Theoretical Framework and Findings from Kenya Example for Free

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The corporate governance discourse has attracted global interest. At the onset, the focus was naturally on the highly developed countries, having witnessed the collapse of giant corporations such as Enron, WorldCom Inc., Tyco, Aldephia, Global Crossing, but a few (Jones & Pollitt 2003) [i] . More recently, due to its apparent significance to an organization’s strategic strength and society’s wellbeing, attention has been devoted to corporate systems in developing countries (Mueller 2006). Knell (2006) and Cadbury (1992) present corporate governance as systems, structured processes, defined policies and institutions that influence the way a corporation is directed, administered or controlled. It includes relationships among principal players such as shareholders, management and the board of directors while recognizing the goals for which the corporation is governed and relationships among other stakeholders including suppliers, customers, employees, banks and other lenders, regulators the environment and community at large.

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Corporate governance has attracted a range of definitions. The Cadbury Report (1992) defines corporate governance as the “system by which companies are directed and controlled”. In their treatise, Metrick and Ishii (2002) describe corporate governance from the perspective of the investor as “both the promise to repay a fair return on capital invested and the commitment to operate a firm efficiency given investment” Metrick and Ishii argue that firm level governance may be more important in developing markets with weaker institutions as it helps to distinguish among firms. On the other hand, Rajan and Zinagales (1998) define a governance system as “the complex set of constraints that shape the ex post bargaining over the quasi rent registered by the firm”. In Mayer (1997) CG is seen as concerned with ways of bringing the interest of (investors and managers) into line and ensuring that firms are run for the benefit of investors. Again, CG is concerned with the relationship between the internal governance mechanisms of corporations and society’s conception of the scope of corporate accountability (Deakin and Hughes 1997). It has also been defined by Keasy et al (1997) to include “the structure, processes, cultures and systems that engender the successful operation of organizations.” From these definitions, it may be stated more generally that different systems of corporate governance will embody what are considered to be legitimate lines of accountability by defining the nature of the relationship between the company and key stakeholders. Thus, corporate governance describes gow companies ought to be run directed and controlled (Cadbury Committee 1992). It is about supervising and holding to account those who direct and control management. Shleifer and Vishny (1997) describe corporate governance as “the way in which suppliers of finance to corporations assure themselves of getting a return to their investment” The elements of corporate governance vary from one country to the other and from company to company. Klappar and Love (2002) found that corporate governance provisions at the firm level matter more in countries with strong legal environment. The emphasis placed on various aspects of corporate governance depends on how corporate governance is defined to bring out the key salient features. According to Hendriske et al (2004) corporate governance is the system that maintains the balance of rights, relationships, roles and responsibilities of shareholders, directors and management in the direction, conduct, performance and control of sustainable performance of company’s business with honesty and integrity in the best long term interests of the company, shareholders and business community stakeholders. The capital markets authority (CMA) provides a comprehensive list of recommended governance practices (CMA 1998). The recommended governance practices have three objectives which include: Economic and financial well being of shareholders, directors and management and employees; Social well being of employees, community and society and environmental well being for every one (Manyuru 2005). The four board attributes namely: composition, characteristics structure and process form the basis for categorizing the corporate governance practices in this study.

What is the purpose of the corporation?

What are its objectives?

Maximisation of shareholder wealth

The theory of CG stems from the thesis “The Modern Corporation and Private Property” by Berle and Means (1932). The thesis highlights a fundamental agency problem in modern firms where there is a separation between management and ownership. It has long been recognized that modern firms are run by professional managers (agents), who are accountable to dispersed shareholders (principals). The scenario fits into the well discussed principal-agent paradigm. The question is how to ensure that managers follow the interests of shareholders in order to reduce cost associated with principal – agent theory. To do that, the principals have to deal with two problems. First they face adverse selection problem: that is they must select the most capable managers. Second they are also confronted with a moral hazard problem: that is how to adequately motivate the managers to put forth the appropriate effort and make decisions aligned with shareholder interests. Separation between ownership and control of corporations characterizes the existence of a firm. The design of mechanisms for effective corporate control make managers act in the best interest of shareholders has been a major concern in the area of corporate governance and finance (Allen and Gale 2001) and continuing research in agency theory attempts to design an appropriate framework for such control. In a corporation, the shareholders are the principals and the managers are the agents working on behalf of and for the interest of the principals.

