Concept of Corporate Governance
There is no singular or commonly accepted definition of corporate governance. The rationale could be the contextual nature of this concept that limits an absolute definition. In studying corporate governance of organisations, it is important to know the specific definition of corporate governance utilised by the organisation to understand decisions made and the outcomes. The definition of corporate governance adopted by firms could be narrow or broad.
A narrow definition of corporate governance is the internal control over the assets and liabilities of the firm by considering shareholders benefit (Monks Minow 2003). The scope of internal management only covers the financial area of operations. This narrow definition refers to the decisions and actions pertaining to the investment and use of company assets as well as the control of liabilities to achieve outcomes that address the interests of shareholders. Corporate governance means the management of the organisation in a manner that upholds the outcomes expected by shareholders, who also comprise stakeholders of the firm. Management works to make the best use of assets and control liabilities to ensure that shareholders receive optimal returns (Solomon 2007). By achieving this, the firm keeps its shareholders and shareholders investments as well as maintains a good investment standing in the market.
Another narrow definition of corporate governance is the management of the interrelationships existing in the firm among the board, managers and supervisors, employees, suppliers, creditors, and consumers (Monks Minow 2003). This is a narrow definition because of the focus on relationships, which comprise an important aspect of corporate governance. Corporate governance is relationship management of all the people involved in the organisation. The development of a relationship conducive to the achievement of organisational goals to the benefit of all interested parties is the target of corporate governance. This operates based on the premise that the management of organisational processes and outcomes depends on the relationship of the people making the decisions, those that implement decisions, and other parties whose participation is necessary to the success of the organisation.
The broad definition of corporate governance widens the areas of management covered to consider not only the interests of shareholders but also the concerns of all stakeholders. The broader definition of corporate governance relates to its social responsibility in considering the interests of shareholders, managers and employees, and consumers (Colley et al. 2005).
One broad definition of corporate governance is management of the firm in a manner that supports business growth and success as well as accountability (Tirole 2001). This broad definition involves two goals, which is achievable in an optimum manner by finding the appropriate balance between both goals. Corporate governance that achieves the optimum balance between two goals is able to boost business growth in a manner that supports accountability. This means sufficient auditing should accompany financial and business outcomes. Business growth reflects the methods employed in obtaining this outcome. Accountability provides legitimacy to the methods used in ushering business growth and the business outcome itself. The combination of business growth and accountability fosters the objectives of corporate governance.
Another broad definition of corporate governance is the exercise of authoritative direction towards the organisation by applying the basic tenets of accountability, honesty, integrity, responsibility and trustworthiness (Tirole 2001 Colley et al. 2005). This definition focuses on the quality of management and leadership as well as the traits of managers and leaders. Corporate governance involves management and leadership that operate based on standards of practice. The standards ensure the exercise of authority within a position of trust, as part of obligation to the organisation, and with recognition of attribution of outcomes to the position and oneself. In this sense, corporate governance serves as a system of checks and balance (Tirole 2001). The system checks the actions of those in authority as well as temper authority with standards of practice to prevent negative outcomes.
Principles of Corporate Governance
The definitions give rise to three key principles of corporate governance. The application or presence of these principles in the organisation determines the decision-making and policy development process as well as the concurrent outcomes.
The first principle is organisational architecture. This refers to the framework or system providing guidance and directing the actualisation of the core qualities contained by the vision set by the organisation (Monks Minow 2003 Colley et al. 2005). The system covers the values adhered to by the executives and managers of the organisation in maximising the wealth of shareholders. The existence of a framework and the type framework implemented determines how well corporate governance follows these values. A poor framework would likely result to unscrupulous decisions and actions and the lack of means to check or punish any wrongdoing. Organisational architecture has two components. One is the provision of a framework to guide decision-making and action. The other is the existence of a system to ensure compliance, prevent non-compliance, and commence procedures in response to non-compliance.
The second principle is operational architecture. This pertains to the process and system of managing information on the different business activities and the way of managing information on these business activities (Monks Minow 2003). Information management is a core aspect of corporate governance. Information supports decision-making and responsiveness to situations. Informed decision-making is a sound corporate governance practice. Information and access to it also explains and reports on decisions and actions that led to a particular outcome. A good information management system fosters decisions and actions sufficiently based on information as well as provide appropriate access to support accountability. Having an independent audit or audit team in covering the financial records of the company is a good information management practice. Weak information management creates opportunities for information manipulation and suppression and unchecked decisions or actions that are likely to result to negative outcomes.
