Corporate Governance

Directors in management must comply with such duties and responsibilities as it forms the basis of their obligation to the company and its overall corporate governance. It is critical for management to acknowledge the expectation bestowed upon them not only due to the fact that ignorance does not mitigate any penalties for breach but also to safeguard the company from unnecessary risk taking.

2. How well is that obligation manifested in Australian corporate governance practice?

The board’s obligation has been duly manifested, and in some cases, almost absent in Australian corporate governance practice. During the first half of the twentieth century, Australian companies were best described as ‘family capitalism’ with important directors and managerial positions held by a close-knit business group.  A study by Wheelwright (1957) showed empirically that the founding families of the large Australian companies in the 1950s were in a position to control the majority of those companies through their board positions and shareholdings. As directors were not subjected to too much outside scrutiny during the time, they were able to act opportunistically to improve their own welfare.

The second half of the twentieth century saw a change in the nature of the separation of ownership from control. There was a greater dispersion of ownership and firms adopted a range of ownership and corporate governance mechanisms to reduce agency issues between shareholders and directors. The subsequent diffused ownership structure of the 1950s and later decades further reinforces the relaxed market scrutinised environment that managers and directors faced than would be the norm in the 1990s.

         Where there are issues of priority involved in the delegated decision making of directors, the interest of small individual shareholders are most likely to be unprotected and expended. This has given financial institutions the means and incentive to provide closer scrutiny of the board and management. The last forty years has witnessed changes in three governance mechanisms – the level of share ownership by directors and managers, structure of the board of directors, and the importance of shareholding blocks to be held by the board was established by the 1990s by financial institutions.

Share ownership by directors ensures that the interests of all shareholders are protected. It enables the alignment of interests on the maximisation of share value while simultaneously reducing the likelihood of directors partaking opportunistically in excessive risk taking or monitoring ineffectively.

Block-holders serve an important role in the governance process because they are willing to incur the transaction costs associated with monitoring and its importance has been recognised by financial institutions towards the 1990s. The trend of increasing board size can be justified by the difficulty of directors to act opportunistically against the best interest of the company due to a much more complex control and decision making system. It was suggested that these market-mediated actions improved the monitoring, decision making and governance practices generally in corporations.

The study has shown that by the 1990s Australian managers faced greater scrutiny by a market based corporate governance system. In accordance to contract theory, the market forces stimulating greater scrutiny upon directors to fulfil its’ obligations acted as the ‘invisible hand’ to bring effect doctrinal constraints upon management.

One prominent example in the financial press regarding the poorly manifested obligation of the directors is One Tel. Its collapse is primarily accounted to the inadequate internal management leading to insolvent trading and over remuneration of directors. The board’s interests were in conflict the decision to expand did not only stem from the adequate performance base of the directors but also fuelled by their personal interest of greater remuneration. The ASX corporate governance principles outlined the preferable majority of independent directors for the establishment of remuneration committees so as to reduce the possibility of directors from making impaired decision creating substantially detrimental agency costs for the company.

Consistent to contractarian beliefs, the market’s ‘invisible hand’ brought into effect doctrinal constraints upon management such as to ensure the performance of the contract relationship between directors and shareholders in corporate governance. However, there are exceptional cases whereby market forces were seen to be insufficient to stimulate director’s obligation to be properly manifested in Australian corporate governance practice.

3. With reference to the theory you have chosen, consider why, and in relation to whom, we might want to improve the governance of risk taking by Australian boards of directors?

Shareholders claims usually stem from them being the ultimate risk bearers in a company in that their financial claim are postponed to those of creditors in liquidation. They are the residual claimants on firm value, and delegate the corporate decision making to managers and the board of directors. Since their wealth is in the control of the corporation, they should be secured from the improper use of their investment capital by the directors through excessive risk taking. It is imperative that such confidence should be built as it helps attract further equity financing from shareholders.

The Contractarian perception is that directors are employed by shareholders and hence owe a fiduciary duty to them. Intra-firm agency problems arise mostly in large firms with divisional managers who may ‘side contract’ to further their own interest, rather than that of the head office.  Due to the vulnerable and highly exposed nature of the shareholders to risk taking, the improvement of the governance of risk taking by the board is vital. Reduction of such agency cost may be achieved by implementing a mandatory shareholding structure of the board. With stricter corporate governance via an assimilated interest, the board would not consequently become risk adverse and avoid risky investments but instead they are provided with a means and incentive to perform their side of the contract for shareholders, that is, maximising their investment and share value yet not abusing their oversight role of management.

