Corporate Governance and the Different Governance Models Finance Essay

The purpose of this essay is to critically analyze, describe and compare the two fundamental governance methods while finalizing and summarizing on the most efficient and dynamic model. The rules governing the structure of the corporation and the distribution of power and control in a business are generally referred to as corporate governance. According to a definition of Shleifer and Vishny (1997) “corporate governance deals with the way in which suppliers of finance to corporations assure themselves of getting a return on their investment” Consequently, corporate governance will only be necessary in a situation where the suppliers of finance (the shareholders or owners of the company) do not run the company themselves but hire a management team that is responsible for the daily activities of the company.

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Corporate governance is a field that concentrates on the relationship between boards, stockholders, top management, regulators, auditors and other stakeholders. The principal characteristics of effective corporate governance are: transparency, protection and enforceability of the rights and prerogatives of all shareholders and directors capable of independently approving the corporation’s strategy and major business plans and decisions and of independently hiring management, monitoring management’s performance and integrity and replacing management when necessary. Of importance to this study is the recognition that boards of directors are essential to most definitions of corporate governance. Cadbury (1993:9) states that it is “the ability of boards of directors to combine leadership with control and effectiveness with accountability that will primarily determine how well companies meet society’s expectations of them. Maassen (2002). Over the years, the traditional one-tier management system was expanded and developed into a more complicated and advanced two-tier management system. The well-known one-tier system derived from the Anglo-Saxon or Anglo-American system which is characterized by the lack of enthusiasm in employee participation and strong corporate perceptions. In contrast, the two-tier management system (known as Continental or dualistic) is heavily influenced by labor law and owes its basic organizational features in Germany. The way in which corporate governance is organized in different countries, depends on the business context which it prevails. This entails a separation between ownership and management. The diversity of board roles in the governance of corporation differences in the leadership structure, the organization structure and the composition of boards provide a wide range of prototypes. However, both management and directors also share another more fundamental goal, to develop a board which can bring the most informed and most objective advise available. Thus, after the knowledge was drawn from corporate governance lecture for the “competition” among the two different systems of corporate governance we will provide a preliminary evaluation. Distinctive perspectives of corporate governance give rise to differences in the definition of boar’s roles in the governance of corporations. We are going to examine their advantages and disadvantages referring examples in European countries. The purpose is not to favor one model above another but to look at similarities and differences. In conclusion, we can say that methods used to appoint management and controlling bodies are not trivial, but they are not the most important distinctive trait of the systems of governance.

