Page 12 - DMGT503_DMGT301_CORPORATE GOVERNANCE AND ETHICS

Unit 1: Understanding Corporate Governance

Notes
interest of non-controlling shareholders through effective monitoring. But, in practice,
companies do not prefer a monitoring board of directors.
They see value in having an advisory board of directors. This is so because companies do
not see a business case for a board of directors, which effectively monitors the executive
management. Although researchers argue that good and effective corporate governance
system in a company reduces the cost of capital, their research findings do not provide
conclusive evidence of reduced cost of capital. The argument is based on the principle that
higher the risk, higher is the expected return. Therefore, if corporate governance reduces
the total risk by reducing the risk of expropriation of shareholders’ wealth by the executive
management, the return expected by shareholders, which measures the cost of capital,
should also reduce.
The logic is simple. But that may not work in practice. If corporate governance results in
too much and too many controls, it kills the managerial entrepreneurship and innovation
resulting in less than the optimal performance. Shareholders are not benefitted as both the
expected return and actual return on investment are reduced. This is likely to happen if
independent directors exercise too much control over the executive management.
Performance of companies improve if, independent directors restrain themselves from
imposing controls on the management and intervene when there are signs of
mismanagement. Therefore, companies prefer advisory board of directors and shareholders
do not resent to the same.

Shareholders are not too much bothered about the quality of corporate governance in a
company because the quality of corporate governance is not observable. What is observable
is the composition of board, qualifications of board of directors, number of meetings held,
number of meetings attended by each board member, constitution of various board
committees and number of meetings held by them and attendance members in those
meetings. The board process is not observable to those who are not privy to board
proceedings. Therefore, the adequacy of the corporate governance system can be observed
but its effectiveness cannot be observed.
On the other hand, performance of the company is observable. Often, enterprise performance
is used as a measure of the effectiveness of the corporate governance system. Capital flows
to companies, have good track record of economic performance in terms of creating
shareholders’ wealth. In fact, shareholders have little to choose between companies in
terms of the corporate governance system because the corporate governance system is
uniform for all the companies.
The government has interest in reducing the cost of capital for companies. If the cost of
capital can be reduced, some projects that are unviable will become viable with reduced
cost of capital. Companies prefer to use effective supervisory board to improve performance
rather than establishing an effective monitoring board. The alternative way of reducing
the cost of capital is to reduce the information asymmetry between the executive
management and the capital market and to reduce the chances of earnings management.
These also strengthen the passive monitoring by capital mar-ket participants and others
and enhance activities in the corporate control market. Quality of Accounting practices,
disclosures in annual reports and in financial statements, disclosures to investors through
stock exchanges and audit effectiveness reduces information asymmetry and chances of
earnings management. Therefore, the government should focus on all those aspects.

Source: http://www.business-standard.com/india/news/should-corporate-governance-be-voluntary-
or-mandatory/427488/

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