role of corporate governance for employee and shareholders

8/9/2019 Role of corporate governance for employee and shareholders

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A Report On

Role of Corporate Governance on

Stakeholders and Shareholders

By

R K Krishna Vazrapu

PGDM-MARKETING

A Report submitted in partial fulfillment

Of the requirements of

PGDM


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ACKNOWLEDGEMENTS

I am indebted to my institution Vignana jyothi Institute of Management for giving me this splendid

opportunity of learning in a professional atmosphere.

I express my sincere thanks to my project guide Col Saeed Ahamd(Retd.), Vignana Jyothi Institute of

management, for guiding me right from the inception till the successful completion of the project. I sincerely

acknowledge him for extending their valuable guidance, support for literature, critical reviews of project andthe report and above all the moral support he had provided to me with all stages of this project.

I also extend my grateful thanks to Mr. Kamal Ghosh ray (Director, VJIM) and all faculty members.

I would take this opportunity to thank all my family members for their helps & suggestions during the

course of project work. I am also thankful to all my friends who gave me constant & continuous inspiration to

complete this project.


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Abstract

Corporate governance plays a major role for stakeholders of a company they are primarily the

employee of the company. The paper throws a light how corporate governance is contributing for

the success of the stakeholders and shareholders without any illegal practices with maximum

security for both the parties. The paper has given a clear view about the stakeholder model of a

company and a shareholder model of a company. With a case study of Johnson and Johnson

which tells us that during their time of crisis how company got a good image because of their

ethical practices.

Objectives

1. how corporate governance is practiced for employee2. Understanding the stakeholder model

3. how corporate governance is practiced for shareholders

4. Understanding the shareholder model

Scope

Due to time constraint, the study role of corporate governance for stakeholders and shareholders presented in

this report is mainly on the secondary data obtained through books, journals, internet, etc.

Methodology

Methodology followed in this study is qualitative research. The secondary data was collected from the websites

of CIPE, OECD and from textbooks, articles and journals.


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Contents

Scope....................................................................................................................................................... 3

Methodology ...........................................................................................................................................3

Introduction............................................................................................................................................. 5

Genesis of Governance ............................................................................................................................ 7

Types of Corporate Governance............................................................................................................... 8

Internal Corporate Governance......................................................................... ................................... 8

External corporate governance .............................................................................................................. 10

Principles of Corporate Governance ....................................................................................................... 10

Organisation and responsibilities of the board of Directors .................................................................... 12

Corporate Governance and Employees .................................................................................................. 12

Wealth creation requires Capital and Labour ..................................................................................... 13

Trade Unions ................................................................................................................................. 14

The firm-specific investment of the worker .................................................................................... 15

A trade union framework of corporate governance ........................................................................ 17

Reinforcing worker representation in corporate decision-making .................................................. 18

Works councils ............................................................................................................................... 19

Board-level employee representation ............................................................................................21

Equity Sharing ................................................................................................................................22

Team production Solution ..............................................................................................................23

Guidelines for Employee representation in Organisation:- .................................................................23

1. Voluntary Participation: There should be voluntary participation on the part of the employees

and the y should not be forced to do anything out of compulsion. If compulsion is exercised either by

unions or employers, it may boomerang, instead of being beneficial. .................................. ..............23

2. Extend Benefits to All: the benefits should be extended to all employee, factory workers, clerical

staff and the executives of the organization indiscriminately. Extension of benefits to selective group

of employees. will create more problems than it will solve and will create dissension among workers

and distrust towards employers. ........................................................................................................23

3. Clarity and transparency: The process by which allocation of shares is done should be clear and

transparent, and not too complicated. Workers should clearly understand and appreciate the

benefits they will get under the arrangement. ...................................................................................23

4. Predetermined Formula: There should be predetermined formula to work out the number of

shares that could be offered, and should not be left to discretion of any party. .................................23


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5. Regularity : There should be some regularity when such offers are made; they cannot be made as

and when the organization feels like making such offer. ....................................................................23

6. Avoiding Unreasonable Risk for Employees: the organization should take into consideration the

interests of employees when they make any decision, and they should see it that there is no undue

risk taken. ..........................................................................................................................................23

7. Clear Distinction: There should be a clear distinction between participation schemes that are

offered to the employee and the regular wages and the benefits that are offered by the organization.

Those participatory schemes should in no way affect regular wages and related benefits paid to

employees. ........................................................................................................................................24

8. Compatibility with worker mobility: The participation schemes offered should be compatible

with worker mobility. The worker should not be penalized by the schemes offered to him. ...............24

The Stakeholder Model ......................................................................................................................24

Corporate Governance and Shareholders ..............................................................................................27

Board Representation ........................................................................................................................28

Self-Dealing and Moral Hazard ...........................................................................................................29

THE JOHNSON & JOHNSON TYLENOL CASE STUDY .................................................................................37

Background........................................................................................................................................ 37

The Crisis ...........................................................................................................................................37

Conclusion .............................................................................................................................................41

Introduction

Corporate governance is the set of processes, customs, policies, laws and institutions affecting

the way in which a corporation is directed, administered or controlled. Various aspects of

corporate governance have been hot topics in a considerable number of studies performed

during the past decades. Nevertheless, there is still absence of consistent definition of corporate

governance. There is no united view on what elements corporate governance incorporates, what

characteristics the elements have, what type of relations there are between them and where the

borders of the concept lay. The reason behind that confusion is the extremely broad plethora of


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issues which are related to the theme of corporate governance. Perhaps the most commonly used

traditional definition is that of OECD which defines corporate governance as: "Corporate

governance is the system by which business corporations are directed and controlled. The

corporate governance structure specifies the distribution of rights and responsibilities among

different participants in the corporation, such as, the board,managers, shareholders and other

stakeholders, and spells out the rules and procedures formaking decisions on corporate affairs.

By doing this, it also provides the structure through which the company objectives are set, and

the means of attaining those objectives and monitoring performance." In other words, the

corporate governance system incorporates participating actors (the board, managers,

shareholders, other stakeholders) and institutions (rules and procedures formaking decisions on

corporate affairs) designed for the achievement of the companys objectives. Systematizing

concepts definitions, one may say that corporate governance may be defined narrowly as the

relationship of a company to its shareholders and more broadly , as itsrelationship to society.

Each country has its unique corporate governance system, formed as a result of certain

historical,economical, social and political events. Based on the distinctive characteristics of the

corporate governance systems, countries may be classified into shareholder and stakeholder

groups.

There are three key aspects of internal corporate governance: ownership structure,

monitoring/control mechanisms and management incentives, and the emerging standards/codes

of corporate governance. Corporate governance also includes the relationships among the many

players involved (the stakeholders) and the goals for which the corporation is governed. The

principal players are the share holders, management and the board of directors. Other

stakeholders include employees, suppliers, customers, banks and other lenders, regulators, the

environment and the community at large. Corporate governance is a multi-faceted subject.

