GOVERNANCE IN THREE PESRPECTIVES K A N Dilhani Department of Accounting, University of Sri Jayewardenepura, Gangodawila, Nugegoda, Sri Lanka firstname.lastname@example.org ABSTRACT This paper suggests the necessity to improve existing Sri Lankan corporate governance mechanisms using three perspectives: Agency Perspective, Stakeholder Perspective, and Institutional Theory Perspective. Several financial collapses of companies in the world have created uncertainty in financial markets and have shaken investors‟ confidence. Therefore, the issue that corporate “influence” is disproportionate to “responsibility” is considered as the main issue of the study. The main objective of the research is to assess the relevance of findings of the study to enhance governance practices in the Sri Lankan corporate sector. Methodologically, the research is more of a theoretical paper supported by empirical evidence. The theme of the study and the case selected from Sri Lanka were analyzed using three perspectives. Selection of the three perspectives is supported by international cases chosen by the researcher from USA, Japan, and India. After analyzing the Sri Lankan case, it was found that major deficiencies in Sri Lankan governance systems as not discharging the fiduciary responsibility by managers and directors satisfactorily, inadequate role played by the auditors and institutional investors, and unpaid attention to stakeholder and institutional theory perspectives. In essence, what companies need to understand is that “Governing” is a very different job from “Managing.” Keywords: Corporate Governance, Agency Perspective, Stakeholder Perspective, and Institutional Theory Perspective INTRODUCTION This paper endeavors to shed some light on the need of reconstructing the corporate governance framework of Sri Lankan companies with a special reference to the collapse of Pramuka Savings and Development Bank Ltd. (PSDB) in Sri Lanka. Corporate governance is a subject of great current concern, not only in developing countries that are in the throes of economic reforms, but also in developed countries such as the United States (US) and the United Kingdom (UK). Although corporate governance has been a long-standing issue, the debate was given fresh impetus by a number of well-publicized corporate problems in the late 1980s such as East Asian financial crisis, the failure of Enron Incorporation, WorldCom and many other corporates. These failures involved creative accounting, spectacular business failures, the apparent ease of unscrupulous directors in expropriating other stakeholders' funds, the limited role of auditors, the claimed weak link between executive compensation and company performance. As emphasized by these failures, the subject of corporate governance is bound to be a prime candidate to generate key issues such as corporate influence vs. corporate responsibility, adequacy of institutional investors‟ demand from corporate entities, adequacy of directors‟ knowledge to implement corporate governance practices, hiring Chief Executive Officers (CEOs) on social connections. Out of the issues aforesaid, the disparity between corporate influence and responsibility is selected as the main issue of the present research study. RESEARCH ISSUE AND THE THEME OF THE STUDY As mentioned in the „Introduction‟, the issue that corporate “influence” is disproportionate to “responsibility” is considered as the main issue of this paper. In the context of this selected issue, the following theme inspired the thought process of the researcher in the current study. “Existing corporate governance systems should be geared up to the require ments of the corporate stakeholders in orde r to reduce the disparity between corporate influence and corporate responsibility.” The aforesaid theme was examined by using the following perspectives with a special reference to the case of Pramuka Savings and Development Bank Ltd. (PSDB) Agency Perspective Stakeholder Perspective Institutional Theory Perspective The rationale for selecting the aforesaid perspectives for the study is supported by international cases chosen by the researcher from USA, Japan, and India. Those cases are presented in the section of Literature Review. METHODOLOGY Methodologically, the research used case study approach and it is more of a theoretical paper supported by empirical evidence. The researcher gathered primary data by conducting unstructured interviews with six business executives worked for the Pramuka Savings and Development Bank. It was a convenient sample. The secondary data were gathered mainly from the sources of international business journals, previous research papers, and Internet websites on research in corporate governance, local publications and magazines on corporate governance, textbooks and annual reports of the Sri Lankan company selected. From the gathered data themes were extracted as specified in the qualitative inquiry methods. For the purpose of case analysis, the following conceptual framework was used. Figure 1. Study Frame work Agency National Perspective Context Corporate The need for gearing Analysis Reconstructing Sri Influence vs. up Governance