Corporate Governance: Double edged sword carried by CEOs

Prof D.S. Withane, PhD

Shareholders, employees and other stakeholders of any organization run the risk that managers will engage in the practices detrimental to the values, health and vitality of the firm.

Prof D.S. Withane

The CEO and members of the top management team set and guide the vision for the firm and its stakeholders are responsible for formulating and implementing the strategy which realizes that vision.

Strategists often argue that once shareholders invest in a firm, they have relatively little direct controls over what happens within the firm.

This separation of the ownership of the capital to fund a business enterprise from the day-to-day operational management of business affairs is the fundamental argument raised here that CEOs and managers carry a double edged sword and it is mainly due to the agency problem.

The crux of the agency problem is that in a corporation CEOs and executives or the board work as the agents of the shareholders to invest the shareholders' wealth in a profitable manner and to manage the corporation so that the other stakeholders including the employees are satisfied with their expectations on the other.

This shows that CEOs and shareholders are self interested decision-makers. It does not mean that they have no interest in the well-being of the other party.

It suggests that they may generally make decisions that are in their own best interests. When their interests are in conflict the regency problem is quite prominent.

The agency problem further emphasizes the fact that the corporate resources and profits are not squandered, but executives will not make the choices that benefit themselves at stakeholders' expense and that stakeholders will receive a positive return on their investment.

The means and mechanisms used to ensure that managers act in accordance with investors' best interests are of much concern here.

The Sri Lankan CEOs of both the public and private corporations seem to lack the power derived through ownership of the capital and mainly engage in operational management only.

The CEOs of public corporations in general do not have much power in managing corporate policies and strategies.

The paper is four-fold. First it explains the concept and structure of corporate governance. It also addresses the links between corporate governance and strategy and major parties involved in corporate governance.

In part two the paper addresses the ownership, the roles of owners, the appointment of the board of directors and composition and powers of the boards.

The powers, roles and responsibilities of Sri Lankan CEOs in general and those of the public corporations in particular are addressed in part three. Part four is devoted to general conclusions.

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Corporate Governance in a nutshell

Corporate governance is the system by which organizations particularly business corporations are directed and controlled by the owners. It addresses the distribution of rights and responsibilities among different participants involved such as the board of management, shareholders and other stakeholders and spells out the procedures, rules and necessary conditions for making strategic decisions on corporate affairs. All organizations - public, private and nonprofit - do have some form of governance in place.

We also can see that governance paves the structure through which the company's objectives are set, the ways and means of attaining those objectives, and monitoring company's performance at large.

A broader stakeholders' view of governance suggests that a firm as a function of governance has a major responsibility to benefit other stakeholders beyond shareholders.

This is sometimes called the triple bottom line in the corporate world because a firm's strategy and related investments have both the financial performance objectives and social and environmental objectives.

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Corporate governance and strategy

At the outset, when we consider the overarching question-what effect does corporate governance have on a corporation's survival, performance and competitive advantage, the answer is that the governance mechanisms which are stipulated by regulators and peer pressure are very complex and cumbersome to implement and maintain.

Strong evidence suggests that stakeholders favour good governance and that it can help firms outperform those with poor governance.

From a strategic management point of view effective governance and control mechanisms are directly related to the firm's competitive advantage.

It is directly linked to strategy formulation and implementation in several ways. Board of management need to ensure that the organization's vision and mission are reflected in its strategy, monitor regularly the way that strategy is implemented and ensure that the top management reaps appropriate career and financial consequences in cases of failure or success.

The risk that managers will deviate from the organization's stated purpose and its guiding documents would inevitably increase when top executives do not have any ownership of the firm.

For instance, when the founders of a company raise capital through an IPO, they usually exchange a significant portion of the firm's stock for the financial capital required to fund the general operations and growth of the company.

After going public, the founders have to dilute their ownership and very often they have to become minority owners of the company.

Simultaneously they have to accept accountability for their actions to outside shareholders. Similarly, executives of older or large publicly held firms are generally owners of a very small percentage of the firm.

Overall the evidence reveals that the CEOs of private firm's can use their offices to manage the firm's strategy and destiny using their powers and the control mechanisms.

Many markets and investor groups across the world have formulated codes of governance - ideal governance standards to which firms should adhere. Some of these are followed voluntarily while the others are formulated by law. Generally codes of governance are aimed at four main concerns:

* equality of shareholders which addresses the upholding of all share holder rights,

* disclosure and transparency through accurate and timely financial and nonfinancial reporting,

* accountability by the board and management, and

* independence of the process of auditing.

Sri Lankan CEOs of both the public and private corporations seem to lack the power derived through ownership of the capital and mainly engage in operational management only.

From region to region and country to country in the world the level of adherence to these codes seems to be different. The Cadbury code of the United Kingdom and the Sarbanes - Oxley Act of the United States of America are some major governance laws which came into operation during the last two decades.

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Ownership and the roles of owners

The ownership of pro-profit firms can be subdivided into different ownership types, such as public and private firms (the definition of public versus private varies from country to country in the various parts of the world).