Governance models

The two-tier model

In many countries most companies are run mostly for the benefit of the shareholders and the rightful of owners. On the other hand some companies run for the benefit of other significant groupings such us customers and employees. This is the two-tier or stakeholder model which we are going to analyze below. In the two-tier system of governance all stakeholder interests and especially public are protected. This model it is constituted from two boards, the management board and the supervisory board. The management board includes one or more individuals appointed by the supervisory board. These members chosen by the supervisory board cannot also be a member of the supervisory body. The business of the company is administered by the management board, conditional to the supervision of the supervisory board. The management board is obliged to report periodically to the supervisory board and the latter may at any time call for information or clarifications. The management of the company itself may not be undertaken by the supervisory board itself, but its approval may be required in the case of specific transactions. The management board is obliged to report periodically to the supervisory board and the latter may at any time call for information or clarifications. The management of the company itself may not be undertaken by the supervisory board itself, but its approval may be required in the case of specific transactions. Chetcuti (2010) The main tasks of the supervisory board are to appoint the members of the management board to the shareholders meeting and to monitor them. To explain, supervisory board is the monitoring body of the corporation. There is a strict separation of control and managerial tasks. The two boards are cooperating and between them there is big confidence while information is shared among all the members with the result of efficiency decision making. This characteristic is the most important strength of two-tier management. Furthermore, in the shareholders meeting an auditor is represented. To remove a member of the board of auditors or the external auditor three conditions must be satisfied, a) first, a good cause is required, b) second, adopted by the shareholder’s meeting is needed, c)third, the resolution adopted by the shareholder’s meeting must be approved by a court. The external auditor may be removed only when this above conditions satisfied. In contrast with the two-tier model where the supervisory board may easy remove persons appointed to corporate bodies such as the members of the management board. The continental European model (two-tier system) where supervisory boards consist solely of non-executives and a lower level management board consists of full time managing directors. Its main difference between the other corporate governance models is the power granted by the law to the shareholders meeting to remove the members of the supervisory board with a simple resolution and without the approval of the court. Also, the control of management (not the corporation) involves the compliance with law and articles of the corporation in its business strategies. The law has strictly restrictions to transfer the authorities of one body to another body. An obvious and comprehensible example of such transfer are the transfer of decision-making on the annual report from the supervisory board to the general meeting of shareholders and the restriction to the management board taking decisions without the supervisory’s board approval. Bajuk (2010) However, business relationships are inherent characteristics of the German supervisory board. In contrast to the USA and the UK, Germany and Netherlands have a two-tier board system. Germany follows this model, where the board comprises a management and a supervisory board, which provides a complete separation between management and supervision of management as we discussed above. The right of employees to participate in decision making in this model is known as “co-determination”, which is also reflected in the fact that workers’ counsels have rights concerning working hours, holidays, hirings and dismissals. “In systems with co-determination the employees are given seats in a board of directors in one-tier management systems or seats in a supervisory board and sometimes management board in two-tier management systems. In two-tier systems the seats in supervisory boards are usually limited to 1/3 of all members. In some systems the employees can select 1/2 of all members of supervisory boards, but a representative of shareholders is always the president and has the deciding vote. The employee representatives in management boards are not present in all systems. They are always limited to a workers director, who votes only on matters concerning employees.” Wikipedia Co-determination (2010). The remaining members of the supervisory board are appointed by the general assembly of shareholders. Furthermore, the assembly has the right to elect the chairman, who has double voting rights in the meeting. To summarize, the two-tier model is characterized by the central role of the supervisory board which has a monitoring character. The supervisory board is granted two powers: to endorse the balance sheet and to oversee the members of the management board without a resolution of the shareholders’ meeting.