The third principle is maximisation of the wealth of shareholders. This is the process of increasing the value in the market of common stock prices (Monks Minow 2003). Corporate governance means having a policy on the maximisation of shareholder wealth. Shareholders are valuable stakeholders in the company and maximisation of stock prices is a means of furthering the interests of shareholders. The practice of maximising shareholders wealth is a balancing act. In the case of institutional stockholders, there should be effective management of interests. Institutional stockholders have a significant impact on corporate governance by influencing areas of investment and other related decisions. Institutional stockholders have a significant share in the firm and actions done by these stockholders communicate messages to other stockholders and the market. The influence of institutional stockholders can have positive or negative outcomes. The maximisation of shareholders wealth requires the careful management of institutional stockholders through good organisational and operational architecture (Monks Minow 2003). Executive compensation is also another concern in the maximisation of shareholders wealth. On one hand, the compensation of executives serves as incentive to do a good job in corporate governance. Executives receive high compensation because of the rigours of the job as well as to motivate effective exercise of authority. On the other hand, an insufficient or excessive compensation can lead to poor performance and negative outcomes for the firm. In managing reasonable compensation, the justification is standard practice and the limit based on the situation of the firm. Compensation based on firm performance alone can lead to manipulation of share price. A more reasonable justification for the value of compensation is service rendered (Monks Minow 2003).
Corporate Governance in Listed Companies
Listed companies refer to the business organisations that have registered their shares in the stock exchange for purposes of trading publicly (Hansmann 1996). By trading their shares publicly, listed companies are able to draw capital from investors, who in turn entrust capital to the company based on expectations of prudent investment management decisions and returns. On the part of listed companies, they create organisational or business conditions that reflect their ability for prudent management. Corporate governance determines how well companies can create these conditions. On the part of investors, they consider the best company with impeccable management standards and market reputation. The corporate governance of a company is one way of determining the best firm to invest in.
Agency is a concept that describes the relationship that emerges between the company and stakeholders (Jenson Meckling 1976). By being in an agency relationship, there exists a contract or agreement between the parties in interest. Agency involves a relationship based on trust between the parties. The principal is the investor who entrusts capital, via the purchase of share, for the agent or the company to invest. The fiduciary relationship involves obligations and liabilities in case of failure to comply.
Two specific agency relationships are pertinent to the study of corporate governance. One relationship is what emerges between executives and managers of the company and shareholders (Jenson Meckling 1976). Executives and managers of the company are agents with responsibility over decision-making on the manner of using and investing capital received through share offerings. Shareholders are the principal by trusting the executives and managers with the use and investment of their money.
The other is the agency relationship between bondholders and shareholders (Jenson Meckling 1976). These two parties in interest have varying involvement and stakes in the company. Shareholders invest in the company based on the current and expected value of shares. Bondholders are creditors by lending a certain amount to the firm in exchange for the return of the principal amount plus an interest or value depending on the agreement with the firm. The decision to lend depends on assessments of risk and expected changes in risk levels. The higher the risk in the operations of the firm, the less likely that bondholders will lend or the higher the interest.
While shareholders influence investment decisions based on the impact of share value and are willing to take greater risks, bondholders are not as inclined to support risky investments. Shareholders can influence corporate decisions that could adversely affect the bondholders. Shareholders exercise influence through executive or management decisions. In case the investment succeeds, bondholders do not gain additional benefit because returns are of a fixed value. The benefit is only to the extent of ensuring the return of the principal amount and the agreed upon interest. If the investment fails, bondholders also share in any loss because this affects the ability of the firm to return the principal and any additional returns. Shareholders can also decide not to support financially sound investments by refusing to infuse capital for funding. The investment plan may benefit bondholders more by increasing the security of the claims of these creditors. Bondholders have first claim over the assets of the firm in case of losses or failure. (Bowie Freeman 1992)
The difference in perspective can lead to conflicts that directly affect corporate governance. The relationship between bondholders and shareholders reflect on the effectiveness of corporate governance via decision-making. Decisions can operate to the benefit of either or both shareholders and bondholders depending on the type of decision made and the outcome. The decisions also have an impact on the furtherance of relationship between the firm and its stakeholders. Shareholders can refuse to continue dealings with the firm based on the trend of decisions made by the company. Bondholders can refuse to lend more or increase demands in exchange for loans in the future. (Bowie Freeman 1992) Concurrently, a balanced and equitable relationship between bondholders and shareholders reflect good corporate governance by preventing conflict while addressing the interests of the stakeholders.