In agency theory, a well developed market for corporate controls is assumed to be non-existent, thus leading to market failures, non existence of markets, moral hazards asymmetric information incomplete contracts and adverse selection among others. Various governance mechanisms have been advocated which include monitoring by financial institutions, prudent market competition, executive competition, debt, developing an effective board of directors, markets for corporate control and concentrated holdings. Developing an effective board of directors remains an important and feasible option for an optimal corporate governance mechanism. Agents or managers may not always act in the best interest of shareholders when the control of a company is separate from its ownership. In June 1959, Simon Herbert (Baysinger and Hoskisson 1990) proclaimed that managers might be satisfiers rather than maximisers that is they tend to play it safe and seek an acceptable level of growth because they are more concerned with perpetuating their own existence than with maximising the value of the firm to its shareholders. But shareholders delegate decision making authority to the agent (CEO) with the expectation that the agent shall act in their best interest. In contrast, Demesetz (1983) and Fama and Jensen (1983) suggest that the primary monitoring of managers comes not from owners but from the managerial labour market. It is argued that management control of a large corporation is completely separate from its security ownership. Efficient capital markets provide signals about the value of a company’s securities and this about the performance of its managers. If the managerial labour market is competitive both within and outside the firm, it will tend to discipline the manager. Therefore the signals given by changes in the total market value of the firms securities become very important. Kaplan and Reishus (1990) find evidence consistent with this argument: directors of poorly performing firms, who therefore may be perceived to have done a poor job overseeing management, are less likely to become directors at other firms. On the other hand, reputation concerns do not correct all agency problems and can in fact create new ones. A comprehensive theory of the firm under agency arrangements was developed by Jensen and Meckling (1976), who show that the principals (the shareholders) can assure themselves that the agent will make the optimal decisions only if appropriate incentives are given and only if the agent is monitored. Incentives include such things as stock options, bonuses and prerequisites which are directly related to how well the results of management’s decisions serve the interest of shareholders. Monitoring consists of bonding the agent, systematic reviews of management prerequisites financial audits and placing specific limits on management decisions. These involve costs which are inevitable result of the separation of corporate ownership and control. Such costs are not necessarily bad for shareholders but the monitoring activity they cover needs to be efficient.

Jensen and Meckling (1976) further define agency relationship and identify agency costs. Agency relationship according to them is a contract under which “one or more persons (principal) engage other person (agent) to perform some service on their behalf, which involves delegating some decision-making authority to the agent.” The scenario normally generates a conflict of interest. The conflict of interest between managers or controlling shareholder, and outside or minority shareholder refers to the tendency that the former may extract perks out of a firm’s resources and be less interested to pursue new profitable ventures. Agency costs in this case include monitoring expenditures by the principal such as auditing, budgeting, control and compensation systems, bonding expenditures by the agent and residual loss due to divergence of interests between the principal and the agent. Usually the share price paid by the shareholders (principal) reflects such agency costs. This is one way to view the linkage between corporate governance and corporate governance. Fama (1980) aptly comments that separation of ownership and control can be explained as a result of “efficient form of economic organization” Previous empirical studies have provided the nexus between corporate governance and firm performance (Yermack 1996; Claessens et al 2002; Gompers et al 2003; Black et al 2003; and Sanda et al 2003). Others Bebchuk & Cohen (2004) and Bebchuk et al (2004) have shown that well governed firms have higher firm performance. The main characteristic of corporate governance identified in this studies include board size, board composition and whether the CEO is also the board composition. There is a view that larger boards are better for corporate governance because they have a range of expertise to help make better decisions and are harder for a powerful CEO to dominate. In recent times on the contrary emphasis has geared towards smaller boards. Jensen (1993) and Lipton and Lorsch (1992) contend that large boards are less effective and are easier for a CEO to control. The reason is that when a board get too big it becomes difficult to co-ordinate and process problems. Klapper and Love (2002) examine corporate governance and performance in a sample of firms in 14 countries most of which are developing economies. They find that better corporate governance is associated with better performance in the form of Tobin’s q and ROA.

Agency theory, agency problem, agency costs and the Anglo-saxon model (market based model)

Maximisation of stakeholder interest

John and Senbet (1998) provide a comprehensive review of the stakeholder theory of corporate governance. The main issue raised in the theory is the presence of many parties with competing interests in the operations of a firm. They also emphasized the role of non-market mechanisms such as the size of the board, committee structure as important to firm performance; Jensen (2001) critiques the stakeholder theory for assuming a single valued objective. They thus propose an extension of the theory called an enlightened stakeholder theory. However, problems relating to empirical testing of the extension have limited its relevance and applicability in a modern day corporate entity (Sanda et al 2003). In Kenya, CG is still at its infancy stage and therefore an examination of its relationship with the performance of a vital sector such as the microfinance sector is not only desirable but long overdue.