The one-tier model

One-tier model (Continental European) knows two bodies of corporate governance. The one-tier model in United Kingdom characterized by a more flexible approach than in two-tier system in Germany. The two bodies of governance are the general meeting of shareholders and the board of directors. Both management and control entrusted to the hands of board of directors. The shareholder’s meeting appoints the board of director who performs the monitoring function. In the Anglo-Saxon countries one specific stakeholder can be identified which can exert a substantial influence on managerial decision-making: the influence of shareholders is strongly institutionalized in these countries. Also in one-tier model the shareholders are strongly protected by the law. As a result, in the Anglo-Saxon countries apply the democratic principle of “one share, one vote”. A one-tier board of directors further characterizes the Anglo-Saxon countries: executive and supervisory responsibilities of the board are condensed in one legal entity. Furthermore, in its composition and competencies, the general meeting of shareholders does not differ considerably from the general meeting seen in two-tier management system. The final decision on the composition of controlling and management bodies is still made by the shareholder’s meeting however the combination of monitoring and managing bodies are the most important features in this model. In addition, one of its characteristics is that the shareholder’s meeting may remove the members of the board of directors at any time. Here I have to stress that the board of directors consists of both executive and non-executive directors who are not members of the board of directors. As all directors have the same powers, non-executive directors can also take management decisions when at the same time this is restricted by the supervisory board in two-tier management (Germany). From a practical point of view, the non-executive board members advise the inside directors on major policy decisions for the corporation. If we compare director duties in Germany, what we observe is weak rules on care and skills and at the same time powerful on fiduciary duties. There has been considerable debate over the effectiveness of executive and non-executive directors. The revised Combined Code provides the description of their functions. The Combine Code recommends composing at least half the board of independed non-executives. Also, a core element of the combined Core is the separation of the positions of board chairman and chief executive officer (CEO). The effect of both elements is the management and control of the corporation. Derek (2003) As we have described in the above analysis some one-tier boards are dominated by a majority of executive directors while others are composed of a majority of non-executive directors. In addition one-tier board can have one leadership structure that separates the CEO and chair positions of the board. One-tier boards can also operate with a board leadership structure that combines the role of CEO and the chairman. The one-tier boards also make often use of board committees like audit remuneration and nomination committees. Continental European countries such as Germany, Finland and Netherlands have adopted variants of the two-tier board model which make it more particular management system from one-tier system. The internal audit of the listed corporations that adopt the one-tier system is performed by an internal control committee composed by non-executive directors. An external auditor controls compliance with accounting procedures, and the term of the corporate bodies and of the external auditor is a maximum of three It is worth to mention that the appointment of a director to the management control committee it should be approved by the board of directors. In that case, the removed member has its position on the board of directors but will not belong any more in the managing body of the corporation. Thus the removal procedure in one-tier model of governance does not follow the procedure required to remove the members of the board of auditors in two-tier system. The most interesting aspect of the one-tier system is the way boards of directors operate in combination with managing and monitoring functions. The main advantages that have been cited for one-tier governments include: better service coordination, clearer accountability (because there is only one tier), more streamlined decision-making, and greater efficiency. (Bahl and Linn, 1992) Finally, the Anglo-Saxon system of corporate governance is characterized by relatively short-term economic relationships. Quite unrestricted markets for capital, labor, goods and services ensure rapid adjustment to changing circumstances, thereby disfavoring long-term and stable relationships (Gelauff and Den Broeder, 1996). This phenomenon has led some to observe that managers in the Anglo-Saxon countries are myopic, focusing on boosting the next quarterly figures while under-investing in long-term assets such as research and development or training (e.g.Porter, 1992; Prodhan, 1993). However, according to others, there is no concrete evidence to support these claims (e.g. Shleifer and Vishny, 1997). The most important conclusion in one-tier board counties is the emphasis on market operation where they are trying to maximize shareholders value.

Comparison of two models

One-tier and two tier corporate governance models have numerous differences. Their main differences are due to the dissimilar roles of their executive organs and the power that can force. One important mechanism which is a common theme in both corporate governance models is the board of directors. As well common themes are the board of shareholders and auditors. In Continental European model (two-tier system) two extra organs make the difference. The supervisory board and the Works Councils have a vital role in the countries which are following the two-tier system. Previous members of the management board often become ordinary members or even preside of the supervisory board (Schmidt and Drukarczy, 1997). A major difficulty with the supervisory board is the ownership structure in Continental Europe where the two-tier board system is predominant. In those countries certain groups often hold large shares of companies. Although, the way in which corporate governance differs from country to county; the separation between ownership and management exists in both systems. A demonstration follows below in making a comparison through their advantages and disadvantages. One-tier model which is typical in Anglo-Saxon countries and known as a shareholders model. Continental European model which adopts its characteristics of the German countries and is known as stakeholders’ model. The first significant difference is the shareholders concentration, the number or percentage of the prospective elements of dividends. In Continental European model shareholders represent a large percentage of the total number of shares which are publicity traded. The shares give the proof of membership or ownership for shareholders is a piece of paper that has a value. Every share gives you the right to vote, the right to pay dividends and both. On the other hand in Anglo-Saxon countries the shareholders concentration is very low. This happened due to the fact that companies in Anglo-Saxon countries are larger and the percentage of shares represents an enormous capital Franks & Mayer (1994). This model is characterized by the fact that relationships between companies and shareholders as well as with their employees are temporary in nature. We observe a greater mobility on the capital and labor markets where counterparts does not happen the same in Continental model. This is characterized by the very good and institutional relationships with stakeholders for the maintenance of balance. The role of shareholders can move the threads in the operation and development of enterprise. Their identity differs in these two models. In United States and United Kingdom most of the totals of shares are in the hands of agents of financial institutions. In Germany happens completely opposite, private companies, financial institutions and private persons hold the most of the shares. In one-tier system due to the regulations the financial institutions are not allowed to hold shares on their own behalf, on the other hand in two-tier system companies and individual persons act directly without using agents to manage their affairs. Financially the one-tier system shareholding via the stock exchange is very widespread and the individual shareholders do not have enough attendance in the daily practice of the corporation but the influence of the stock exchange is decisive. The term “business context” is the number of listed companies as a percentage of the total number of companies in a country. In one-tier board system many companies are listed and their shares are publicity traded as a result of less personal contact with their shareholders. In contrast, the two-tier model is characterized by a business management who’s seeking lasting institutional relationships with all stakeholders. In European countries fewer companies are publicity traded, so a strong relationship exists between the management of the company and its shareholders. The majority of European companies hold large stakes in associated companies and shareholding and vice-versa. The existence of different holdings and top-down structures in these companies regulates the diverse patterns of control, which are often maintained over the long term. However, transparency is much more limited in these countries because of the limited number of shareholdings and thus the limited extent of information disclosure. Furthermore, regulations as anti-trust laws and arms-length between parent and daughter companies have limited the complexity of the ownership structure within the tier-two countries.