Capital Structure Decision in Listed Companies
Corporate governance in listed companies involves capital structure decisions. The capital structure of companies is the combination and composition of financial liabilities (Marks et al. 2005). There is no certainty over the financial capital of firms because this depends on sources. As such, the sources of financial capital exercise a certain level of control over firms. Firms can have two types of financial liability. One is debt and the other is equity. (Godfred et al. 2009) The sources of these two types of financial capital represent two of the primary investors in companies. Incurring any of these liabilities involves varying benefits, degree of control, and risks as shown in Table 1 below.
Table 1 Distinction between Debt and Equity Capital Structure
Source (Kochhar 1997)
The parties providing debt-based capital to firms gain a fixed value added to the return of the premium. The relationship is contractual and debt holders experience protection based on the terms of the agreement. Debt holders exercise a limited degree of control over decision-making in the firm with influence pertaining mostly to compliance with contractual obligations. The parties providing equity to the firm hold a residual claim to the firms financial condition and incur greater risk in investment decisions made by the firm. As such, equity holders exercise greater control over decision-making. (Marks et al. 2005 Godfred et al. 2009)
Financial management involves the decision on the capital structure of the firm with implications on the utilisation and management of the finances of the firm. Firms transact with providers of capital financing to generate funds. The share in the cash flow from the investment of capital obtained depends on the extent of capital sourced through debt or equity. The debt-to-equity ratio is the measure of the cash flow share of debt and equity holders. A debt-based capital structure means creditors as the primary source of capital and that the share of the debt holders depends on contractual provision. The duration of share of debt holders could also be short or long-term but this has a definite period as indicated in the contract. An equity-based capital structure means that shareholders are the primary source of funding and the share of equity holders depends on the shifts in share value. Equity holders have residual claims to cash flow, which means the share extends in the long-term. (Marks et al. 2005 Godfred et al. 2009)
If corporate governance were to maximise the wealth of shareholders, then the debt-to-equity ratio covers a lesser proportion shared by debt holders. Nevertheless, there are costs associated with having a debt-based or equity-based capital structure. The decision over the particular capital structure of the firm should then consider benefits as well as costs. Sound decision-making over capital structure indicates the need to target optimal debt-to-equity ratio, which depends on the firms strategic assets (Marks et al. 2005). On one hand, the firms that are able to establish successfully an efficient capital structure are likely to realise the optimum value of its strategic assets. On the other hand, firms that are unable to establish an efficient capital structure will likely experience downturn in performance. An efficient capital structure, which aligns capital sources with resources, ushers firm benefits (Godfred et al. 2009).
Board of Directors and the Capital Structure Decision
Financial decisions over capital structure form part of the decisions of the board of directors of a listed company. The board of directors plays an important role in the corporate governance of firms, particularly pertaining to decisions over debt versus equity. The composition and size of the board of directors of listed companies determine the decision over capital structure.
Size of the Board and Capital Structure Decision-Making
Earlier studies showed that decision-making in larger groups is more difficult. The explanation is greater diversity of perspectives accompanied by the difficulty and longer time it takes to come up with an agreement. In larger groups, the decision-making process involves many compromises (Kogan Wallach 1966). The result is a decision that is not radical when compared to decisions made in smaller groups (Moscovici Zavalloni 1969).
In latter studies, there is also preference for small board size. The explanation for preferring lesser number of board members is technology and organisational change. The onset of information and communications technology has enabled better access and sharing of information (Jensen 1993). This means that the rationale of having a large board to prevent unscrupulous decisions may no longer be as strong. In addition, the shift towards efficiency has directed preference for cost cutting through downsizing and streamlining (Lipton Lorch 1992).
Another explanation in preferring smaller board size is effectiveness, with large groups being less effective than small groups (Hermalin Weisbach 2003). By having many members, challenges in the agency function arises. Some of the board members may become free riders depending on the influence of the other members and the expected benefits of deciding one way or the other. Having a large group of decision-makers weakens responsibility over contributions to decision-making.