Lankan Corporate Corporate Mechanisms Governance Responsibility Mechanisms Stakeholder Institutional International Perspective Theory Perspective Context LITERATURE REVIEW Corporate governance is popularly understood as the system by which companies are directed and controlled. It can be conceived as a socially constructed force field of driving and preventing forces that shape a firm‟s strategic behavior (Lewin as quoted in Carney and Gedajlovic, 2001, 337). A society‟s corporate governance system is a part of a wider institutional structure that regulates the relationship between executives who control the organization‟s resources and activities and those social & economic stakeholders that possess a legitimate vested interest in the firm‟s activities (Pfeffer & Salancik as quoted in Carney and Gedajlovic, 2001, 337). Viewed as such, governance systems represent a fulcrum upon which organization action and the nexus of stakeholder interests are balanced. Therefore when considering corporate governance practices, one has to focus on the processes used to direct and manage the business and affairs of a company with the object of balancing: the attainment of corporate objectives the alignment of corporate behavior with the expectations of society, and the accountability to the owners (ICASL, 1997, 12). Boards of directors are responsible for the governance of their companies. The shareholders‟ role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place. The responsibilities of the board include the setting out of the company‟s strategic aims, providing the leadership to put them into effect, supervising the management of the business and reporting to shareholders on their stewardship. Therefore, the process of corporate governance involves: Responsibilities- who should do what? Accountability- to whom should those with responsibilities account and how? Checks and balances- the system of supervision and control procedures, and communication flows (ICASL, 1997, 12). Owing to numerous differences in their historical development, institutional & cultural norms, resource endowments, and political & legal traditions, very different governance systems or philosophies have evolved around the world to address the relationship between the firm & society. As per Carney & Gedajlovic, the corporate governance arrangements found in capitalist economies generally reflect a distinctive blend of three archetypal governance .philosophies which can be termed as Managerial Capitalism, Alliance Capitalism & Personal Capitalism (2001, 337). Figure 2 distinguishes between underlying governance arrangements along three interrelated aspects: shareholder vs. stakeholder orientation, arm‟s length as opposed to relational contracting, and the separation vs. the coupling of ownership and control. Figure 2. Systems Of Corporate Governance Insider Coupled Ownership and Control Oriented Shareholder Oriented Personal Capitalis m Alliance Managerial Capitalis m Capitalis m Stakeholder Oriented Separated Ownership Outsider Oriented and Control Source: Michael Carney & Eric Gedajlovic, “Corporate Governance and Firm Capabilities: A Comparison of Managerial, Alliance & Personal Capitalism,” Asia Pacific Journal of Management, Vol. 18, 2001, p. 338. As stated in the section of „Research Issue and the Theme of the Study‟ of the paper, three perspectives were used when assessing the effectiveness of existing governance mechanisms. Explanations to these perspectives are produced below. Agency Perspective attempts to deal with problems that arise in bilateral relationships when the goals of a principal and an agent are in conflict, and when it is difficult or expensive for the principal to verify the agent‟s actions (Eisenhardt as quoted in Yoshikawa and Phan, 2001, 185). According to Eisenhardt (1989), the large modern corporation, wherein professional managers operate the firm as the agent for a large group of shareholders, presents a classic situation in which the agency problem arises. To align managerial incentives with the economic interests of stockholders, various governance mechanisms should be built into the agency contract (Demstez and Lehn as quoted in Phan and Yoshikawa, 2001, 4). However, the problem of designing efficient governance mechanisms seems to be the problem of redressing (or at least addressing) the inefficiencies caused by the triple corporate veil (Figure 3), which lies behind the Agency Perspective (Moldoveanu and Martin, 2001, 8). Legal veil insulates shareholders from corporate liabilities, thus sheltering them from the downside of decisions that have onerous financial consequences and partially insulates directors from the negative financial consequences of their actions, excep t for actions construed to contravene the fiduciary obligations of the board members to the shareholders. Informational veil operates at three levels: 1) It insulates shareholders from information that they need to run the company competently through mechanisms that concentrate decision rights (decision management rights and decision control rights) into the hands of top managers and corporate directors effecting an essential separation of ownership and control. 