitimacy theory is defined as “a generalized perception or assumption that the actions of an entity are desirable, proper, or appropriate with some socially constructed systems of norms, values, beliefs and definitions” (Suchman 1995). Similar to social contract theory, legitimacy theory is based upon the notion that there is a social contract between the society and an organization. A firm receives permission to operate from the society and is ultimately accountable to the society for how it operates and what it does, because society provides corporations the authority to own and use natural resources and to hire employees.
Traditionally, profit maximization was viewed as a measure of corporate performance. But according to the legitimacy theory, profit is viewed as an all-inclusive measure of organizational legitimacy.
The emphasis of legitimacy theory is that an organization must consider the rights of the public at large, not merely the rights of the investors. Failure to comply with societal expectations may result in sanctions being imposed in the form of restrictions on firms operations, resources, and demand for its products. Much empirical research has used legitimacy theory to study social and environmental reporting, and proposes a relationship between corporate disclosures and community expectations. The increasing scrutiny on corporate governance directly and indirectly affects information technology and the direction information technology will take. Furthermore, an era where technology is critical to business, corporate is incomplete without adequate information technology governance. Information technology governance is the responsibility of the board of directors and executive management. New digital and social networking technologies are making boards more morally and ethically observant and activist shareholders are able to publicize failures of organizations and thereby threaten reputational harm globally.
Potential Benefits of Corporate Governance
The effectiveness of corporate governance depends on the application of principles in a manner that benefits stakeholders, as well as broader industries and economic sectors. Benefits to stakeholders include resolving conflicts of interest, instilling controls and a sense of ethics, and enforcing and encouraging transparency.
Corporate governance promotes efficient use of resources within the firm and the larger economy. It also helps firm’s to attract low-cost investment capital through improved investor and creditor confidence, both nationally and internationally. It also increases the firms’ responsiveness to the need of the society and results in improving long-term performance (Gregory and Simms 1999).
Good governance promotes firmwide efficiency and a fair return for investors. Furthermore, good governance can benefit a company through better flow of funds and improved access to low-cost capital, strong internal controls, and discipline, and might achieve better credit ratings that would lead to lower debt funding and higher stock price valuation, which can result in equity dilution when additional stock is floated. Companies that are properly governed are supported by deep and transparent financial markets, robust legal systems, and efficient resource allocation. This, in turn, promotes financial and economic stability and increases national and global growth rates, whereas poorly governed companies do the opposite. Good corporate governance brings better management and prudent allocation of the company’s resources, and enhances corporate performance that would significantly contribute to the appreciation company’s share price.
Better corporate governance is supposed to lead to better corporate performance by preventing the expropriation of controlling shareholders and ensuring better decision making. In expectation of such an improvement, the firm’s value may respond instantaneously to news indicating better corporate governance. However, quantitative evidence supporting the existence of a link between the quality of corporate governance and firm performance is relatively scanty (Imam 2006).
Good governance means little expropriation of corporate resources by managers or controlling shareholders, which contributes to better allocation of resources and better performance. As investors and lenders will be more willing to put their money in firms with good governance, they will face lower costs of capital, which is another source of better firm performance. Other stakeholders, including employees and suppliers, will also want to be associated with and enter into business relationships with such firms, as the relationships are likely to be more prosperous, fairer, and long lasting than those with firms with less effective governance.
Implications for the economy as a whole are also obvious. Economic growth will be more sustainable, because the economy is less vulnerable to a systemic risk. With better protection of investors at the firm level, the capital market will also be boosted and become more developed, which is essential for sustained economic growth. At the same time, good corporate governance is critical for building a just and corruption-free society. Poor corporate governance in big businesses is fertile soil for corruption and corruptive symbiosis between business and political circles. Less expropriation of minority shareholders and fewer corruptive links between big businesses and political power may result in a more favorable business environment for smaller enterprises and more equitable income distribution (Iskander and Chamlou 2000).
Comply or Explain
In the wake of corporate scandals like Polly Peck (UK), Enron (U.S.), and Metallgesellschaft (Germany), there have been increasing calls for more effective regulation of corporate behavior in general and the actions of company directors in particular. In response to that, various laws on issues of corporate governance have been passed in many countries around the world. In addition, in recent years there has been a strong trend toward the adoption of “soft law” (Mörth 2004) or “soft regulation” (Sahlin-Andersson 2004) in the form of codes of corporate governance. A code of corporate governance can be defined generally as “a non-binding set of principles, standards or best practices, issued by a collective body and relating to the internal governance of corporations” (Weil and Manges 2002).