Discussion is also difficult in a large group. Obtaining all ideas from many people takes too much time and there is no certainty of uniformity in perspective. Large groups are not very cohesive as a body (Lipton Lorch 1992). The difficulty of coordinating variances weighs more than the benefits of having many members in the board (Jensen 1993). A large board carries the benefit of enabling diversity in terms ideas and advice to cover all perspectives needed to support informed and objective decision-making (Dalton Dalton 2005). When the board is very large, its role shifts to becoming merely symbolic instead of assuming a role in management (Hermalin Weisbach 2003).
However, there are also downsides to having very small board membership. The board members may not be sufficiently diverse in terms of skills and experience to provide expert advice and make good decisions (Dalton Dalton 2005). The very small number of board members would also likely lead to preoccupation with making decisions and neglect of their role in monitoring the activities of the firm (Jensen 1993).
In terms of the decision-making and monitoring role, there is divergence in opinion over the better size. One opinion considers small boards as more appropriate when the primary role of the board is monitoring because of the lower cost of coordination and better outcomes (Yermack 1996 Eisenberg et al. 1998). Another opinion considers a large board as better in the monitoring function, especially in firms with complex operations such as by having a number of business units (Mak Li 2001).
The difference in opinion implies that the optimal number of board members depends on the characteristics of the company and the directors (Raheja 2005). A small board can work for some listed companies while a large board can also work for other companies. While the size of the board depends on the circumstances of the company, a recommended size is 7 to 8 members (Lipton Lorch 1992). Having a smaller or larger number creates problems to prevent optimal fulfilment of board functions. Decision-making over capital structure involves challenges when the size of the board is too small or too large. The management of the size of the board affects decisions on the capital structure of the firm. The impact on the preference towards one capital structure or the other also depends on board composition.
Composition of the Board and Capital Structure Decision-Making
The board of directors of listed companies comprise of internal and external or independent directors. The internal and external directors share some functions. There are functions that exclusively emerge from the situation of these directors.
Internal directors exercise two management roles. One is to contribute to corporate governance by protecting the interest of shareholders and the other is ensuring compliance with the contractual relations of the company and its board (Williamson 1985). Internal directors also assume the monitoring role in providing other directors with first-hand data on operations (Boumosleh Reeb 2005). The rationale for internal directors as direct sources of information is their involvement in decision-making over operations and investment activities of the company. External directors do not experience the same position. As such, outside directors likely pose questions that internal directors should be able to address (Anderson Reeb 2004). Part of the monitoring role of internal directors is towards the CEO. While the monitoring function over the decisions and actions of the CEO could be indirect since the CEO also exercise a monitoring role over internal directors, the latter can perform this function by providing information to external directors in case of observed remiss by the CEO (Boumosleh Reeb 2005). By sharing information, internal directors significantly contribute to effective monitoring.
However, in actual corporate practice, internal directors are likely to side with the CEO. As the top executive, the CEO holds the power over the appointment of executives. It is common for CEOs to appoint directors that would likely be loyal. The loyalty to the CEO of directors can work both ways. On one hand, loyal CEO proves beneficial in supporting sound decisions that target the maximisation of shareholder wealth and pursuing performance goals. On the other hand, loyalty can also carry the downside of poor monitoring in case of untoward actions of the CEO. (Sirmans et al. 2006)
External directors share the monitoring role with internal directors. As external directors, they exercise independent judgment. External directors balance the monitoring of executive decisions and company operations. Part of the monitoring function is to evaluate management practices and manager actions. External director should also be able to contribute to building firm strategy. They should also exercise vigilance in ensuring the accuracy of financial information shared by the company and check on the risk management practices of the company. (Klein 2002) By being in a position of independence, external directors are necessary to effective corporate governance.