2) It insulates the board of directors from relevant information about the company, through mechanisms that concentrate decision rights over the flow of information in the hands of top managers. 3) It insulates managers from information that their employees succeed in keeping from them, through mechanisms that create incentives for employees to hoard information. Motivational veil operates at four levels: 1) It insulates shareholders from the exposure (e.g. debt and other liabilities) of the corporation. 2) It insulates the board of directors from directly bearing the consequences of their actions (with the exception of actions construable as violating fiduciary responsibility to the shareholders). 3) It insulates top managers from the consequences of their actions to the shareholders, if their compensation packages are not responsive to the price of the company‟s equity. 4) It insulates employees from the consequences of their actions to the shareholders, provided that their compensation packages are not responsive to changes in the value of the shareholders‟ equity. Figure 3. The Triple Corporate Veil Shareholders Legal Veil: Limited Liability Board of Directors Informational Veil: Limited Knowledge Managers Employees Motivational Veil Source: Mihnea Moldoveanu & Roger Martin, “Agency Theory and the Design of Efficient Governance Mechanisms,” email@example.com., 2001, p. 57. Accordingly, agency perspective brings some arguments for reconstructing the governance systems towards stockholders. An empirical case was examined by the researcher with in the scope of agency perspective to convince the empirical validity of the Agency Problem. The collapse of Enron Incorporation in the USA was chosen as the case. An extraordinarily serious crisis of confidence developed in the corporate world in the US and globally due to the Enron failure and deeply disturbing events around this debacle. Enron‟s investments used large amounts of debt financing, but the investments- including a water distribution business in the UK, gas pipeline and distribution operations in Brazil, power plant project in India, and fiber optics cable network in the US- did not generate adequate profits and cash flows to support the company‟s debt load (Mudalige, 2002, 12). The resulting drop in Enron‟s revenue, decline in the value of investments aforesaid, general economic decline, and increased competition drove down Enron‟s profits and stock price. With its deteriorating credit and inability to raise new capital, the company was unable to continue entering into new trading contracts and couldn‟t generate cash flows sufficient to repay existing debt obligations. Considering that its value was driven by its trading business, once the business relationships deteriorated, the company began to collapse. Enron filed for Chapter 11 Bankruptcy Protection on December 2, 2001(Mudalige, 2002, 12). Robert E Litan of the Brookings Institution, the research organization said that, “This was a massive failure in the governance system. You can look at the system as a series of concentric circles from management to directors to regulators and analysts so forth. This was like a nuclear melt down where the core melted through all the layers” (Robert E Litan as quoted in Mudalige, 2002, 12). The statement by Litan signifies the problem as one caused by the triple corporate veil due to the separation of ownership and control. However, this perspective is not adequate enough to understand the governance mechanisms comprehensively. Stakeholder Perspective speaks of the modern corporation as a nexus of contracts with different stakeholders. The model implies that the company, its management and the board of directors should adequately reciprocate the stakeholders who provide resources, for its efficient functioning. The importance of stakeholder-centered governance can be justified by looking at the arguments brought by two Indian business executives, David Wheeler and Maria Sillanpaa. The main arguments forwarded by them were „Capital is no more as critical as it was‟, „Alternate models are also quite popular and successful‟, „Myopic financial markets create negative effects on the long-term sustainability of the company‟, and Maximizing shareholders‟ wealth is necessary but not sufficient.‟ They captured the essence of the stakeholder model as follows. The long-term value of a company rests primarily on: the knowledge, abilities and commitment of its employees; and its relationships with investors, customers and other stakeholders. Loyal relationships are increasingly dependent upon how a company is perceived to create “added value” beyond the commercial transaction. Added value embraces issues like quality, service, care for people and the natural environment and integrity. It is our belief that the future of the development of loyal, inclusive stakeholder relationships will become one of the most important determinants of commercial viability and business successes. (David Wheeler and Maria Sillanpaa quoted in Kumar, Murphy and Balsar, 2001, 4). . Further, the Institutional Theory Perspective in corporate governance for modeling firm