A central element of most national codes is the “comply-or-explain” principle, which was first put forward in the Cadbury Code as a practical means of establishing a single code of corporate governance while avoiding an inflexible “one size fits all” approach. Cadbury (1992) required that, “Listed companies… should state in the report and accounts whether they comply with the Code and identify and give reasons for any areas of non-compliance.”
Comply or explain is a regulatory approach used in the United Kingdom, Germany, the Netherlands, and other countries in the field of corporate governance and financial supervision. Rather than setting out binding laws, government regulators (in the United Kingdom, the Financial Reporting Council, in Germany, under the Aktiengesetz) set out a code, which listed companies may either comply with, or if they do not comply, explain publicly why they do not. The UK Corporate Governance Code, the German Corporate Governance Code (or Deutscher Corporate Governance Kodex), and the Dutch Corporate Governance Code “Code Tabaksblat” use this approach in setting minimum standards for companies in their audit committees, remuneration committees, and recommendations for how good companies should divide authority on their boards.
The purpose of comply or explain is to let the market decide whether a set of standards is appropriate for individual companies. Since a company may deviate from the standard, this approach rejects the view that one size fits all, but, because of the requirement of disclosure of explanations to market investors, anticipates that if investors do not accept a company’s explanations, then investors will sell their shares, hence creating a market sanction, rather than a legal one. The concept was first introduced after the recommendations of the Cadbury Report of 1992.
“Comply or explain” is appropriate in the sense that a company should explain if it does not comply. Discretion on compliance should not be as broad as it is without making some provisions mandatory. The suggestion is that it should apply the principles or explain (already adopted by King the III in South Africa) rather than comply with the provision or explain. This is not a good move in the right direction as there is more room for to say they apply a principle when they probably don’t. Consideration should be given to making some current “comply or explain” corporate governance provisions mandatory, and to requiring shareholder approval for departure from any aspect of the corporate governance code. Some might say that an approach with more mandatory rules has been shown, as with the U.S. experience, not to be any more effective. But how much worse might the U.S. experience have been without their Securities and Exchange Act, without their Sarbanes-Oxley Act (with penalties of up to $5,000,000 fine and prison for 20 years),and so on?
Sir Adrian Cadbury supported a principles-based approach to corporate governance, rather than a rules-based approach. He has argued that rules can be “got round” more easily than principles. For instance, if a rule stated that the chairman should not also be the chief executive, then a company could observe the rule by designating one person as the CEO and another as the chairman, even though the reality might be different. On the other hand, if there were a principle that excessive concentration of power at the top of the company should be avoided, then such a principle might be harder to avoid. However, this approach does require the principles to be mandatory. For the United Kingdom and other parts of the world, disclosure has been inadequate and applying the principles is not mandatory. Indeed, by their nature, principles would be harder than rules to make mandatory. Vince Cable who is to bring in tougher penalties for “dodgy directors” in the United Kingdom said companies will be forced to list their true owners on a public register in a bid to combat tax evasion and money laundering. He stated “it is only right to put the toughest possible sanctions in place, make sure they stamp out unfair practices and deter those who are looking to act dishonestly.” Dishonest directors can cause a huge amount of harm in terms of large financial losses, unnecessary redundancies, and lifelong investments going down the drain. Tackling the damaging behavior of a small minority of individuals will help to reinforce confidence in the majority of directors who run their businesses well and create jobs and growth in the economic environment.
The new rules, which need parliamentary approval, would force UK-registered firms to give details of anyone with an interest in more than 25 percent of its shares or voting rights. These details, held by Companies House, would need to be updated every year. Under the new measures, there would be greater freedom for courts to ban those with fraud convictions overseas from setting up in Britain, which could have prevented the Italian businessman Massimo Cellino from becoming a director of Leeds United Football Club. Courts would also have the power to force directors to compensate those who have lost out because of misconduct or serious failures in a business.
Judges in such cases would also have a duty to take past misdemeanors into account when deciding whether to disqualify a director, including previous business failures, the nature of any losses, overseas conduct, and breaches of specific laws. This will indeed help fight corruption in companies
The Role of Internal Corporate Governance Mechanisms in Organizational Performance
According to Dallas (2004), various instruments are used in financial markets to improve corporate governance and the value of a firm. Economic and financial theory suggests that the instruments mentioned in the following affect the value of a firm in developing and developed financial markets. These instruments and their role are as follows.