A private firm is one in which the owners have not listed shares of the firm on a public exchange , shares are typically owned largely by the founding families or by an investor group, such as leveraged buyout firm or venture capitalist. When a public company has sold shares to the general investing public, how those publicly traded shares are dispersed or concentrated varies significantly and leads to another way to categorize public firms.

Ownership has been dispersed in many ways. Some firms have a few select owners who control significant stakes in the firm.

Consequently, these parties have so much voting power that they can have significant influence and control over the firm's strategy and governance.

Some times they use that influence to determine who stays in power as the CEO or chair of the board.

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The composition of board of directors and their powers

One of the main monitoring devices available to shareholders is the board of directors.

All publicly held organizations are required to have a board of directors --a group of individuals who formally represents the company's shareholders. This board of directors is charged with overseeing the work of top executives.

The legal role of the board is comprised with hiring and firing of top executives, monitoring management, ensuring that shareholders interests are protected, establishing executive compensation and reviewing and approving the company's strategy.

Also the board plays some informal roles such as acting as conduits of information from external sources, providing leads for acquisition and alliance partner candidates, influencing important external parties such as industry regulators and foreign government policy makers and providing advice and counsel for the CEO and other top executives.

Although corporate laws vary around the globe, which results in some differences in board practices, the general responsibility of the board of directors is to ensure that executives are acting in shareholders' best interests.

For example in the United States of America, shareholders elect members of the board of directors. In the wake of several high- profile financial scandals during the past two decades boards have been under the increasing pressure to exercise their monitoring responsibility with greater vigilance.

Part of this pressure comes from the U.S congress, which has created laws that require public companies to put particular governance reforms into place.

A board of directors is typically composed of several experienced individuals. In many countries these individuals are generally not officers of the company but, rather, are employed by other companies. Executives of the firms who also serve on the board are often referred to as insiders; those on the board who are not employed by the firm are known as outsiders.

Outsiders can typically be more independent in fulfilling their board responsibilities but being an outsider does not necessarily make a director independent.

For instance, the independent judgment of a director who has another business relationship with the company may often be compromised. We have seen that most institutional investors and watchdog groups prefer a large majority of independent directors.

This usually helps to avoid conflicts of interests in carrying out their fundamental responsibilities.

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The powers, roles and responsibilities of Sri Lankan CEOs

Sri Lankan CEOs and the boards are charged with various powers, duties and responsibilities to protect the interests of the shareholders. Both in the private sector firms and public corporations in Sri Lanka, there are more outsiders than insiders in the boards. In the private sector companies such as UniLevers, John Keells and Hemas Group the board plays legal roles such as setting and reviewing of the corporate strategy, hiring and firing of the executives at the highest level, establishing their compensation packages and monitoring of the overall operational activities.

However, the Chairmen and CEOs of public sector corporations do not enjoy much of a legal power. They are mostly in charge of the day-to-day administration of the corporation.

It seems that the model adopted in selecting, entrusting the executive powers to the CEOs and the appointment of the other directors to the board in Sri Lanka is very different from the other countries.

Since the appointment of the chairman and CEO of a public corporation is mostly done with the knowledge and often with the approval of the President of the country the independence of the CEO in terms of directing and managing the organization is limited.

Powers of the Sri Lankan CEOs of many public sector corporations compared to those of the United Kingdom, Canada and the United States are diluted in many ways. In fact the CEOs of Sri Lankan corporations do not enjoy much control over the strategy formulation and implementation. Many of the codes of governance do not exist in the way they should be.

For example, the disclosure and transparency of accounts through accurate and timely financial and nonfinancial reporting is inadequate while the accountably of the board of management is insufficient.

For instance, many public sector organizations do not follow the rules and procedures of the Registrar of Companies and often do not prepare and file final accounts of the corporation on time.

In some corporations the final accounts have not been audited for decades.

Furthermore, the appointment of corporation directors, hiring and firing of the senior executives, making decisions regarding the remuneration and incentive packages of the directors do not come under the purview of the CEOs.

Decisions related to such matters are often made without any formal procedure. Furthermore there is no uniformity of these matters across the various public enterprises of the country.

Apparently the organization which was entrusted to supervise, control and advice the public sector corporations in Sri Lanka - Public Enterprises Reform Commission (PERC) either did not have teeth to bite or it was reluctant to perform its duties.

It is the high time to have a more enterprising body to rejuvenate the public sector corporations in Sri Lanka.

In conclusion it is suggested here that the CEOs should be entrusted with more power in managing the strategic aspects of the corporations and directing them to achieve their goals and objectives.

The political influence over them should be reduced so that the CEOs could make their decisions in a more independent manner. Also more qualified and experienced personnel should be appointed to such positions at large.

Finally, it could be argued that unlike in Canada, the United States, the United Kingdom, and Germany both edges of the corporate governance sword carried by the majority of the public sector CEOs in Sri Lanka are really blunt.

Without delegating adequate powers to CEOs to manage the public enterprises as innovative and growth oriented entities, making Sri Lankan CEOs responsible partners of national development process would be a forlorn hope.

(The writer is Chairman, Ontario Educational Centre, emeritus Professor of Business Management, Windsor University, Ontario, Canada and former Chairman of Building Materials Corporation.)