behaviors asserts that organizations attempt to incorporate norms in their institutional environments so that they can gain legitimacy, resources, stability and enhance survival prospects (DiMaggio and Powell as quoted in Yoshikawa & Phan, 2001, 188). Though this view of organizational behavior flies in the face of standard economic theory, it suggests that contemporary corporations should pay more attention to their corporate governance practices because of the increased public expectations for corporations to deal with this issue. Accordingly, the Institutional Theory Framework suggests that such pressures and expectations force organizations to show conformity, because organizations compete not only for economic resources but also for political power and institutional legitimacy. According to Yoshikawa and Phan, as a path to legitimacy this perspective rejects rational choice as the motivator of firm behaviors but instead put a greater emphasis on the appearance of rationality. Thus management of legitimacy has become one of the important tasks for managers and this is achieved by conforming to exogenously created norms (existing rules, belief systems, and examples). An example is cited from Japanese context to justify the adaptation of this perspective to the governance mechanisms. A main characteristic of the Japanese industrial system has been its tight network of supplier and buyer companies (keiretsu), which are known for their extensive cross shareholdings among members and their banks (Yoshikawa and Phan, 2001, 185-186). Consequently, the boards of directors of many Japanese firms have given more attention to claims of competing stakeholders (such as employees, suppliers, banks) and thereby traditional Japanese corporate governance system is stakeholder-centered. There is anecdotal evidence that an increasing number of firms within the corporate groups under the stakeholder-centered governance system are slowly adopting one or more elements of the stockholder-centered governance system (Table 1). Table 1: Recent Moves to Improve Corporate Governance by Japanese Firms Affiliated with Corporate Groups Company (affiliation) Recent Moves Foreign Owners hip (1995-2000) Orix (Sanwa) Board restructuring (21 to 18) Stock option plans 27.9 36.7 NYSE listing Toshiba (Mitsui) Board restructuring (33 to 12) 11.5 26.6 Nissan Diesel (Nissan) Board restructuring (21 to 10) 2.8 24.1 Fujitsu (DKB) Stock option plans Greater information disclosure 13.4 27.6 NEC (Sumitomo) Board restructuring (37 to 17) 16.5 29.8 Greater information disclosure Mitsui & Co. (Mitsui) Stock option plans 11.8 19.0 Mitsubishi Motors Greater information disclosure 9.6 17.4 (Mitsubishi) Source: Toru Yoshikawa & Phillip H. Phan, “Alternative Corporate Governance Systems in Japanese Firms: Implications for a Shift to Stockholder-Centered Corporate Governance,” Asia Pacific Journal of Management, Vol.18, 2001, p. 198. According to the Table 1, the impact of the change in ownership pattern is greater in some firms than in others. In part, this has been due to the rise in acquisition activity by the foreign competitors of Japanese firms. For example, after Renault-a French automobile manufacturer- acquired a large portion of Nissan‟s shares in 1999 Nissan‟s ownership structure changed dramatically. In March 2000, foreign ownership, including the 36.8% by Renault, reached 53.3%. As a result, well over 60% of Nissan‟s shares are now in the hands of foreign and market investors. Together with this change in ownership, Nissan is attempting to reduce its cross-shareholdings. After Carlos Ghosn, who is President of Nissan, was sent from Renault as Chief Operating Officer, he immediately announced a plan to sell most of Nissan‟s stockholdings in its keiretsu firms. While Nissan represents an extreme case of ownership change, many Japanese firms are experiencing the rising pressure of non-keiretsu, especially foreign, shareholders to reform their corporate governance structures and practices. Along with these changes, the institutional pressures on corporations to reform their corporate governance are also increasing. The current transition, a shift to stockholder-centered corporate governance practices has taken place due to capital market pressures and institutional pressures Figure 4. The Transition from Stakeholde r-Centered to Stockholder-Cente red Corporate Governance System in Japanese Firms Glo balization of Capital Markets and Accounting Change Ownership Change Foreign ownership Keiretsu ownership Capital Market Pressures Cross-holdings Stockholder-Centered Corporate Governance Loss of Legitimacy Practices Long poor performance Institutional Pressures Large profit decline Corporate scandals Changing Institutional Expectations Source: Toru Yoshikawa & Phillip H. Phan, “Alternative Corporate Governance Systems in Japanese Firms: Implications for a Shift to Stockholder-Centered Corporate Governance,” Asia Pacific Journal of Management, Vol.18, 2001, p. 200. As per Figure 4, a number of things may cause to lose legitimacy. Prolonged poor corporate performance, drastic declines in profits, and ethical scandals have been caused Japanese companies