Role of Auditor
The role of an auditor is important in implementing corporate governance principles and improving the value of a firm. The principles of corporate governance suggest that auditors should work independently and perform their duties with professional care. In case of any financial manipulation, the auditors are held accountable for their actions as the availability of transparent financial information reduces the information asymmetry and improves the value of a firm (Bhagat and Jefferis 2002).
However, in developing markets, auditors do not improve the value of a firm. They manipulate the financial reports of the firms and serve the interests of the majority shareholders, further disadvantaging the minority shareholders. The weak corporate law and different accounting standards also deteriorate the performance of the auditors and create financial instability in the developing market.
Role of Board of Directors’ Composition
The board of directors can play an important role in improving corporate governance and the value of a firm (Hanrahan, Ramsay, and Stapledon 2001). The value of a firm is also improved when the board performs its fiduciary duties such as monitoring the activities of management and selecting the staff for a firm. The board can also appoint and monitor the performance of an independent auditor to improve the value of a firm. The board of directors can resolve internal conflicts and decrease the agency cost in a firm. The members of a board should also be accountable to the shareholders for their decisions as argued by Nikomborirak (2001) and Tomasic, Pentony, and Bottomley (2003), Fiduciary Duties of Directors: Interview Schedule, Personal Communication. Melbourne.
The board consists of two types of directors: outsider (independent) and insider directors. The majority of directors in a board should be independent to make rational decisions and create value for the shareholders. The role of independent directors is important to improve the value of a firm as they can monitor the firm and can force the managers to take unbiased decisions. The independent directors can also play a role of a referee and implement the principles of corporate governance that protect the rights of shareholders (Bhagat and Jefferis 2002; Tomasic, Pentony, and Bottomley 2003).
Similarly, internal directors are also important in safeguarding the interests of shareholders. They provide the shareholders with important financial information, which will decrease the information asymmetry between managers and shareholders as argued by Bhagat and Black (2002) and Bhagat and Jefferis (2002). The board size should be chosen with the optimal combination of inside and outside directors for the value creation of the investors. The boards of directors in the developing market are unlikely to improve the value of a firm, as the weak judiciary and regulatory authority in this market enables the directors to be involved in biased decision making that serves the interests of the majority shareholders and the politicians providing a disadvantage to the firm.
Role of Chief Executive Officer
The CEO of an organization can play an important role in creating the value for shareholders. The CEO can follow and incorporate governance provisions in a firm to improve its value (Brian 1997; Defond and Hung 2004). In addition, the shareholders invest heavily in the firms having higher corporate governance provisions as these firms create value for them (Morin and Jarrell 2001).
The decisions of the board about hiring and firing a CEO and their proper remuneration have an important bearing on the value of a firm as argued by Holmstrom and Milgrom (1994). The board usually terminates the services of an underperforming CEO who fails to create value for shareholders. The turnover of CEO is negatively associated with firm performance especially in developed markets because the shareholders lose confidence in these firms and stop making more investments. It is the responsibility of the board to determine the salary of the CEO and give him proper remuneration for his efforts (Monks and Minow 2001). The board can also align the interests of the CEO and the firm by linking the salary of a CEO with the performance of a firm.
This action will motivate the CEO to perform well because his own financial interest is attached to the performance of the firm.
The tenure of a CEO is also an important determinant of the firm’s performance. CEOs are hired on short-term contracts and are more concerned about the performance of the firm during their own tenure causing them to lay emphasis on short- and medium-term goals. This tendency of the CEO limits the usefulness of stock price as a proxy for corporate performance (Bhagat and Jefferis 2002). The management of a firm can overcome this problem by linking some incentives for the CEO with the long-term performance of the firm (Heinrich 2002).
The Role of Board Size
Board size plays an important role in affecting the value of a firm. The role of a board of directors is to discipline the CEO and the management of a firm so that the value of a firm can be improved. A larger board has a range of expertise to make better decisions for a firm as the CEO cannot dominate a bigger board because the collective strength of its members is higher and can resist the irrational decisions of a CEO.
On the other hand, large boards affect the value of a firm in a negative manner as there is an agency cost among the members of a bigger board. Similarly, small boards are more efficient in decision making because there is less agency cost among the board members.
Role of CEO Duality
Similar to the other corporate governance instruments, CEO duality plays an important role in affecting the value of a firm. A single person holding both the chairman and CEO role improves the value of a firm as the agency cost between the two is eliminated. On the negative side, CEO duality lead to worse performance as the board cannot remove an underperforming CEO and can create an agency cost if the CEO pursues his own interest at the cost of the shareholders.