Stakeholder theory

How are its objectives met?

Board attributes

The corporate governance literature identifies four sets of board attributes; namely, composition, characteristics, structure and process (Zahra and Pearce 1989; Maassen 1999). Board composition refers to the size of the board and the mix of different director’s demographics (insiders/outsiders, male/female, foreign/local) and the degree of affiliation directors have with the corporations (Zahra and Pearce 1989; Maassen 1999). Board characteristics encompass director’s background, such as director’s experience; tenure; functional background; independence; stock ownership and other variables that influence director’s interest and their performance (Hambrick 1987; Zahra and Pearce 1989). Board structures covers board organization; the role of subsidiary boards in holding companies; board committees; the formal independence of one-tier and two-tier board; the leadership of boards and the flow of information between board structures (Maanssen 1999). Board process refers to decision making activities; styles of board; the frequency and the length of board meetings; the formality of board process and board culture on evaluation of director’s performance (Vence 1983; Pettigrew 1992). Growing literature focused on some aspects of the four sets of board attributes from a variety of theoretical perspectives have produced a plethora of varying results regarding boards’ attributes and corporate performance (Zahra and Pearce 1989; Dalton et al 1998; Maassen 1999). A summary of the four sets of boards attributes most commonly studied as provided in Table 1 The concern of corporate governance has been with both the accountability of the directors and with the board effectiveness Cadbury (1997).

To ensure the board effectiveness the Cadbury Committee (1992) recommends the inclusion of sufficient number of non-executive directors who would bring independence in the board’s judgement. These non-executive directors should be in the majority. Mace (1986) and Herman (1981) argue that outside directors were valued for their ability to advise to solidify business and personal relationships and to send a send a signal that the company is doing well rather than for their ability to monitor. Mace (1986) further argues that in selecting outside directors the title and the prestige of the candidates are the primary consideration. The agency theory, at the other end of the spectrum argues that the presence of boards of directors is to monitor management and to protect the interest of shareholders (Mallette and Fowler 1992; Fama and Jensen 1983). It is further argued that outside directors are stricter in discharging their responsibilities as they are not directly affiliated with the management (Weisbach 1988). Having outside directors who are argued to be impartial is vital as they can act as “providers of relevant complementary knowledge” to the management (Fama and Jensen 1983:315). Hence outside directors could bring into the board the wealth of expertise that is useful to the management in deciding the direction of the firm or to clarify its strategies. This could further enhance the board’s role as being the ratification and the monitoring of management decisions as argued by Fama and Jensen (1983). As a result the performance of the management is expected to improve and more importantly increase the wealth of shareholders. Evidence of board independence effectiveness was also offered bu O’Sullivan (2000) who found that audit fees (a proxy for extensiveness of the audit works) were negatively associated with board independence. The author argued that board independence should lead to a better quality of financial reporting and thus the scope of the audit and therefore the audit fees would be reduced.

The evidence found by Peasnell et al (2000) on the effects of outside directors on the financial reporting aspects further confirm that high monitoring tendency of outside directors. In addition, evidence has also showed that outside directors are more likely to join and inside directors leave the boards of poor performing firms (Hermalin and Weisbach 1988). Thus it may be argued that poorly performing firms are expected to benefit from the entry of more outside directors. In a study on the extent of fraudulent reporting Beasley (1996) further documented evidence supporting the significant roles of outside directors. Evidence of outside directors’ effectiveness was also documented in New Zealand by Bradbury and Mak (2000). The concern has been on the issue of non-executive directors who may not be truly independent (Bhagat and Black 1997; Vicknair et al 1993). Perry (1995) argues that the inclusion of independent non-executive directors may negatively influence the board cohesiveness since they are involved in the decision-making process of the firm and at the same time act as monitors of management. This Perry (1995) argues could lead to a conflict of interest. This argument could perhaps lead to the performance of the firm not being improved even though the board is dominated by outside directors. The lack of non-executive directors’ incentives to remove members of the top management following the firm’s poor performance as a result of their insignificant shares in the firm and their compensation and the views of the CEOs could determine their re-appointment as non-executive directors (Conyon and Peck 1998). Further it was earlier found that performance review by the board in most companies was minimal and it was purported to satisfy the minimal requirement of law (Boulton 1978) and except during the period of crisi, most boards were content with a superficial review of the performance (Clendenin 1972). In an empirical study, Fosberg (1989) found that there was no significant difference in various financial ratios (indicative of the firm’s performance) between firms whose boards were dominated by outside directors and firms whose boards were not dominated by inside directors. The argument, that having outside directors on the board could adversely affect the board performance could largely be due to the fact that outside directors do not have access to adequate knowledge about the firm. This is due to the nature of non executive directors’ appointments who are not full-time employees in the company and the limited time commitment that could result in boards that are composed in the majority of weak outside directors (Koontz 1967). Moreover, these directors either hold no shares or hold insignificant shares in the firm as argued by Conyon and Peck (1998).