to follow publicly endorsed governance reform plans, such as the reduction of the board members, separation of the role of executive officers and directors, and better information disclosure practices (Yoshikawa & Phan, 2001,199). Accordingly, the Institutional Theory may shed some light on shifts of corporate governance systems. Based on Oliver‟s theoretical reasoning (1991), the firms which are making a rational choice to conform to the emerging institutional norms of governance, doing that because it could help them to regain social legitimacy, regardless of the effects of such practices on corporate performance. From the available literature it is possible to conclude that when analyzing the effectiveness of corporate governance mechanisms, it should be examined in multiple perspectives. So, the main case of this study, the collapse of Pramuka Savings and Development Bank Ltd. (PSDB) in Sri Lanka, is examined by applying multiple perspectives. Case Analysis: Pramuka Savings and Development Bank Ltd. (PSDB) The Central Bank of Sri Lanka liquidated PSDB with effect from December 19 2002, due to the detection of mismanagement, unsound, improper and imprudent practices at the bank by those who were responsible for the affairs of the bank (Daily News, 21 Dec. 2002, p. 5). By the time of liquidation, the bank had 160 employees and 15,000 account holders. The main allegations that were made against the management and the board of directors were found as the following. Loss situation in the bank and high level of non-performing loans Alleged fraudulent transaction relating to the purchase of a house at Gregory‟s Road, Colombo 7 Gratifications given to the public officials to bring in business to the Pramuka Bank- Heads of 33 government departments had been given gratifications over Rs.40.5 million as incentive “Gold Certificates” from over Rs.70.2 billion state funds deposited in Pramuka Bank from 1997 to 2002. Withdrawal of money by the Chairman and by the Managing Director after serving of Suspension Order-The funds have been withdrawn from accounts by the two working directors of the bank after the bank was suspended. Alleged exchange of shares for land at the time the bank was established in 1997 and obtaining the minimum required share capital through this maneuver without an actual cash infusion However, a fundamental question is that who is responsible for the massive collapse of PSDB. It is possible to find that there are several leading candida tes for the collapse. Among such candidates would be the management, the board, the external auditors, the advisers and even the Central Bank of Sri Lanka. The Central bank blamed the manage ment and the board on above listed allegations. This is a good example to prove that the interests of owners and managers are not ex ante, aligned. There is also a big question over the role of the auditors in the issue. How did this management of hundreds of million of poor depositors had happened without the knowledge of the auditors. If so, what is the purpose of doing audit, and getting a mere certificate from the auditors? However, former Chairman of the liquidated Pramuka Bank, Rohan Perera blamed Central Bank on the issue. As specified by him a prolonged delay in granting approval for Pramuka Bank to embark on business lines according to its business plan and impeding the bank from carrying on business within the city of Colombo as a city- based bank resulted in additional losses in its operations. Further, the forme r Chairman blamed Central Bank for not giving adequate Parate rights, which was considered by him for having high level of non-performing loans. The conclusion what can be stated is, at the heart of the scandal of PSDB there was a failure of corporate governance. This failure can be analyzed with reference to the triple corporate veil (Figure 3) which insulates decision makers from the consequences of their decisions as a result of the Agency Perspective. Table 2 highlights two issues emerged within the corporate veil. Table 2: Governance Failure and Corporate Veil Aspect of Corporate Governance Cause Disclosure and transparency Management of the bank disclosed overstated earnings by incorporating non performing loans and investors could not derive accurate information- Informational Veil External Auditors The auditors signed off misleading accounts and they were not legally responsible for negative financial consequences of their actions- Legal Veil Further the case of PSDB pinpoints the need of emphasizing the Stakeholder Perspective into the governance mechanisms. The validity of this argument is implied in the following extraction that was appeared in an article published in Daily News on the Pramuka Savings and Development Bank Ltd. (PSDB) issue. It highlights the need to incorporate other important stakeholders in governance mechanisms (internal and external) other than the shareholders who provide the equity capital. In all countries, there is a variety of financial institutions and persons that seek financial deposits and investments from the public, and who perform a variety of lending and financial services. Unlike in other institutions