An important theme of corporate governance deals with issues

of accountability and fiduciary duty, essentially advocating the implementation of policies and

mechanisms to ensure good behaviour and protect shareholders. Another key focus is

the economic efficiency view, through which the corporate governance system should aim to

optimize economic results, with a strong emphasis on shareholders welfare. There are yet other

aspects to the corporate governance subject, such as the stakeholder view, which calls for more

attention and accountability to players other than the shareholders (e.g.: the employees or the


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environment). Corporate Governance (CG) is viewed as Approach, System, Concept, Ethics,

Law, Method, a set of principle and so on. On the basis of how it is viewed, CG can e used in

maximising wealth of stakeholders. In implementing CG, Accounting Standards play vital role .

Recently there has been considerable interest in the corporate governance practices of modern

corporations, particularly since the high-profile collapses of a number of large U.S. firms such

as Enron Corporation and World com and India based IT firm Satyam. Board members and those

with a responsibility for corporate governance are increasingly using the services of external

providers to conduct anti-corruption auditing, due diligence and training.

Genesis ofGovernanceOne may govern life in accordance with the revealed truth as one sees it or natural law or a

simple percept of not treating others as just ends, or in the pursuit of the good life of

contemplation prized by Aristotle. One may believe that morality lies in doing the best one can

do for oneself and ones children and giving something back to the society, when one can buy

money or time. One may also think that morality is simply being responsible for ones actions,

not harming others, and when one can compensate people for their pain and when one cannot.

One may think that morality is simply doing whatever produces the greatest good for the greatest

number; others may believe that morality is nothing more than maximizing ones wealth. One

may believe any of these things has a moral compass to direct ones daily life. One should come

to the realization that sometimes the ends do not justify the means and sometimes the ends

themselves are not pursuing. But a company/corporation has one end in mind. Corporations have

nothing called systems or beliefs. The result is that corporations are able to act without morality

or accountability, for they are formed for that one purpose: To maximize pecuniary shareholders

value. Therefore, to maintain the sanctity of a corporate self, the corporations self, the

corporations are required to follow a moral and ethical suit that has become more pronounced inthe present scenario, and has indeed exceeded the axiom of wealth maximization.


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2

Corporate Governance and Capital Markets

Source:A McKinsey Survey of Global Investors

Types ofCorporate Governance

Internal Corporate Governance


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Internal corporate governance controls monitor activities and then take corrective action to

accomplish organisational goals. Examples include:

a) Monitoring by the board of directors: The board of directors, with its legal authority to

hire, fire and compensate top management, safeguards invested capital. Regular board

meetings allow potential problems to be identified, discussed and avoided. Whilst non-

executive directors are thought to be more independent, they may not always result in more

effective corporate governance and may not increase performance. Different board structures

are optimal for different firms. Moreover, the ability of the board to monitor the firm's

executives is a function of its access to information. Executive directors possess superior

knowledge of the decision-making process and therefore evaluate top management on the

basis of the quality of its decisions that lead to financial performance outcomes, ex ante. It

could be argued, therefore, that executive directors look beyond the financial criteria.

b) Internal control procedures and internal auditors: Internal control procedures are policies

implemented by an entity's board of directors, audit committee, management, and other

personnel to provide reasonable assurance of the entity achieving its objectives related to

reliable financial reporting, operating efficiency, and compliance with laws and regulations.

Internal auditors are personnel within an organization who test the design and


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implementation of the entity's internal control procedures and the reliability of its financial

reporting

c) Balance of power: The simplest balance of power is very common; require that the President

be a different person from the Treasurer. This application of separation of power is further

developed in companies where separate divisions check and balance each other's actions.

One group may propose company-wide administrative changes, another group review and

can veto the changes, and a third group check that the interests of people (customers,

shareholders, employees) outside the three groups are being met.

d) Remuneration: Performance-based remuneration is designed to relate some proportion of

salary to individual performance. It may be in the form of cash or non-cash payments such

as shares and share options, superannuation or other benefits. Such incentive schemes,

however, are reactive in the sense that they provide no mechanism for preventing mistakes or

opportunistic behaviour, and can elicit myopic behaviour.

External corporate governance

External rporate governancecontrolsencompassthecontrolsexternalstakeholdersexerciseoverthe

organisation.Examplesinclude:

1. competition

. debtcovenants

3. demand orandassessmentofperformanceinformation

4. governmentregulations

5. manageriallabourmarket

6. mediapressure

7. takeovers

Principles ofCorporate Governance

Key elements of good corporate governance principles include honesty, trust and integrity,

openness, performance orientation, responsibility and accountability, mutual respect, and

commitment to the organization. Of importance is how directors and management develop a


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model of governance that aligns the values of the corporate participants and then evaluate this

model periodically for its effectiveness. In particular, senior executives should conduct

themselves honestly and ethically, especially concerning actual or apparent conflicts of interest,

and disclosure in financial reports. Commonly accepted principles of corporate governance

include:

1. Rights and equitable treatment of shareholders: Organizations should respect the

rights of shareholders and help shareholders to exercise those rights. They can help

shareholders exercise their rights by effectively communicating information that is

understandable and accessible and encouraging shareholders to participate in general

meetings.

2. Interests of other stakeholders: Organizations should recognize that they have legal andother obligations to all legitimate stakeholders.

3. Role and responsibilities of the board: The board needs a range of skills and

understanding to be able to deal with various business issues and have the ability to

review and challenge management performance. It needs to be of sufficient size and have

an appropriate level of commitment to fulfill its responsibilities and duties. There are

issues about the appropriate mix of executive and non-executive directors. The key roles

ofchairperson and CEO should not be held by the same person.

4. Integrity and ethical behaviour: Organizations should develop a code of conduct for

their directors and executives that promotes ethical and responsible decision making. It is

important to understand, though, that systemic reliance on integrity and ethics is bound to

eventual failure. Because of this, many organizations establish Compliance and Ethics

Programs to minimize the risk that the firm steps outside of ethical and legal boundaries.

5. Disclosure and transparency: Organizations should clarify and make publicly known

the roles and responsibilities of board and management to provide shareholders with a

level of accountability. They should also implement procedures to independently verify

and safeguard the integrity of the company's financial reporting. Disclosure of material

matters concerning the organization should be timely and balanced to ensure that all

investors have access to clear, factual information.


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Organisation and responsibilities of the board of Directors

The composition and organisation of boards themselves is key to their operation and

accountability. There must be a balance between directors whose primary function is to

implement the strategy (the executive directors) and those supervising them (the nonexecutive

directors) with clear channels of accountability. Their respective roles and functions must be

articulated through public policy, including clear definitions of independence and

objectivity, and set out in the companys articles of association. In one-tier systems, a majority

of the board must consist of non-executive directors. Beyond that, the Chair of the board must be

fully independent from the executive directors. That is the case by definition in two-tier systems

(the CEO chairs the management boards, all members of the supervisory board are non-executive

directors), in single-tier systems, the positions of Chair of the board and CEO must be separated.

Board meetings must also reflect the collegiality of the institution and its primary

function as a forum where corporate strategy is discussed in an open and unrestricted way, and

where different views over that strategy are resolved. Diversity can help in this regard, Workers

Voice in Corporate Governance not least in the gender balance, which should be a matter of

public policy. Directors should also understand the interests of company stakeholders, its

economic, social and environmental constraints, as well as the market forces that drive the

business. The board should thus ensure a satisfactory dialogue with shareholders, employees and,

where appropriate, other stakeholders, to discuss their concerns and interests in the formulation

and implementation of company strategy. That dialogue should take place in a transparent

manner. Furthermore, audit committees should take responsibility for ethical reporting and

disclosure or they should alternatively work closely with a separate ethic committee. Both audit

and/or ethic committees should have the power to launch internal reviews of the corporation

independent of management. The following table proposes a framework for directors

responsibilities and those that are specific to executive and non-executive directors.