Thus their incentives to monitor management and thus contribute significantly in the pursuit of the shareholders’ interests may be low. In fact Baysingers and Hoskisson (1990) argue that non executive directos have negative influences on corporate entrepreneurship. Research evidence showing a negative association between the proportion of independent non-executive directors and firm performance was documented (Klein 1998; Agrawal and Knoeber 1996; Yermack 1996). In a survey done in Singapore, Goodwin and Seow (2000) found that the majority of company directors felt that independent directors should make up 25% to 50% of the board. The study also found that none of the directors in the survey felt that independent directors should be less that 25% of the board. These findings therefore are not different from the recommendation contained in the Report on Corporate Governance (1999) and the Malaysian Code on Corporate Governance (2001) which recommends that at least one-third of the board members be independent directors. Similar recommendation was also found in the Hampel Report (1998). However according to Goodwin and Seow (2000), the respondents in their survey which included directors, auditors and institutional investors, all felt that there was a need for a clear definition of “independent directors”. An absence of this definition would make it difficult to determine compliance with the recommendation. On the importance of non-executive directors’ representation on the board, Goodwin and Seow (2000) found that non-executive directors were more convinced that strong corporate governance enhances the board effectiveness more than executive directors were. Though the findings are mixed, evidence generally supports the effects of outside directors on the firm’s performance. This is because outside directors are expected to be independent of management and were generally “appointed for their business acumen, wide commercial experience or contacts on the government industry” (Reay 1994:74).

CEO duality

The board of directors argues Jensen (1993:862) is “at the apex of internal control systems, has the final responsibility for the functioning of the firm.” However, when the board chairman is also the CEO, the board intensity to monitor and oversee management is reduced as a result of lack of independence and a conflict of interest (Lorsch and Maclver 1989; Fizel and Louie 1990; Dobryzynski 1991; Millstein 1992; Daynton 1984). The issue arises when companies practice CEO duality is “who monitors management?” This is best expressed as “custodias ipso custodiet” or “who will watch the watchers”. Unlike in a two-tier system, the unitary system has the board at the highest internal control system, as argued by Jensen (1993). It has been argued that the firm’s managers’ influence in setting board agenda and controlling information flows could impede the board’s ability to perform its duties effectively (Solomon 1993; Aram and Cowan 1983). The firm’s managers’ ability to determine the board agenda and the flow of information is predicted to be much stronger when the board chairman is also CEO than when the firm adopts a non-dual structure. Daynton (1984) asserts that the board is the primary force pushing the company towards realizing the opportunities and meeting the obligations to the shareholders and other stakeholders. He argues that it is the CEO who enables the board to play the primary force. In a similar vein, dual leadership structure “signals the absence of separation of the decision management and the decision controls” (Fama and Jensen 1983:314; Rechner 1989) argued that the ideal corporate governance structure is one in which the board is composed of a majority of outside directors and a chairman who is an outside director. She stated that the weakest ccroporate governance is one where the board is dominated by insider directors and the CEO holds the chairmanship of the board. When one person dominates a firm, the role of independent outside directors becomes “hypothetical” (Rechner 1989; Daynton1984). Rechner (1989:14) claimed, “this structure is likely to function as a rubber stamp board given the total control of the CEO. A structure of this type is likely to lead to the board being incapable of protecting the interest of the shareholders.