Shareholder’s rights should be acknowledged and given consideration by directors due to the existence of information asymmetry between the principal and the agent. However, although a shareholder theorist would prioritise shareholders value and interest above all other stakeholders by placing high relevance in the investors input into the corporation, such abuse of shareholder’s rights can contribute to long term instabilities of companies. As such, a fair and balanced stakeholder’s perspective should be taken into consideration to produce a long-term shareholder maximisation value.

Companies have a number of relationships with other major stakeholders within its nexus of contracts; the suppliers, customers, employees and the community. Directors, to an extent, can act opportunistically in their relationship with suppliers and customers but is limited to the powers held by each party. They may ‘hold-up’ contracts, or other norms of business, with suppliers or customers to further their own ends which may be inconsistent to the interest of the company.

Short-term maximisation of shareholder’s wealth leads to system abuses which is evident in the dramatic financial scandals in the early years of the twenty first century. The maximisation of stakeholder’s interest alone can lead to assets waste and diversion by the corporation. It is therefore good governance means to organise, structure and to establish a balanced and efficient prioritisation of differing interests. The improvement of the governance of risk taking by the board to other stakeholders would benefit the shareholders long term interest. In essence, consumers would prefer to purchase products from trusted companies; suppliers would contract with reliable companies; employees rather work for companies they respect; large investment funds would favour socially responsible firms; and non-government organisations would prefer to cooperate with companies conciliating their investment interests with community goals.

Revenue obtained from customers is the main source of the distributed wealth to shareholders. Customer satisfaction is positively correlated to economic returns and hence management should not assume such risk as to reduce the level of customer satisfaction for short term benefits. There are no material incentives for management and shareholders to disregard the interest of customers and thus good governance would be beneficial to the parties within the nexus of contract.

Another crucial stakeholder is the supplier’s interest. Any attempts to produce short term profits by paying below market prices at the expense of quality problems would be detrimental to both the interest of corporations and suppliers. Supply disruptions would have the accumulated effect to reduce the corporation’s profit, supplier’s profit, and ultimately shareholder’s wealth. Management should thus act in harmony with suppliers prospectively in light of the long-term aggregate benefits rather than taking advantage of early short term profits by assuming the unnecessary risk associated with reducing the quality of its inventory, delivery-production schedules and the like.

The success of a company is cannot be derived from any individual. Like a team is only as good as its worst player, companies should not take advantage of their employees by paying them below market wages, or undermine their talents in any way. Wasting valuable assets in the form of scamming employees and consequently demotivating them is contrary to the primary objective to maximise shareholders wealth. Corporations with capable human resources records are in a better position to achieve long-term profitability.

Finally there exist a social agency relationship between the corporation and the community. This encompasses responsibilities in terms of being a ‘good’ corporate citizen. Recent trends show that Australia began to explicitly recognise such a corporate governance relationship such as the area of environmental sustainability. Ignorance of community goals by management would close the possibility of non-government organisations from cooperating with the company. As such, good corporate governance promotes long-term cooperative relationship with the community which is ultimately a good ground for long term wealth maximisation.

Overall, good corporate governance is essential for the benefits of all the parties within the nexus of contracts in a corporation. In many cases, the failure of the risk management system is accounted to obvious conflicts of interest between management and associated stakeholders. It is the attractive peculiar incentive that drives directors into putting forward their own interest above all. As such, the unnecessary yet excessive risk taking purely for the short term gain can resulted in the failure of many well established companies, for example One Tel. Such corporate crimes are usually disguised by the ‘phalanx of professional advisers’ through deception and manipulation of evidence into a well protected scheme of ‘legitimate transaction’. The result is not a product of inadequacies in computer models alone, but is mainly driven by the independent incentives of the directors in the corporate governance system.

Improvements from such governance failures can be accredited to the use of audits. As a checking and monitoring means, the utilisation of external audits provides a third party review of the mechanisms designed to minimise agency costs. They ensure that the behaviour of management, the board of directors and related parties are in the best interests of equity and debt holders and verifies the accurate communication of the company’s financial position.

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