Corporate Governance and Employees


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It is a fact that better and ethically acceptable corporate governance has been critically

important ever since the start of modern corporations, in which owners and mangers of

companies are separated. When owners directly manage their own company, governance issues

may not be that important. The recent downfall of Satyam, Enron, world com and many other

large corporations, partly due to the failure of their board of directors.

Wealth creation requires Capital and Labour

An organization needs capital and labour to create wealth. Earlier, the most important

need for an organization to be a success was capital; as long as they had capital, the organization

was able to be successful. But, today the need has extended beyond capital and includes labour.

The conventional model was the shareholder primacy model, which left out the role of

employees in the creation of wealth. The western reforms advocates have promoted the concept

of shareholder capitalism where sole emphasis is on strengthening the rights of, and the

protection for financial investors. Today, the growing recognition that human capital is a source

of competitive advantage has led to the understanding that labour is, if not, more important

atleast as important as, capital. Today, corporate leaders in developed countries increasingly

understand that people and the knowledge that they create are often most valuable assets in a

corporation. This is what the call is knowledge capital, which is considered as an invaluable asset

of an organization. In fact when a company acquires another company they value human capital

more than the plant, the machinery. There are a variety of ways by which the interest of

employees can represented in an organization. The growing representation proves that

employees participation does create wealth. There is a need that shareholders long run interests

are probably well served by including employees in corporate governance.

The interests of employees can be protected through

1. Trade unions

2. Board level employee representation

3. Work councils

4. Profit- sharing

5. Equity-sharing

6. team production


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Trade Unions

Trade unions are unique organisations whose role is variously interpreted and understood

by different interest groups in the society. Traditionally trade unions role has been to protect jobsand real earnings, secure better conditions of work and life and fight against exploitation and

arbitrariness to ensure fairness and equity in employment contexts. In the wake of a long history

of union movement and accumulated benefits under collective agreements, a plethora of

legislations and industrial jurisprudence, growing literacy and awareness among the employees

and the spread of a variety of social institutions including consumer and public interest groups

the protective role must have undergone, a qualitative change. It can be said that the protective

role of trade unions remains in form, but varies in substance.

There is a considerable debate on the purposes and role of trade unions. The predominant

view, however, is that the concerns of trade unions extend beyond 'bread and butter' issues.

Trade unions through industrial action (such as protests and strikes) and political action

(influencing Government policy) establish minimum economic and legal conditions and restrain

abuse of labour wherever the labour is organised. Trade unions are also seen as moral

institutions, which will uplift the weak and downtrodden and render them the place, the dignity

and justice they deserve. To safe guard their rights they have initialed the

The need for a trade union platform on corporate governance

Properly regulated and governed, the corporation is an effective institution for the

creation of wealth. But it must be accountable to society for the way that goal is achieved. The

description and explanation of the crisis provided in the first part of this report indicates why

corporate governance is important to workers and the day-to-day work of trade unions, and why

current regulations fail to ensure that corporations fulfil their wealth-creating mission. The

internal structures and strategies of companies have changed with the globalisation of product,

service and capital markets, and those changes imply new challenges for workers and trade

unions. In particular, the labour movement needs to be concerned with the internal constitution

of the corporation rather than rely simply on public regulation of markets or on governments to

protect workers rights at national or international levels. Corporate governance is crucial in

determining both how companies operate and create wealth, and also how that wealth is divided


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between investors, corporate management, stakeholder groups and wider society. A role for trade

unions engaging in public policy debate is even more necessary given the weak government

response following the Enron crisis. Trade unions should recognise that corporate governance

relates to every aspect of their work, be it organizing workers, collective bargaining, or public

policy advocacy.

One priority area for trade unions should thus be to improve their knowledge of the

internal dynamics of large corporations. Small changes in corporate governance mechanisms that

are not necessarily visible from the outside such as separation of CEO and Chair-ofthe-

board functions can make a difference to the output of company operations. This knowledge

should extend to the entire global supply chain, web of partnerships and fictional legal

arrangements from the OECD-based headquarters to the plant in China that help management

to avoid responsibilities while concentration of power is maintained. Trade unions have already

engaged corporate governance related strategies. Workers have a complex relation to publicly

traded corporations. Trade unions represent workers as employees, of course, but they also

represent them as shareholders and as citizens. They have done so in different ways, reflecting

different national regimes: in Germany, and more broadly in Continental Europe, by defending

worker representation within companies, in the US, and where pre-funded retirement systems are

predominant (pension funds), by ensuring active stewardship of workers capital invested in

companies. A central concern of the labour movement is how to coordinate the roles of employee

representative and shareholder representative to hold corporations accountable. Such emphasis

on corporate governance in unions activities might also encourage corporate social

responsibility (CSR) initiatives. What is needed is to ensure that a stronger emphasis on binding

regulation sets clear standards and that the social responsibilities of corporations do not rest

solely on voluntary initiatives

The firm-specific investment of the worker

A first step in building such knowledge is to reassert workers as core constituents of the

corporation and to make sure their firm-specific risks and investments are recognised,

irrespectively of differences among national regulatory frameworks. In response to the

shareholder value model, several scholars have developed an alternative stakeholder approach


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in the corporation, financial capital for shareholders, labour (or human capital) for workers and

managers. In fact the nature of workers investments is much more sunk than shareholders who

typically spread their investments over many companies precisely to diversify their risk. If

stakeholders are not represented, they will under-invest in the enterprise for fear of being

expropriated by those who are represented. Such underinvestment compromises firm

performance and weakens its capacity to face up to crisis and manage change. Thus under-

representation of workers in corporate governance violates the public purpose for which

corporations exist.

By contrast, external stakeholders such as creditors invest generic resources in the

corporation that is, resources that do not lose value if transferred outside the company and

have their interests fully protected by law and contractual relationship. Other stakeholders local

communities, consumer groups, interest groups, the environment, wider civil society do not

invest as such in the corporation, but can be exposed to its activities. As regards suppliers, the

nature of their investment (specific or generic) may vary. Suppliers who have a diversified client

portfolio and are not dependent on one client company are assimilated to external stakeholders.

On the other hand suppliers who may tool a whole plant to supply the needs of one major

customer do make firm-specific investments.

A trade union framework of corporate governance

The challenge facing public policymakers is to implement a broad range of reforms thatcan restore trust to modern corporations. Piecemeal and ad hoc solutions, even where welcome,

are insufficient. Root-and-branch regulatory reforms and reviews are required to ensure that

corporations are properly accountable to society to serve the public purpose of creating wealth.

Beyond that fundamental requirement to society at large, corporations must be regulated for their

particular responsibility to stakeholders contributing firm-specific assets as outlined above.