Role of Managers
Managers can play an important role in improving the value of a firm. They can reduce the agency cost in a firm by decreasing the information asymmetry, which results in improving the value of a firm (Monks and Minow 2001). Managers in the developed market create agency cost by under and overinvestment of the free cash flow. Shareholders are disadvantaged in this case as they pay more residual, bonding, and monitoring costs in these firms.
Managers in developing financial markets generally play a negative role in the value creation of investors. The rights of the minority shareholders are suppressed and the firms in these markets cannot produce real value for shareholders as actions of the managers mostly favor the majority shareholders. The management and the shareholders in a developing market do not use the tools of hostile takeover and incentives to control the actions of managers. In the case of a hostile takeover, the managers are forced to perform well to be able to hold their jobs. Similarly, appreciation and bonuses can motivate managers to produce value for shareholders (Bhagat and Jefferis 2002).
The ownership of the management in a firm has an important bearing on its value. Firms can improve their value in developing markets by streamlining the interests of managers with those of the shareholders. This results in the convergence of the goals of shareholders and managers, ultimately improving the value of the shareholders.
Capital Markets and Corporate Governance
A capital market is the place to issue and trade debt and equity capital, which is important to global financial systems and for the survival and growth of the national economies. Firms may not be able to operate or exist if they are unable to access primary capital, in which case corporate governance would not be relevant as there would be no suppliers of capital. The economic growth of a business depends on its role in creating safe, efficient, and competitive capital markets. The life blood of capital markets is the capital provided by investors. This capital must therefore be protected through appropriate regulations, effective corporate governance, and the optimal market mechanism. Globalization has resulted in the flow of capital from international markets enabling firms to access capital from a much larger pool of investors. To reap the benefits of the global capital markets and attract long-term capital, corporate governance practices must be credible and well understood across borders. Even if countries do not rely on foreign investments, adherence to corporate governance practices will increase the confidence of the domestic investors, reduce the cost of capital, and induce a more stable source of capital (OECD 1999).
The ability of capital markets to attract capital depends on various factors including investors having confidence in the integrity and transparency of the markets. Confidence is earned over time through honest and fair markets, and provides investors with the material information necessary to make informed decisions.
Some of the key drivers of economic growth of a country are investor confidence and its capital markets. The efficiency of the stock market has an important implication for investors and regulatory authorities. Therefore, efficiency in information dissemination ensures that funds are allocated to investment projects that result in higher returns with necessary adjustments to risks.
Sustainability of public companies is considered the key to investor confidence, which requires accurate financial reports for investors to make informed investment decisions. Financial information, which is reliable, accurate, and transparent, is important to the efficiency, integrity, and safety of capital markets. As a result, investors rely on the quality of corporate financial reports in making rational investment decisions. Therefore, financial statements are a vital form of information to capital markets and their participants.
Disclosure of information over and above the accounting regulations has benefits in the capital markets. Those items of information that are contained within the annual reports and those that are made through media and press releases and conference calls to security analysts are information that is voluntarily disclosed. Firms with more informative disclosure policies tend to have a larger analyst following. Accurate analyst earnings forecasts always tend to result in reduced information asymmetry. Increased voluntary disclosures are associated with low cost of capital.
Corporate Governance Practices in Emerging Economies
One of the reasons for emerging economies to consider external corporate governance is the need to build investor confidence to attract foreign and local investment to expand their businesses. International donor agencies such as the IMF and World Bank as well as organizations such as the Organization for Economic Cooperation and Development (OECD) indirectly influence developing countries to improve their external corporate governance mechanisms and regulatory infrastructure. The effects of these changes can be seen in the actions of investors who are increasingly becoming confident in investing in some markets that were considered risky at one stage. However, the corporate sectors in emerging countries do seem to lag behind the benchmark for sound corporate governance.
The economic crisis that hit the South East Asian stock markets in 1997–1998 was partly attributed to weak corporate governance in the region, which prompted governments to consider ways of improving governance structures in their countries (Mobius 2002). This resulted in governance reforms in the emerging markets for restoring investor confidence by providing a secure institutional platform to build an investment market (Monks and Minow 2004 305). Therefore, codes of corporate governance were established by most of these countries to promote a continuous flow of funds and to boost investor confidence in their capital markets (Haniffa and Hudaib 2006). Even though emerging markets are aware of the concept of corporate governance, implementation of corporate governance practices has not been effective (Mobius 2002). The codes, which were derived from recommendations in developed countries, may not be applicable to developing countries due to their national character, and economic and social priorities. Therefore, what is effective in one country may not be so in another. Likewise, every corporation has its unique characteristics due to their history, culture, and business goals. Hence, all these factors need to be taken into account in their efforts to reform corporate governance (Haniffa and Hudaib 2006).
