Framework Corporate Governance World Bank by wyr96520

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                                    K A N Dilhani
             Department of Accounting, University of Sri Jayewardenepura,
                         Gangodawila, Nugegoda, Sri Lanka


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

Keywords: Corporate Governance, Agency Perspective, Stakeholder Perspective, and
Institutional Theory Perspective


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.


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.


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
                        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
           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

                                          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

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

                                                              Legal Veil: Limited Liability

                               Board     of
                               Directors                      Informational Veil: Limited Knowledge


                                  Employees                        Motivational Veil

         Source: Mihnea Moldoveanu & Roger Martin, “Agency Theory and the Design of
         Efficient Governance Mechanisms,”, 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

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

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
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
   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
                                                                Corporate Governance
   Loss of Legitimacy                                                 Practices
      Long poor performance          Institutional Pressures
      Large profit decline
      Corporate scandals

                                      Changing Institutional

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

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
              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
              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
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.


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


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