Finally, there is a responsibility that all companies have to all parties who are affected by

corporate activities. Some of these responsibilities are mandated by law and others by voluntary

CSR programs. The role of government is to craft an overarching regime of interlocking

regulatory frameworks that serve the twin objective of corporate accountability to society and

responsibility to its core constituencies. Full compliance of the corporation with enforceable laws

and regulations under which the corporation and its subsidiaries operate (labour, corporate,


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competition, tax laws, safety and health standards, etc.), forms the basis upon which the

accountability of the corporation and the protection of stakeholders interests can be considered.

From there, an effective corporate governance framework should define the responsibility

mechanisms for core constituencies, including workers interests representation within the

decision-making process and collective bargaining. Finally, outreach to stakeholders should

complement the broader accountability framework with initiatives that are not necessarily legally

required but are expected by society for corporations to contribute fully to wealth creation.

Together they form the basis for a four-tier structure of corporate accountability: (i) compliance

with laws and regulations, (ii) an effective corporate governance framework, (iii) collective

bargaining and, finally, (iv) broader social and environmental initiatives and outreach to external

stakeholders.

These four tiers constitute a mutually reinforcing package that public policy reforms

should simultaneously focus upon and that trade unions should seek to implement. They set out

two ways in which a stronger worker voice is currently operationalised: reinforcing worker

representation within the company and encouraging responsible shareholders. The two are not

mutually exclusive, and trade unions will campaign around one or both of these systems,

depending on national circumstances. More importantly, both strategies have as a common

objective to ensure well functioning and accountable boards of directors.

Reinforcing worker representation in corporate decision-making

Collective bargaining is central in any system of checks and balances that gives workers

a voice in corporate decision-making. Collective bargaining is not commonly thought of as

corporate governance, but it is. Collective bargaining is much more important to corporate

governance, certainly, than bondholder issues, particularly considering the firm specific

investments which workers make to the success of the corporation. Trade unions at the enterprise

level and above do more than simply bargain over wages. They negotiate over broader

workplace terms and conditions affecting their members. They may also negotiate pension and

health-care entitlements, and the systems that govern their provision. These non-wage bargaining

issues are often handled through workplace committee structures that report to the board, and

whose negotiated outcomes frequently guide board decision-making.


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Traditional collective bargaining has been challenged by the internationalisation of

corporations. Workers and their organisations are disadvantaged in having to negotiate separate

agreements with management in different countries and sites. That concern may well be directly

addressed in the future through the growing number of International Framework Agreements

(IFAs) - negotiated agreements between Global Union Federations (GUFs18) and individual

large corporations. About 29 such agreements now cover over 2.6 million workers, and their

numbers are increasing. Rather than being detailed collective agreements, these instruments are

enabling frameworks built around commitments by the corporations concerned to implement and

respect the core labour standards of the International Labour Organisation (ILO). However, these

agreements could evolve to cover a broader range of issues, including workers rights within the

decision-making processes of large corporations.

As a contractual relationship between workers and corporations, collective bargaining

addresses a core dimension of the relations between them. In a majority of industrialized

countries, however, workers are also recognised by law (or by those same collective agreements)

as having the right to be represented in company decision-making, through works councils

and/or the board of directors. Developing worker representation strategies has been an important

theme for European trade unions, most notably the European Trade Union Confederation

(ETUC) and its research centre, the European Trade Union Institute (ETUI). There may be scope

for a renewed reflection on, leading to modernization of, existing worker representation

mechanisms.

Works councils

Works councils constitute the principal mechanism for worker representation within

corporate decision-making procedures, and are found across continental Europe. They are

usually composed of elected worker (sometimes but not necessarily via unions) and management

representatives. Though varying across countries their typical mandate is to deal with direct

workplace issues, including workplace organisation and hours, restructuring, the introduction of

new technologies, health and safety at work, and other employment conditions. The prerogatives

of worker representatives vary from information (the right to be informed by the management) to

consultation (the right to be informed and express views) to negotiation (the right to a veto on


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certain issues). In some countries, works councils may receive substantial financial support to

undertake cultural and leisure activities for employees.

Furthermore, as from 2005, European Union countries have to guarantee a generalised

right to information and consultation for all workers, subject to limitations on the enterprise size.

The European Works Council (EWC) directive 1994 has added a regional dimension. It

requires all companies operating across the EU, irrespective of their home base, and employing

more than 1,000 workers in at least two countries, to set up European-wide information and

consultation bodies with employee representatives. Of the more than 1,800 companies estimated

to be covered by the directive in 1994, around 600 have established one or more EWCs.

Approximately 10 million European workers are represented in such bodies. EWCs should not

be considered as a European practice alone. More than a third of corporations with EWCs have

their headquarters outside the EU, predominantly in the USA, and compliance with the directive

is often higher for corporations from countries with lower levels of social dialogue.

The OECD Guidelines for Multinational Enterprises

The OECD Guidelines for Multinational Enterprises alongside the ILO Tripartite

Declaration of Principles concerning Multinational Enterprises and Social Policy constitute the

most advanced international agreements to ensure social responsibility of business. Negotiated

by governments, they include information and consultation rights for workers. The Guidelines

state the need to respect human rights and observe the core labour standards of the ILO - but they

go much further. They set out prescriptions for attitudes to union recognition, employment

conditions, procedures for plant closures, and health and safety issues, to mention only a few

elements. They also specify procedures for prior consultation and negotiation regarding changes

in company activities.

Although the OECD Guidelines are not legally binding, they set out government

expectations for how their companies (that is, companies based and originating in the 38

signatory countries) should behave wherever they operate. These companies account for 85% of

global foreign direct investment. The Guidelines may be voluntary in the sense that they are

not binding, but they are not optional for management. They are political commitments by

governments, backed by government implementation mechanisms, the National Contact Points.


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This is the key difference between the Guidelines and other instruments labelled as corporate

social responsibility codes of conduct.

Board-level employee representationBoard-level employee representation constitutes a distinct form of direct worker

representation. It differrs from works councils in that it provides employee input into overall

company strategic decision-making, rather than information and consultation on day-to-day

operational matters. It operates via worker or union representatives who sit on the supervisory

board, board of directors, or similar structures. Within the OECD, 16 countries (out of a total of

30) have generalised provisions or sector-specific agreements for board-level employee

representation.

Board-level representation is designed to improve communication and decision making

between the board, the CEO and employees, who can inform the board on practices that may not

be known through the traditional company hierarchy. They can give first-hand information

concerning the situation within the company, and advance response to decisions that may affect

the workforce, while providing early information to works councils on strategic moves planned

by the company. Board-level representation is also an opportunity for employees to discuss and

negotiate alternative company strategies that secure socially acceptable outcomes, within the

objective of financial sustainability. Furthermore, board representation is important to ensure theaccountability of the board and of the CEO. Employee representatives are by definition

independent directors from the management. They can usefully provide information to other

non-executive directors and, having independence of mind, are likely to be more willing than

other directors to question the CEO on sensitive issues.

Having a voice in the corporate decision-making process is, however, no guarantee that it

will be exercised effectively. Success depends on there being regular meetings and discussions,

provision of adequate time off for workers representatives, provision of adequate information to

them, and the threat of real sanctions on those employers who fail to meet their responsibilities.