As the business environment of the developed countries is different from that of emerging countries, the governance structures designed to enhance performance should take into account the unique business environment that exists in the country without blindly adopting the practices from other countries. For example, Haniffa and Hudaib (2006) concluded, from a study on Malaysian listed companies, that the applicability of recommendations derived by the Cadbury Report and Hampel Report in the United Kingdom may be disputable due to high ownership concentration, close control by owners and substantial shareholders, cross-holdings of share ownership or pyramiding, and the close relationship between the firms, banks, and government. Corporate governance is affected by the ownership structure of the firm in the emerging markets.
Cases
South Africa
By the late 1980s, many of South Africa’s corporations were bloated, unfocused, and run by entrenched and complacent managers. These firms were sustained and tolerated by a very different environment from that in advanced economies and capital markets. The mainstay of the South African environment was isolation. Tariffs and political isolation shielded firms from foreign product competition, while financial sanctions kept international institutions out of the domestic capital market, and South African firms out of international capital markets.
Corporate practices fell behind international norms, as did laws and regulations. In 2001, little of that comfortable, introverted world remained. With political reform, engagement and change have replaced isolation and stasis. South African corporations, their managers, and domestic shareholders have been exposed, in succession, to a new political system, rapid trade liberalization, demanding international investors, an emerging markets crisis, and rapid-fire regulatory reform.
Within 36 months, corporate governance has in South Africa changed from being a “soft” mainly ethical issue to a “hard” issue, recognized as pivotal to the success and revitalization of the country’s capital markets and, ultimately, the prospects of the corporate economy (Malherbe and Segal 2001). These high stakes have produced a succession of measures aimed at transforming corporate governance in the economy.
Corporate structure has changed irrevocably. In 1994, the King Report on Corporate Governance (King I) was published by the King Committee on Corporate Governance, headed by former high court judge, Mervyn King S.C. King I, incorporating a code of corporate practices and conduct, was the first of its kind in the country, and was aimed at promoting the highest standards of corporate governance in South Africa.
Over and above the financial and regulatory aspects of corporate governance, King I advocated an integrated approach to good governance in the interests of a wide range of stakeholders. Although ground breaking at the time, the evolving global economic environment together with recent legislative developments have necessitated that King I be updated. To this end, the King Committee on Corporate Governance developed the King Report on Corporate Governance for South Africa 2002 (King II).
King II acknowledges that there is a move away from the single bottom line (i.e., profit for shareholders) to a triple bottom line, which embraces the economic, environmental, and social aspects of a company’s activities. In the words of the King Committee:
. . . successful governance in the world in the 21st century requires companies to adopt an inclusive and not exclusive approach. The company must be open to institutional activism and there must be greater emphasis on the sustainable or non-financial aspects of its performance. Boards must apply the test of fairness, accountability, responsibility and transparency to all acts or omissions and be accountable to the company but also responsive and responsible towards the company’s identified stakeholders. The correct balance between conformance with governance principles and performance in an entrepreneurial market economy must be found, but this will be specific to each company.
The King III report on corporate governance, strategy, and sustainability recommends that firms produce an integrated report in place of an annual financial report and a separate sustainability report. The report stated that companies create sustainability reports according to the Global Reporting Initiatives and Sustainability Reporting Guidelines (Dekker, 2002).
In contrast to the earlier versions, King III’s report is applicable to all entities, public, private, and nonprofit. The report encourages all entities to adopt the King III principles and explain how these have been applied or are not applicable. It incorporated a number of global emerging governance trends such as alternative dispute resolution, risk-based internal audit, shareholder approval of nonexecutive directors’ remuneration and evaluation of board, and directors’ performance.
A number of new principles have been incorporated to address elements not previously included in the King II reports. Examples of such principles are IT governance, business rescue, and fundamental and affected transactions in terms of director’s responsibilities during mergers, acquisitions, and amalgamations.
Again, the code of corporate governance is not enforced through legislation. However, owing to evolutions in South African law, many of the principles put forward in King II are now embodied as law in the Companies Act of South Africa of 2008. In addition to the Companies Act, there are additional applicable statutes that encapsulate some of the principles of King III such as the Public Finance Management Act and the Promotion of Access to Information Act.