Board composition should have both internal and external directors. Internal directors hold direct information that external director do not have. External directors bring in an outside perspective to balance the oversight functions of the board. By lacking bias, external directors can strengthen corporate governance. Boards with more independent directors are likely to prevent or minimise fraud. The ratio of internal and external directors in the board ranges from one-third to half depending on the jurisdiction. (Beasly 1996 Klein 2002)
Studies on the size of independent directors in the board of listed companies cites positive results from increasing the number of independent directors, including greater returns in stock price and higher profitability (Rosenstein Wyatt 1990 Denis Sarin 1997) as well as accurate financial reporting and lesser earnings management (Peasnell et al. 2005 Osma Belen 2007). The implication of this is that the shift in the composition of the board by increasing or decreasing internal and external directors affects the factors considered by shareholders as favourable. Increasing the number of external directors has association with obtaining more equity-based capital from greater shareholder investment.
Other studies show a different outcome in other aspects. Performance declines when substituting internal with external directors as shown by the negative relationship between the number of external directors and Tobins Q index, which determines prospects for growth relative to cost in replacing assets (Agrawal Knoeber 1996). Past profitability is also low in having a greater number of external directors in the board (Bhagat Black 1997 Klein 1998). Slow growth and profitability create risk. The implication is that the composition of the board affects decisions on capital structure. A greater number of independent directors in the board appear to create a less desirable condition in obtaining more debt-based capital because of risk.
OECD Corporate Governance Principles and Listed Companies
Listed companies have the leeway to determine their own corporate governance practices and system depending on their particular situation. However, there are guides to effective corporate governance. Countries that are members of the Organisation for Economic Co-operation and Development (OECD) can adopt the Principles of Corporate Governance issued by OECD in 1999. These principles are encompassing by providing guidance to all stakeholders in both public and private companies. Since its original introduction, the principles have undergone revision to reflect developments.
The principles cover six areas of corporate governance, which are 1) establishment of the basis for a framework of good corporate governance 2) rights of shareholders 3) equitable treatment of shareholders 4) role of stakeholders in corporate governance 5) disclosure and transparency and 6) role of the board. The last section on the role of the board covers the provision of strategic direction to the company, monitoring of company management, and ensuring accountability of the board to the both the firm and its shareholders. (OECD 2004)
The OECD Principles of Corporate Governance does not provide an exact size or composition that comprises an effective board for companies. The principles comprise the consideration in managing board size and structure. The impact of the management of board size and structure on the capital structure decision on companies depends on the context of the company as well as the manner of adopting the principles into its corporate governance practices. Saudi Arabia is not a member of the OECD. However, the OECD corporate governance principles have become an international standard as a corporate governance framework. The corporate governance system in Saudi Arabia covering listed and other types of companies apply the principles.
Corporate Governance of Saudi Arabian Listed Companies
Corporate governance as a formal framework for companies is in its early stage. Prior to the establishment of the law focusing on corporate governance, regulation of business practice in Saudi Arabia is through the Company Law of 1965, which adopted British law. The Company Law set the legal framework for business aspects including business establishment, company registration, capitalisation, partnership, audit, accounts, and number of directors.
A major change occurred in 2003 with the establishment of the Saudi Arabia Capital Market Authority (SACMA) tasked to monitor the stock exchange. SACMA took the role of drafting the Corporate Governance Regulation (CGR), the first law focusing solely on corporate governance. In 2006, the CGR underwent a major reform with the intention of improving corporate governance of companies in Saudi Arabia. Part of the reform was providing guidelines for corporate governance in listed companies. (Ramady 2005) The implementation of the CGR was in three stages. The first stage is the publication of the CGR to make companies aware of the existing legal framework for corporate governance in Saudi Arabia. The second stage is more directed education of companies to motivate adoption of the CGR. The third stage is the reform of the CGR together with widespread implementation. At present, listed companies fall under staggered phases with some companies in the more advanced stage relative to other companies. (World Bank 2009)
With the presence of a formal legal framework on corporate governance, albeit this remains in its development stage and will likely be subject to reforms, listed companies are encouraged to utilise the principles and provisions in developing their respective corporate governance system. Part of the motivation to comply is the responsibility of listed companies to report to SACMA on their compliance. The report covers matters on the functions and obligations of the board of directors, the formation of the board, the committees established as part of corporate governance including the nomination and audit committees, the meetings held by the board, and the system of remuneration for members of the board.
An effective corporate governance framework plays an important role in supporting effective financial decisions, such as on capital structure, of listed companies in Saudi Arabia. With a developing corporate governance framework for listed companies, investigating the impact of board size and composition on capital structure decisions contributes to the assessment of the regulations as guidance and the implementation by listed companies of the framework.
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