Responsibilities exist too on the other side of the equation. For example, employee

representatives themselves must invest the necessary time and effort to do the job, they must

keep colleagues informed of the deliberations, and they must respect the fiduciary duty that often


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arises from membership of the board. Trade unions have a key role to play here, especially in

providing logistical support and training.

Profit-Sharing

The concept of profit-sharing with employees in order to protect the interests of

employees in the organisation became much more widely used in Europe in 1990s.most profit

sharing plans are broad based i.e. all or most employees were included in the scheme of proft

sharing rather than just executives only. This practice has been followed in firms facing intense

competition and in firms with highly qualified work force. Profit-sharing motivates the

individual workers to put in his best efforts are directly related to the profits of the organization,

in which he gets a share. Profit sharing can be done in many ways

a) Cash based sharing of annual profits where annual cash profits of the organization are

shared among the employees.

b) Deferred profit-sharing where the deferred profits of the organizations are shared among

employees.

The objective of such profit sharing is to encourage employee involvement in the organization

and improve their motivation and distribution of wealth among all the factors of production.

Wage flexibility can improve a firms performance where ones age depends on profit made by

companies.

Equity Sharing

Under equity sharing , employees are given an option to buy the companys share,

identify themselves with, and thus become the owner of the organization. This leads to employee

commitment to managements goal, which motivates the employee to perform better. As a result,

there is an alignment of interests between employee and shareholders. This may help make firms

more adoptable to the changing environment and support the emergence of more transparent and

effective governance . this may more social responsibility of firms.

Various way in which equity sharing can be done: stock bonus plan, ownership plan,

stock option plan, employee buyout, worker cooperatives. This method of equity sharing to

increase employee participation is followed in larger companies, with highly qualified

workforce, and high level of worker empowerment, such as software ompanies.


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Team production Solution

Team production solution is a situation where board of directors must balance competing

interests of various stakeholders and the arrive at decision that are in the best interest of the

organization. Though they are employed by shareholders to safeguard their interests in the

organization, they have to work for the common benefits of all stakeholders of an organization.

As result of increasing participation of employees in the organization, a company can

reap the benefits of increase in productivity, which in turn, increases the profit of the

organization. This is the new perspective of wealth creation which in turn leads to wealth

distribution.

Guidelines for Employee representation in Organisation:-

1. Voluntary Participation: There should be voluntary participation on the part of theemployees and the y should not be forced to do anything out of compulsion. If

compulsion is exercised either by unions or employers, it may boomerang, instead of

being beneficial.

2. Extend Benefits to All: the benefits should be extended to all employee, factoryworkers, clerical staff and the executives of the organization indiscriminately. Extension

of benefits to selective group of employees. will create more problems than it will solve

and will create dissension among workers and distrust towards employers.

3. Clarity and transparency: The process by which allocation of shares is done should beclear and transparent, and not too complicated. Workers should clearly understand and

appreciate the benefits they will get under the arrangement.

4. Predetermined Formula: There should be predetermined formula to work out thenumber of shares that could be offered, and should not be left to discretion of any party.

5. Regularity : There should be some regularity when such offers are made; they cannot bemade as and when the organization feels like making such offer.

6. Avoiding Unreasonable Risk for Employees: the organization should take intoconsideration the interests of employees when they make any decision, and they should

see it that there is no undue risk taken.


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7. Clear Distinction: There should be a clear distinction between participation schemes thatare offered to the employee and the regular wages and the benefits that are offered by the

organization. Those participatory schemes should in no way affect regular wages and

related benefits paid to employees.

8. Compatibility with worker mobility: The participation schemes offered should becompatible with worker mobility. The worker should not be penalized by the schemes

offered to him.

The Stakeholder Model

The stakeholder model takes a broader view of the firm. According to the traditional

stakeholder model, the corporation is responsible to a wider constituency of stakeholders other

than shareholders. Other stakeholders may include contractual partners such as employees,

suppliers, customers, creditors, and social constituents such as members of the community in

which the firm is located, environmental interests, local and national governments, and society at

large. This view holds that corporations should be socially responsible institutions, managed in

the public interest. According to this model performance is judged by a wider constituency

interested in employment, market share, and growth in trading relation with suppliers and

purchasers, as well as financial performance.

The problem with the traditional stakeholder model of the firm is that it is difficult, if not

impossible, to ensure that corporations fulfil these wider objectives. Blair (1995) states the

arguments against this point of view: The idea [...] failed to give clear guidance to help

managers and directors set priorities and decide among competing socially beneficial uses of

corporate resources, and provided no obvious enforcement mechanisms to ensure that

corporations live up to their social obligations. As a result of these deficiencies, few academics,

policymakers, or other proponents of corporate governance reforms still espouse this model.

However, given the potential consequences of corporate governance for economic

performance, the notion that corporations have responsibilities to parties other than shareholders

merits consideration. What matters is the impact that various stakeholders can have on the


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behaviour and performance of the firm and on economic growth. Any assessment of the

implications of corporate governance on economic performance must consider the incentives and

disincentives faced by all participants who potentially contribute to firm performance. With this

in mind, the stakeholder model has recently been redefined, where the emphasis has been to

more narrowly define what constitutes a stakeholder. Therefore, the new stakeholder model

specifically defines stakeholders to be those actors who have contributed firm specific assets.

This redefinition of the stakeholder model is also consistent with both the transaction costs and

incomplete contract theories of the firm in which the firm can be viewed as a nexus of

contracts, see Coase (1937), Williamson (1975, 1985), Jensen and Meckling (1976), and Aoki,

Gustafsson and Williamson (1990).

The best firms according to the new stakeholder model are ones with committed

suppliers, customers, and employees. This new stakeholder approach is, therefore, a natural

extension of the shareholder model. For example, whenever firm-specific investments need to be

made, the performance of the firm will depend upon contributions from various resource

providers of human and physical capital. It is often the case that the competitiveness and ultimate

success of the firm will be the result of teamwork that embodies contributions from a range of

different resource providers including investors, employees, creditors, and suppliers. Therefore,

it is in the interest of the shareholders to take account of other stakeholders, and to promote the

development of long term relations, trust, and commitment amongst various stakeholders

Corporate governance in this context becomes a problem of finding mechanisms that elicit firm

specific investments on the part of various stakeholders, and that encourage active co-operation

amongst stakeholders in creating wealth, jobs, and the sustainability of financially sound

enterprises, see the OECD Principles of Corporate Governance .

However, opportunistic behaviour and hold-up problems arise whenever contracts are

incomplete and firm specific investments need to be made. As discussed previously, one

consequence of opportunistic behaviour is that in general it leads to underinvestment. The

principal-agent relationship discussed in the shareholder model is only one of the many areas in

which this occurs. Underinvestment in the stakeholder model would include investments by

employees, suppliers, etc. For example, employees may be unwilling to invest in firm specific


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human capital if they are unable to share in the returns from their investment, but have to bear

the opportunity costs associated with making those investments. Alternatively firms may be

unwilling to expend resources in training employees if once they have incurred the costs they are

unable to reap the benefits if employees, once endowed with increased human capital, choose to

leave the firm. Suppliers and distributors can also underinvest in firm-specific investments such

as customized components, distribution networks, etc. In this broader context, corporate

governance becomes a problem of finding mechanisms that reduce the scope for expropriation

and opportunism, and lead to more efficient levels of investment and resource allocation.