Ntim and Osei (2011) found a statistically significant and positive association between the frequency of corporate board meetings and corporate performance, implying that South Africa boards that meet more frequently tend to generate higher financial performance. Their further investigation indicates a significant nonmonotonic link between the frequency of corporate board meetings and corporate performance, suggesting that either a relatively small or large number of corporate board meetings impacts positively on corporate performance.
Ghana
In Ghana corporate governance has been gaining roots in response to initiatives by some stakeholders such as the Ghana Institute of Directors (IoD-Ghana), in collaboration with the Commonwealth Association of Corporate Governance, to address corporate governance in Ghana (Kyereboah-Coleman 2005). Again, there have been other initiatives designed to address corporate governance issues in the country. For instance, a study, conducted and launched by IoD-Ghana in 2001, pointed out that there is an increasing acceptance of good corporate governance practices by businesses in the country.
Notwithstanding the aforementioned developments, it must be indicated that more formal corporate governance structures and institutions are relatively not widespread. Good corporate governance has been highlighted to be vital to corporate organizations especially in transition and emergent economies. The effectiveness of a company’s corporate governance structure has a far-reaching effect on how well it functions.
The regulatory framework for an effective corporate governance practice in Ghana is contained in the Companies code 1963 (Act 179), Securities Industry Law 1993 (PNDCL 333) as revised by the Securities Industry (Amendment) Act, 2000 (Act 590), and the listing regulations, 1990 (L.I. 1509) of the Ghana stock exchange. The regulatory framework of Ghana for effective corporate governance has been divided into six major sections, which are as follows:
1. the mission, responsibilities, and accountability of the board;
2. committees of the board;
3. relationship to shareholders and stakeholders, and the rights of shareholders;
4. financial affairs and auditing;
5. disclosures in annual reports; and
6. code of ethics. It may be useful now to proceed to discuss in detail the various sections of the regulatory framework of Ghana.
Studies by Mensah et al. (2003) on corporate governance and corruption revealed that poor corporate governance practices among a sample of surveyed firms resulted in corrupt practices and dealings with the government, which firms were unwilling to disclose. The corporate governance principle is the sovereign rights of shareholders, since the boards of directors, who are to ensure that effective corporate governance prevails, are accountable to shareholders. Again, this section of the principle brings out how the size of the board should be. It states that the board’s size of every corporate entity ought to be arrived at with the belief of promoting the board’s effectiveness as well as ensuring appropriate representational needs. However, no specific number is set with regard to membership but goes on to mention between 8 and 16 members.
The principles of corporate governance of Ghana reflect the shareholder perspective of the Anglo-American model of corporate governance. This is because the principles reflect the sovereign rights of shareholders, since the board of directors who are considered to be the principal mechanism to ensuring effective corporate governance has to account to shareholders. In addition, the principles emphasize the traditional view where the board is regarded as representatives of shareholders. Finally, there are certain elements that determine the effectiveness of the board as a mechanism for corporate control. These elements are the composition of the board, independence of the board, the leadership structure (CEO–chairperson separation), board committees such as the audit committee and remuneration committee, and access to timely and regular information by directors
Organizational characteristics: From Table 8.1, most of the firms have been operating for the past 113 years, though some have been in existence for over 59 years. While the average age of firms is 59 years in South Africa, it is about 36 years in Ghana. On an average, these firms are employing about 9,900 staff; however, some employ over 300,000. It must be pointed out that the sizes of these firms are highly dispersed considering the minimum and maximum employment levels of 20 and 303,098, respectively, and it is clear that firms in the South African sample are larger, with a mean size of about 56,280 employees. It could also be seen that most of these organizations have heavy institutional presence, with 46 percent in South Africa representing the mean value of institutional shareholding while that of Ghana is 57 percent.
Table 8.1 Summary statistics—overall sample (observations = 388): Country-specific summary
Source: Kyereboah-Coleman (2007).
Financing issues: While most of the organizations depend on debt as against equity for financing, long-term debt relatively represents the major component of total debt in the overall sample firms in Ghana. South Africa, on the other hand, uses more of short-term debt to finance their operations. This is more surprising because South Africa with a more developed financial market is expected to have more long-term debts as compared to Ghana.