where the turnover of activity is closely related to the capital, these financial institutions are highly leveraged i.e. their turnover is several times the capital because the turnover depends on large volume of deposits that the public makes with them on trust. Hence, if the depositors‟ monies are misused and lost, the depositors‟ have recourse only to a small capital base to seek relief. That is why these financial institutions are supervised and controlled (Daily News, 04 Feb. 2003, 7). However, the PSDB had not taken measures to incorporate wider stakeholders into the governance mechanism. It is also possible to conclude that the PSDB had not paid attention towards the Institutional Theory Perspective when designing the governance mechanisms. For instance, as stated earlier the management had given a large amount of gratifications to the public officials to bring in business to the Pramuka Bank. This practice was highly criticized by pressure groups and it was one of the reasons where the Bank could not gain social legitimacy. However, the Bank in their annual reports prior to the collapse had stated that they follow the governance procedure while not doing so. Further the overstated earnings, due to not writing off the non performing loans were not disclosed by the auditors of the company and therefore the role of auditors is also questionable. FINDINGS AND CONCLUSIONS OF THE STUDY As a major finding of the study it is possible to say that the failure of corporate governance mechanisms prevailing in Sri Lanka is mainly due to not incorporating three governance perspectives into their governance frameworks appropriately. From the analyzed case it is also possible to say that the unsound and imprudent practices by management and unsatisfactory role played by the auditors accentuate the need for reconstructing governance practices in the Sri Lankan corporate sector. The deficiencies found in Sri Lankan corporate governance systems can be analyzed in three perspectives introduced by the current study. For instance, the motive of management and board of directors to maximize their interests and the unsatisfactory role-played by the auditors highlight the Agency Problem in corporate governance. This is a result of the triple corporate veil that prevails in modern corporations. Further, as emphasized by the case, the Stakeholder Perspective is not taken into account with in the governance frameworks satisfactorily. The fact that Sri Lankan companies do not actually follow governance practices when they say they do, may be to gain social legitimacy as highlighted in the Institutional Theory Perspective. As a result it is capable of producing some important conclusions, which are summarized below as propositional derivations of the present research. Proposition 1: Governance is very different from management. Management is literally a “hands on” activity and governance is essentially a “brain on” activity (Perhaps, it could be said that a paradigm shift is needed from the previous concept of managed corporations to the model of governed corporations). Proposition 2: In many contexts the most immediate concern is to protect shareholders other than stakeholders. Corporate governance systems should optimize the interests of various stakeholders over lop-sided maximization of one class of stakeholders. Proposition 3: Agency Perspective which is based on the divorce of control and ownership, it self is not sufficient to address the issues of corporate governance. The problems prevail in Sri Lankan context can be justified together with Stakeholder Perspective and Institutional Theory Perspective. Proposition 4: Governance structures will reduce the chances for corporate fraud, but ultimately it is determined by the ethical values of the participants in corporates. REFERENCES Daniel, M. & Sheila, P. 2002. Corporate Governance in Russia: Towards a European, US or Russian Model?. European Management Journal, 20 (6), 630-640. Micahel, C. & Gedajlovic, E. 2001. Corporate Governance and Firm Capabilities: A Comparison of Managerial, Alliance & Personal Capitalism. Asia Pacific Journal of Management, 18, 335-354. Moldoveanu, M. & Martin, R. 2001. Agency Theory and the Design of Efficient Governance Mechanisms. firstname.lastname@example.org. 57. Mudalige, S. 2002. What Happened? The Chartered Accountant. .37 (2), 11-14. Panchali, J. N. & Baid, R. 2002. Corporate Governance: An Alternative Approach. Vision: The Journal of Business Perspective, 41-44. Rangarajan, C. 1998. Lessons from East Asia. Vikalpa, 23 (4), 3-9. Rubach, M. J. & Sebora, T. C. 1998. Comparative Corporate Governance: Competitive Implications of Emerging Convergence. Journal of World Business, 33 (2), 167- 184. The Committee to Make Recommendations on Matters Relating to Financial Aspects of Corporate Governance. 1997. Code of Best Practice, Colombo: The Institute of Chartered Accountants of Sri Lanka, 12. Yoshikawa, T. & Phan, P. H. Alternative Governance Systems in Japanese Firms: Implications for a Shift to Stockholder-Centered Corporate Governance. Asia Pacific Journal of Management, 18, 183-205.
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