According to the stakeholder model, corporate governance is primarily concerned with

how effective different governance systems are in promoting long term investment and

commitment amongst the various stakeholders, see Williamson (1985).6 Kester (1992), for

example, states that the central problem of governance is to devise specialised systems of

incentives, safeguards, and dispute resolution processes that will promote the continuity of

business relationships that are efficient in the presence of self interested opportunism. Blair

(1995) also defines corporate governance in this broader context and argues that corporate

governance should be regarded as the set of institutional arrangements for governing the

relationships among all of the stakeholders that contribute firm specific assets.

One of the critiques of the stakeholder model, or fears of participants in the reform

process, is that managers or directors may use stakeholder reasons to justify poor company

performance. The benefit of the shareholder model is that it provides clear guidance in helping

managers set priorities and establishes a mechanism for measuring the efficiency of the firms

management team i.e. firm profitability. On the other hand, the benefit of the stakeholder model

is its emphasis on overcoming problems of underinvestment associated with opportunistic

behaviour and in encouraging active co-operation amongst stakeholders to ensure the long-term

profitability of the corporation.

One of the most challenging tasks on the reform agenda is how to develop corporate

governance frameworks and mechanisms that elicit the socially efficient levels of investment by

all stakeholders. The difficulty, however, is to identify those frameworks and mechanisms which


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promote efficient levels of investment, while at the same time maintaining the performance

accountability aspects provided by the shareholder model. At a minimum, this implies that

mechanisms that promote stakeholder investment and co-operation should be adopted in

conjunction with mechanisms aimed at preventing management entrenchment. Stakeholder

objectives should not be used to prevent clear guidance on how the firms objectives and

priorities are set. How the firm will attain those objectives and how performance monitoring will

be determined also need to be clearly defined.

Corporate Governance and Shareholders

The simple and main fact of a firm is in shareholder interest lies in the maximization of

corporate profit. But shareholders have different time horizons, subjective discount rates and

propensities to risk. Moreover the temporal strategy of corporate management can change, even

dramatically: for instance a company can change its behaviour deciding to maximize accounting

profits in the short run at the cost of their future reduction (goodwill can be cashed in and run

down by increasing prices to a level higher than it would be optimal in a long run perspective).

Furthermore, future profits are uncertain. Even if we were to know them, what discount rate

should be used for determining the present value of a company? This is unclear, owing to

imperfections and limitations of the credit market and the intrinsic riskiness of capital

investment. However the working of financial markets allows to overcome the above difficulties.

The possibility of trading shares provides flexibility, permitting different portfolio allocations

according to preferences, while the market continuously values and actualizes future prospects.

In the end the maximization of the discounted value of corporate profits can be seen to be

conceptually akin to the maximization of the market value of shares.

Shareholders are undoubtedly entitled to take collective action in relation to two principal

subjects namely board representation, and changes to the articles of association. Even this

bare statement of shareholders rights contains a germinal idea of importance: neither of these

areas constitutessubstantive collective action, by which I mean the sort of action which directly


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commits collective resources, thus indirectly taxing the other shareholders. In this way, the law

and constitutions of corporations limit the scope by which shareholder collective action can

impose externalities on other shareholders. At the same time, limiting the entitlement of

shareholders directly to affect the management of corporate resources limits their capacity to

hold up other constituencies for quasi-rent-seeking purposes. In light of this introductory

premise, I now seek to examine and explain the nature of permissible collective action in these

and cognate areas. I focus in most detail on collective action with respect to self-dealing and

fiduciary breaches as these are neglected subjects which play a crucial role in shareholder

constitutionalism.

Board Representation

Shareholders are entitled to elect, as well as to remove, directors by ordinary resolution

(in the case of public companies). However, the specific electoral procedures are largely

unregulated, and there are substantial discretions over the specific procedures to be applied. As a

general principle, the standard for collective choice in this area is simple majority rule. The

appeal of such a rule is obvious a very low representational requirement (self-appointment

being the extreme case) could result in excessively large boards. There is no evidence that board

effectiveness increases monotonically with board size. A very high representational

requirement, requiring a very high degree of support, has the opposite problems. Where the

tenure of a director is limited to a certain number of years before re-election, a high

representational requirement could result in a board without directors, since there may be no

candidate meeting such an onerous standard. Simple majority rule prevents either outcome.

To put these points differently, a very low representational requirement is likely to

impose a higher level of externalities because of the greater incidence of inappropriate or self-

interested board appointments. A very high representational requirement imposes high decision-

making costs, because of the need for side-payments and negotiation between different factions.

The absence of a mandated voting system is a straightforward reflection of the fact that

there is no voting system which satisfies all of the indicia of an optimal system.[36] There are, in

theory, risks of cycling. However, experience with large corporations is inconsistent with cycling

phenomena. Boards are far more likely to be static and apparently self-perpetuating. This


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suggests, then, that members of the board (especially the Chief Executive Officer) have and use

procedural advantages, such as the holding of proxies and influence over nominations. This

result is also significantly reinforced by the presence of business norms such as the famous to

some, infamous Wall Street Rule, which counsels voting with managers, or selling ones

shares, in the absence of serious violations of other norms which management is expected to

observe.

Self-Dealing and Moral Hazard

To the extent that the processes and norms associated with determining board

representation engender self-perpetuation, it is clearly important for other mechanisms to exist to

mitigate the potential for complacency and sub goal pursuit. There are many such mechanisms.

Some, such as the takeover, are market-based. Others involve contracts, such as executive

remuneration packages. There is also a role for law in limiting certain forms of undesirable

conduct, such as fraud and overreaching. Fiduciary duties and certain related statutory

constraints are important in this regard.

The law created the scope for collective action in the shadow of the rules it applied to

self-dealing. Courts traditionally applied a strict, inflexible standard, but permitted the

shareholders to resolve to affirm or ratify fiduciary breaches in order to release directors from the

consequences that these rules cause, such as the forfeiture of interests by means of

rescission. One cannot have a strict (and thus potentially over-inclusive) rule without having

some basis for the release of legal liability outside a court. This enhances the sense that

corporations can function in a self-governing manner, since the determination of whether legal

sanctions are to be imposed occurs endogenously through the collective action of shareholders.

What constitutional constraints should be imposed on this form of collective action by

shareholders?

(a) Bare Majority Requirements

What degree of consent must there be, and who should have the right to initiate collective

action? The general principle is that shareholders are capable of ratifying an ordinary resolution

by simple majority. However, that ratification is dependent on the shareholders receiving full


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information and on the absence of coercion. On occasions, it has been suggested that unanimity

is required, but this view has not prevailed.

On one hand, it might be thought that a bare majority requirement is undesirable because of the

greater incidence of externalities that may be borne by shareholders as a result of the lower

consent requirement. The fiduciary protection is limited by not demanding unanimity and by

making overreaching easier to ratify. However, other factors cut against this point. Equitable

doctrine implies that the court is able to review the procedural circumstances of the

transaction. This rule, and the possible application of the doctrine of fraud on the

minority,[46] are likely to limit the absolute value of the externality that shareholders could

possibly bear. These legal rules reduce the potential number of proposed resolutions that can be

put to shareholders, which in turn limits the scope that management has to manipulate the agendain order to procure a resolution contrary to a majoritys wishes. The curve describing the value of

externalities, E (in Figure 2), as a function of the required level of consent is likely to be flatter,

which justifies a lower consent requirement.