Organizational financial performance: By comparing accounting and market-based performance measures, it seems the firms are relatively doing better on the market-based measure. While the mean value of return on assets is 0.13 in Ghana, that of Tobin’s q is 0.30, indicating an average return on assets of 13 percent. Expectedly, firms in South Africa with a relatively developed corporate governance structure are ahead of Ghana in terms of performance.
Governance characteristics: South Africa appears to have a mean board size is 9, with a maximum of 23 directors. The standard deviation of 4.31 suggests that there is rather a wide dispersion. In the overall sample, these boards are relatively less independent as they are mostly dominated by executive directors. The mean value of 0.24 for board independence suggests that on an average about 76 percent of these boards are made up of executive directors in Ghana.
However, some of these boards could be said to be highly independent, with 85 percent of their membership being constituted of nonexecutive directors. The study shows, however, that corporate boards in South Africa is largely dependent constituted mostly by nonexecutive directors.
Most of these boards in the overall sample largely have their positions of CEO and board chair separated, with only about 19 percent of the firms whose boards have the CEO and board chair positions entrusted in the same personality. However small it may be, recent thinking has shown that the appointment of one person into these two key positions has serious repercussions for agency costs and firm performance. Situations like that generate enormous conflict of interest because decision control and decision management functions are all embedded in the same person. The King Reports clearly indicate how these two positions should be separated. Further analysis shows that in South Africa, there is a clear separation of the positions of the board chair and CEO. None of the firms in the South African sample have the positions of the board chair and CEO occupied by the same person. Thus, 39 percent of firms in the Ghanaian sample have the same person as both the CEO and board chair. It could be pointed out that there are greater conflicts of interest with regard to firms in Ghana where as much as 39 percent of sampled firms have decision control and decision management embedded in the same personality. The sample analysis shows that boards in the South African sample have rather been meeting more frequently with a mean frequency meeting of 12 times. Twelve times in the year suggest that these meetings are for problem solving and could essentially be due to corporate crisis. Boards in Ghana have a meeting frequency of about 10.
Audit committee: The audit committees of these firms have sizes ranging between 3 and 9 with a mean size of about 6 members. Indeed, the mean size of 4 is representative of Ghanaian firms. Nonexecutive directors and nonaffiliates of these organizations dominate most of these audit committees at country level. Thus, one could say that to a large extent these firms have independent audit committees. Unlike the boards, the audit committees have a mean annual meeting frequency of about 5, suggesting that the audit committees may be meeting on quarterly basis to attend to business of interest.
Solutions and Recommendations
The study showed that generally both countries practiced to reasonable extent good corporation governance. However, the following recommendations are important to enhance good governance in organizations.
First, in order to implement good corporate governance, managers need to know that they should be concerned about the interrelationships between corporate governance and firm performance. The study findings strongly confirm this correlation and therefore firms that adopt and implement good corporate governance have higher advantage of increasing their performance. More so, this will ensure that interests of the firm are served and there is easier access to funding from investors.
Secondly, there is need for the regulatory agencies in relation to corporate governance to continue enforcing and encouraging firms to adhere to the guidelines on corporate governance for financial institutions. This can be ensured through enacting more rules and regulations, thus ensuring that firms maintain confidence in shareholders and customers.
Thirdly, empirical evidence from the study that corporate governance has some influence on a firm’s performance; hence, clear policy implications should not be lost. This study recommends that corporate entities should promote corporate governance to send a positive signal to potential investors.
Fourthly, this empirical findings indicate that different types of ownership structure have similar concerns on implementing good corporate governance; the findings can be used to inform the government and other regulatory agencies that they have to be more concerned over corporations with worse corporate governance practices. In addition, the regulatory agencies including the government should promote and socialize corporate governance and its relationship to firm performance across industries.
Lastly, shareholders need to know that they have an important role in ensuring that firm’s management are following and implementing good corporate governance. They can do this through establishing certain control means and thus undertake the monitoring process. Furthermore, other stakeholders should play a more active role in ensuring good corporate governance in corporations.
Suggestions for Future Research
The study may have assumed that the efficient performance of firms relies on corporate governance as mentioned earlier. However, the study does not openly rule out the fact that some other variables in the environment could be critical for firm performance. Hence, future research could usefully focus on the macroeconomic conditions necessary to promote maximum performance within the developing economies.