Summary & Conclusion

By analyzing the regulations for the two board systems to elaborate the respective advantages and pitfalls, we find a strong evolution of the systems towards each other. The independence of corporate governance boards is an important corporate governance issue. The monitoring bodies of the organizational structures of the two models have to keep the balance of power among corporation. One-tier boards stand for faster decision making and flexibility as they are characterized by a clearly defined management body. On the downside, there is a greater risk of board capture because the members are heavily influenced by the CEO. To empower non-executive directors, stock exchanges, legislators and other comment factors promote changes to existing board structures in Anglo-Saxon countries. In this context we found that Anglo-Saxon countries rely on a majority of independent directors within the board of directors to guarantee an alignment of interests between the management and the shareholders, which is claimed by all the recently released corporate governance codes. Consequently both the responsibilities of monitoring and the strategy-setting are incorporated in the same body. The board members fulfill both economical and monitoring roles, that’s why they face dilemma, they should make decisions, and, at the same time to monitor these decisions. While this problem does not exist in two-tier system due the formal separation of control and management, it is essential to obtain this separation affected in the one-tier system. Two-tier boards ensure a clear separation of direction and control. This separation can protect both, shareholders and the public interest, this is the major advantage. Although, the separation of management and control a little enervates the independence of the members of the supervisory board, this separation remains a strength regarding to the management board. Each member of the management board has the same task, to run the business in a way that allows further development and financial prosperity. The control claims an open discussion between the members of the supervisory board and the management board. The members of the supervisory board are chosen by the management board and are only formally obtained at the general meeting. In practice the members of the management board and usual the chairman switches to the supervisory board, and frequently become the chairman after retirement. Although the co-determination statute had even the advantage to reduce the possibility of strikes and is an early warning system for social conflicts. Furthermore, co-determination is capable of protecting companies from hostile takeovers. Aside from marginal differences we observed the same difficulties of control for both board systems. The strong evolution of the systems towards each other on the one hand illustrated an obstacle for the new legal form since the additional benefit of the new freedom of choice between different board structures is lowered. This research concludes that Continental European forms of board organization are hardly ever acknowledged by both reformers as well as researchers in the fields of corporate governance and thus still limited on widespread relevance and recommendation. On other hand, resent financial developments in both corporate Amecrica and Europe have shown tremendous short comings on both control and diligence on both systems. Further development and clarification of both financial and governance laws need to both refine and merge elements from both systems.

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