This conclusion is reinforced when it is understood that the law in this area was formulated at a

time when the fiduciary principle was largely contractible. That is, it was possible to waive the

conflict rule by a provision in the articles of association. Empirical evidence suggests these

provisions were very common. Thus, it took only a special resolution, with a requirement of a

three-quarters majority, to include such a provision in the articles notwithstanding that such a

provision presented greater risks of moral hazard, since it had of necessity to be voted on without

reference to any of the details of future transactions to which it might apply. It seems logical that

the law would require a lower level of consent when managers put forward the full details of a

specific transaction. This provided an incentive to managers of corporations lacking the term to

relax the conflict rule to seek the approval of a bare majority for the transaction rather than to put

forward a special resolution for the generic provision for the approval of a special majority.

Before discussing the issues associated with the initiation of collective action, I should say a

word about the duty of care. As is well known, the requirements of this duty were historically

highly undemanding, and there are very few instances of affirmative findings of negligence in

the 19th and early 20th centuries. The use of low standards of care made it unnecessary for


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managers to seekex ante shareholder authorisation to engage in particular businesses or

transactions. This minimised the scope for collective action by shareholders in the field of

management of the corporation, and thus reduced consequent delays and impoverished choice

(owing to apathy and limited information). Any other rule on the duty of care would have the

indirect consequence of attenuating the discretion of management vis--vis the shareholders. The

optimal rule in this respect is therefore one that delegates managerial decisions to managers only,

and which holds them to a low standard of care.

(b) Rights to Initiate Collective Action

The final and considerably complex question to be considered in this part is the process

associated with initiating collective action in relation to self-dealing and moral hazard. It is

clearly the case that a director has the right to requisition a vote in relation to his or her self-

dealing putting such a transaction before the shareholders is the proper course for him or her

to take. When the transaction is inchoate (as whereex ante approval is sought), the director must

determine the price that he or she should offer in the transaction. This therefore has the quality of

a take-it-or-leave-it offer, because shareholders have limited opportunities to counter-offer, and,

in any event, face collective action problems in doing so effectively.

Does theshareholderhave an independent right to initiate the review of such a transaction by thegeneral meeting afterthe transaction occurs, or to propose the restitution of benefits obtained by

the director thereunder? This question is not answered very clearly in the law. The shareholder,

faced with a fiduciary breach, can choose between two possible courses of action he or she

could attempt to litigate the transaction, seeking its judicial review, or he or she could attempt to

put the transaction before the general meeting. We know that until the recent enactment of the

derivative suit provisions in the the the rule inFoss took a very limiting approach to the

entitlement of individual shareholders to seek judicial review of such transactions.

AlthoughFoss is now substantially obsolete, it is worth understanding the doctrinal logic and

economic effects that justified the decision. These not only conform to the economic logic of

constitutions, but also highlight the problems that arise in the new law. In the remainder of this

part, I discuss the relation betweenFoss and the shareholders right to initiate review. I then use


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a game-theoretic illustration to justify the approach of the old law, and briefly compare it with

the new law.

That is, there is no entitlement to litigate the transaction as of right. This premise remained until

the enactment in the then Corporations Law of the statutory derivative action. Instead, the

validity of the transaction or voidable act depends on the will of the majority on collective

action. This is, of course, subject to well-known exceptions, each of which has clear

constitutional justifications:

1. The special resolution exception. This exception enables a minority to constrain a bare

majority by insisting on due compliance with the procedural and special majority

requirements for a special resolution. Rights could be protected by providing for them in

the corporate constitution, since a special resolution would be required for amendment.

2. The ultra vires exception. This exception functioned by rendering constitutional rights

inalienable, since acts ultra vires could not be ratified, even unanimously. It therefore

enabled the parties to tie their hands for the future, which may be useful if shareholders

are not expected to act rationally in making collective decisions.

3. The fraud on the minority exception. This provision responds directly to cases in which

there is a major divergence between the majority and the minority; it seeks to prevent the

former from using governance institutions to impose externalities on the latter.

4. The interests of justice exception. Though rarely affirmed in explicit terms, one

Australian case has suggested some scope for the exception in large corporations in

which shareholdings are highly diffuse. Such a justification fits the Buchanan-Tullock

framework, since it implies that a shareholder holding only a small interest can invoke a

process (litigation) that imposes costs on all shareholders because the costs of decision-

making in such a large shareholder body are very high.

In the absence of these exceptions, the individuals substantive entitlement is subject to

majoritarian disposition. However, there is no suggestion inFoss, or the authorities that followed

it, that the individual cannot invoke the processes that lead to a constitutionally valid majority

decision. This is presumably a personal right, albeit procedural in nature, which the shareholder


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would be entitled to enforce by declaration or injunction. The only bar to this would be if the

right were taken away by the constitution or otherwise regulated by statute.

There are also strong consequential justifications for the traditional legal position in relation to

overreaching. It lies close to the optimal legal regime, one which would afford both the directors

and the shareholders the right, but not the obligation, to seek a decision regarding ratification by

the shareholders at the same time as limiting the right of individual shareholders to litigate these

matters of their own motion. Such a regime is likely to reduce litigation costs while deterring

transactions that make shareholders worse off.

To conclude this subsection, my point is that, although there are no special reasons to

require shareholder consent to a fiduciary breach substantially to exceed a bare majority, there

are strong reasons to permit shareholders to raise in general meeting the question of overreaching

and fiduciary breaches. The law should not disable shareholders rights to raise these objections

or impose excessive transaction costs on the complaining shareholder (for instance, by requiring

a threshold interest that the shareholder must meet).

The Shareholder Model

According to the shareholder model the objective of the firm is to maximise shareholder wealth

through allocative, productive and dynamic efficiency i.e. the objective of the firm is to maximise profits.

The criteria by which performance is judged in this model can simply be taken as the market value (i.e.

shareholder value) of the firm. Therefore, managers and directors have an implicit obligation to ensure

that firms are run in the interests of shareholders. The underlying problem of corporate governance in this

model stems from the principal-agent relationship arising from the separation of beneficial ownership and

executive decision-making. It is this separation that causes the firms behaviour to diverge from the

profitmaximising ideal. This happens because the interests and objectives of the principal (the investors)

and the agent (the managers) differ when there is a separation of ownership and control. Since the

managers are not the owners of the firm they do not bear the full costs, or reap the full benefits, of their

actions. Therefore, although investors are interested in maximising shareholder value, managers may have

other objectives such as maximising their salaries, growth in market share, or an attachment to particular

investment projects, etc.