Conclusion
The idea of this chapter was to demonstrate that corporate governance affects a firms’ performance. The examples drawn in this chapter aim to raise awareness that corporate governance has potential benefits on firms’ performance. Such benefits include resolving conflicts of interest, instilling controls and a sense of ethics, and enforcing and encouraging transparency. It promotes efficient use of resources, fair return for investors through better flow of funds and improved access to low-cost capital, strong internal controls and discipline, and might achieve better credit ratings that would lead to lower debt funding and higher stock price valuation, which can result in equity dilution when additional stock is floated.
Moreover from the aspects of literature review, evidence indicates that corporate governance is gaining more attention in the developing economies such as South Africa and Ghana.
Discretion on compliance should not be as broad as it is. Consideration should be given to making some current “comply-or-explain” corporate governance provisions mandatory, and to requiring shareholder approval for departure from any aspect of the corporate governance code.
To reap the benefits of the global capital markets and attract long-term capital, corporate governance practices must be credible and well understood across borders. Even if countries do not rely on foreign investments, adherence to corporate governance practices will increase the confidence of the domestic investors, reduce the cost of capital, and induce a more stable source of capital.
Countries have corporate governance differences that have created different understanding and behaviors of the board members. All these potential benefits of corporate governance have been observed and analyzed in this research, and so I can conclude that there is a positive relationship between corporate governance and performance.
References
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Additional Reading
Coleman, A., and Nicholas- Biekpe, N. 2006. “Does Board and CEO Matter for Bank Performance? A Comparative Analysis of Banks in Ghana.” Journal of Business Management, University of Stellenbosch Business School (USB), Cape Town, South Africa. 13, pp. 46–59.
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Discussion Questions/Study Questions
1. Discuss the statement that ‘Certain political parties in the economic environment are known to promote and favor good corporate governance principle’.
2. What are the overarching principles of corporate governance? Discuss
Auditor: An auditor is a person appointed and authorized to examine accounts and accounting records, compare the charges with the vouchers, and verify balance sheet and income items. An auditor can be either an independent auditor unaffiliated with the company being audited or a captive auditor, and some are elected public officials.
Audit committee: The audit committee of the board of directors is primarily concerned with ensuring that the company’s financial statements are timely, relevant, and reliable; that financial controls are adequate; that the company complies with relevant regulation; and that the internal and external auditors are fulfilling their proper roles. They are commonly responsible for recommending the selection and compensation of the external auditors.
Board committees: Board committees are subset of directors with appropriate skills to spend additional time focusing attention on their assigned subject matter. These committees, however, do not relieve the full board of its responsibility for these matters; they merely allow for specialization and help streamline the operations of the full board. The committee chairs typically present a report to the full board with the committees’ recommendations on how the board can best fulfill its responsibilities.
Capital market: Capital market is the part of a financial system concerned with raising capital by dealing in shares, bonds, and other long-term investments. These markets channel the wealth of savers to those who can put it to long-term productive use, such as companies or governments making long-term investments.
Chief executive officer: A CEO is generally the most senior corporate officer or administrator in charge of managing a for-profit or nonprofit organization. An individual appointed as a CEO of a corporation, company, nonprofit, or government agency typically reports to the board of directors.
Chief executive officer duality: Chief executive officer duality refers to the situation when the chief executive officer also holds the position of the chairman of the board. The board of directors is set up to monitor managers such as the CEO on the behalf of the shareholders.
Corporate Governance: There several definitions of corporate governance, including the following: Corporate governance involves a set of relationships between a company’s management, its board, its shareholders, and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined.
Corporate governance code: The corporate governance code of a company is a document developed and approved by the board of directors, which stipulates the company’s governance policies as regard to the shareholders rights, functioning of the board of directors and management, control environment, information disclosure, and transparency.
Directors: Persons serving as members of the company’s board are directors. They are usually elected by voting the company’s shares under rules established in the firm’s organic documents. Directors have formal fiduciary duties established under relevant company and other law. If the firm is publicly listed, directors may also have additional accountability under applicable securities legislation.
Emerging Economy: An emerging economy describes a nation’s economy that is progressing toward becoming more advanced, usually by means of rapid growth and industrialization. These countries experience an expanding role both in the world economy and on the political frontier.
Author’s Biography
Christopher Boachie is a lecturer at the central University College at the finance and banking department, Ghana. He has an extensive work experience in the mining, manufacturing, and insurance sectors.
He had his first degree in geological engineering at Kwame Nkrumah University of Science and Technology, Ghana, in 1966. He continued with his master’s degree in business administration, finance at Technical University of Freiberg, Germany, in 2002. He is a chartered accountant and a member of Association of Certified Chartered Accountants. He is currently doing his PhD with Open University of Malaysia.