The principal-agent problem is also an essential element of the incomplete contracts view of


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the firm developed by Coase (1937), Jensen and Meckling (1976), Fama and Jensen (1983a,b),

Williamson (1975, 1985), Aghion and Bolton (1992), and Hart (1995). This is because the principal-agent

problem would not arise if it were possible to write a complete contract. In this case, the investor and

the manager would just sign a contract that specifies ex-ante what the manager does with the funds, how

the returns are divided up, etc. In other words, investors could use a contract to perfectly align the

interests and objectives of managers with their own. However, complete contracts are unfeasible, since it

is impossible to foresee or describe all future contingencies. This incompleteness of contracts means that

investors and managers will have to allocate residual control rights in some way, where residual control

rights are the rights to make decisions in unforeseen circumstances or in circumstances not covered by the

contract. Therefore, as Hart (1995) states: Governance structures can be seen as a mechanism for making

decisions that have not been specified in the initial contract.

So why dont investors just write a contract that gives them all the residual control rights in the

firm, i.e. owners get to decide what to do in circumstances not covered by the contract? In principle this is

not possible, since the reason why owners hire managers in the first place is because they needed

managers specialised human capital to run the firm and to generate returns on their investments. The

agency problem, therefore, is also an asymmetric information problem i.e. managers are better

informed regarding what are the best alternative uses for the investors funds. As a result, the manager

ends up with substantial residual control rights and discretion to allocate funds as he chooses. There may

be limits on this discretion specified in the contract, but the fact is that managers do have most of the

residual control rights.2 The fact that managers have most of the control rights can lead to problems of

management entrenchment and rent extraction by managers. Much of corporate governance, therefore,

deals with the limits on managers discretion and accountability i.e. as Demb and Neubauer (1992) state

corporategovernance is a question of performance accountability.

One of the economic consequences of the possibility of ex-post expropriation of rents (or

opportunistic behaviour) by managers is that it reduces the amount of resources that investors are willing

to put up ex-ante to finance the firm, see Grossman and Hart (1986). This problem, more generally known

as the hold-up problem has been widely discussed in the literature, see Williamson (1975, 1985) and

Klein, Crawford and Alchian (1978). A major consequence of opportunistic behaviour is that it leads to

socially inefficient levels of investment that, in turn, can have direct implications for economic growth.

According to the shareholder model, therefore, corporate governance is primarily concerned with finding

ways to align the interests of managers with those of investors, with ensuring the flow of external funds to

firms and that financiers get a return on their investment.


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1)An effective corporate governance framework can minimise the agency costs and hold-up problems

associated with the separation of ownership and control. There are broadly three types of mechanisms that

can be used to align the interests and objectives of managers with those of shareholders

and overcome problems of management entrenchment and monitoring:

One method attempts to induce managers to carry out efficient management by directly aligning

managers interests with those of shareholders e.g. executive compensation plans, stock options, direct

monitoring by boards, etc.

2) Another method involves the strengthening of shareholders rights so shareholders have both

a greater incentive and ability to monitor management. This approach enhances the rights of

investors through legal protection from expropriation by managers e.g. protection and

enforcement of shareholder rights, prohibitions against insider-dealing, etc.

3)Another method is to use indirect means of corporate control such as that provided by capital

markets, managerial labour markets, and markets for corporate control e.g. take-overs.

One of the critiques of the shareholder model of the corporation is the implicit presumption that

the conflicts are between strong, entrenched managers and weak, dispersed shareholders. This has led to

an almost exclusive focus, in both the analytical work and in reform efforts, of resolving the monitoring

and management entrenchment problems which are the main corporate governance problems in the

principal-agent context with dispersed ownership. For example, most of this work has addressed concerns

related to the role of the board of directors, stock options and executive remuneration, shareholder

protection, the role of institutional investors, management entrenchment and the effectiveness of the

market for take-overs, etc.

The fact is that the widely held firm, presumed in Berle and Means (1932) seminal work, is not

the rule but is rather the exception.3 Instead, the dominant organisational form for the firm is one

characterised by concentrated ownership. One of the reasons why we observe ownership concentration

may be due, in part, to the lack of investor protection. However, unlike the widely-held corporation where

managers have most of the residual control rights with shareholders having very little power, the

closelyheld corporation is usually controlled by a majority shareholder or by a group of controlling

blockholders. This could be an individual or family, or blockholders such as financial institutions, or

other corporations acting through a holding company or cross shareholdings.


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Another reason why ownership concentration is so prevalent as the dominant organisational form

is because it is one way of resolving the monitoring problem. According to the principle-agent model, due

to the divergence of interests and objectives of managers and shareholders, one would expect the

separation of ownership and control to have damaging effects on the performance of firms. Therefore, one

way of overcoming this problem is through direct shareholder monitoring via concentrated ownership.

The difficulty with dispersed ownership is that the incentives to monitor management are weak.

Shareholders have an incentive to free-ride in the hope that other shareholders will do the monitoring.

This is because the benefits from monitoring are shared with all shareholders, whereas, the full costs of

monitoring are incurred by those who monitor. These free-rider problems do not arise with concentrated

ownership, since the majority shareholder captures most of the benefits associated with his monitoring

efforts.

Therefore, for the closely held corporation the problem of corporate governance is not primarily

about general shareholder protection or monitoring issues. The problem instead is more one of cross

shareholdings, holding companies and pyramids, or other mechanisms that dominant shareholders use to

exercise control, often at the expense of minority investors. It is the protection of minority shareholders

that becomes critical in this case. One of the issues that arises in this context is how do policy makers

develop reforms that do not disenfranchise majority shareholders while at the same time protect the

interests of minority shareholders. In other words, how do we develop reforms that retain the benefits of

monitoring provided by concentrated ownership yet at the same time encourage the flow of external funds

to corporations, and which, in turn, should lead to dilution of ownership concentration.

Another critique of the shareholder approach is that the analytical focus on how to solve the

corporate governance problem is too narrow. The shareholder approach to corporate governance is

primarily concerned with aligning the interests of managers and shareholders and with ensuring the flow

of external capital to firms. However, shareholders are not the only ones who make investments in the

corporation. The competitiveness and ultimate success of a corporation is the result of teamwork that

embodies contributions from a range of different resource providers including investors, employees,

creditors, suppliers, distributors, and customers. Corporate governance and economic performance will be

affected by the relationships among these various stakeholders in the firm. According to this line of

argument, any assessment of the strengths, weaknesses, and economic implications of different corporate

governance frameworks needs a broader analytical framework which includes the incentives and

disincentives faced by all stakeholders.


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THE JOHNSON & JOHNSONTYLENOLCASE STUDY

Background

Before the crisis, Tylenol was the most successful over-the-counter product in the United

States with over one hundred million users. Tylenol was responsible for 19 percent of Johnson &

Johnson's corporate profits during the first 3 quarters of 1982. Tylenol accounted for 13 percent

of Johnson & Johnson's year-to-year sales growth and 33 percent of the company's year-to-year

profit growth. Tylenol was the absolute leader in the painkiller field accounting for a 37 percent

market share, outselling the next four leading painkillers combined, including Anacin, Bayer,Bufferin, and Excedrin. Had Tylenol been a corporate entity unto itself, profits would have

placed it in the top half of the Fortune 500.

The Crisis

During the fall of 1982, for reasons not known, a malevolent person or persons,

presumably unknown, replaced Tylenol Extra-Strength capsules with cyanide-laced

role of corporate governance for employee and shareholders

Documents