The board, with the high influence of the management will not be able to discipline the management appropriately as the management who controls the board will over-rule such initiatives. Miller (1997) also argues that a non-executive chairman promotes a higher level of corporate openness. The issue of separation of the top two posts has been addressed in the Cadbury Committee (1992), which recommended that the roles of the board chairman and the CEO be separated. The Malaysian Code on Corporate Governance (2001) also recommends a similar board structure. The reason for the need for separation is that when both the monitoring roles (ie the board chairman) and implementation roles (ie the CEO) are vested in a single person, the monitoring roles of the board will be severely impaired. The impairment in the board independence could affect the board incentives to ensure that management pursues value-increasing activities. The Hampel Report (1998) points out that, in some circumstances, the top two roles can be combined but it recommends that the reasons for combining the roles should be publicly disclosed. Though literature seems to consistently argue that separate individuals for the post of CEO and chairman leads to a better corporate governance system, the real issue is whether this leads to the board to be a better monitor and thus is capable of increasing the value of the firm. Proponents of the CEO duality structure argue that combining these two roles provide a clear focus for objectives and operations (eg. Andersen and Anthony 1986; Stoeberl and Sherony 1985). Separation of CEO and chairman posts has both costs and benefits and it was shown that for larger firms the costs are greater than the benefits (Brickley et al 1997). Evidence by Shamsul Nahar Abdullah (2002) in the Malaysian setting and Bradbury and Mak (2000) in the New Zealand setting confirmed the cost and benefit contention. In their study Berg and Smith (1978) found that there was no significant difference in various financial indicators between firms, which experienced CEO duality and firms which did not. The substantial cost of the separation could come from “incomplete transfer of company information and confusion over who is in charge of running the company ” (Goodwin and Seow 200:43). This could hamper the performance of the firm’s financial indicators. It could also be argued that when one person is in charge of both tasks, the decisions are reached much faster. Moreover, when the board chairman and the CEO is the same person, he or she is well aware of the decisions needed to improve the performance of the firm. In another study, Chaganti et al (1985) also documented evidence similar to that found in Berg and Smith (1978) involving firms that experienced bankruptcy (failure) and survival. Rechner and Dalton (1991) also showed that forms with CEO duality consistently outperformed firms with a CEO non-duality structure, which contradicts expectation.

In another study, Baliga et al. (1996) investigated the announcement effect of changes in the leadership structure. Using accounting measures of operating performance and long-term measures of performance their findings however suggest that: The market was indifferent to changes in the leadership structure; There was no significant effects on the firm’s operating performance; and There was no significant influence on the firm’s long-term performance. In a survey in Singapore by Goodwin and Seow (2000), the respondents’ opinion regarding the need for a separation of the board chairman and the CEO was not very strong, where the mean score was only 4.85 out of 7.00. Of the three groups in their study only auditors had a mean score of 5.08 while the directors; mean score was only 4.52 and the mean scores were not found to be statistically different. This evidence could be interpreted that the issue of separating the board chairman and CEO was not viewed as critical in the corporate governance structure. As argued the board independence is important in determining its effectiveness to discipline management. It may also be further argued that a board is more independent if the board is dominated by outside directors and the chairman is not the CEO of the firm. As argued by Daynton (1984:35), if one person is wearing two hats, “it is always the governance hat that is doffed.” In fact, the Malaysian Code on Corporate Governance argues that when the roles of CEO and chairman are combined, the risk of a board being ineffective in discharging its leadership and control duties is high and thus, there needs to be a sufficient number of independent directors on the board. Hence, it appears that the performance of the firm is improved if the board is independent and the CEO is not the chairman of the board.

Community of human beings, a nexus of contracts, possession of its shareholders

Describe the legal system – common law

Conclusion – corporation purpose


Several studies have been done to establish relationship between governance structure and firm’s performance. One argument is that a strong governance structure could lead to high performance (Sanda et al 2005). It will help promote a firm’s performance and protect stakeholder’s interests. Nam et al (2002) found that corporate governance should lead to better performance since managers are better supervised and agency costs are decreased. Poor corporate governance on the other hand is a fertile ground for corruption and poor financial performance. Brown et al (2003) found that firms with weaker corporate governance perform poorly compared to those with stronger corporate governance in terms of stock returns, profitability, riskiness and dividend payments.

Building investor confidence through insuring protection of shareholder rights (property rights protection)

It is believed that good governance generates investor goodwill and confidence. Again, poorly governed firms are expected to be less profitable. Claessens et al (2003) also posits that better corporate governance framework benefits forms through greater access to financing, lower cost of capital, better performance and more favourable treatment of all stakeholders. They argue that weak corporate governance does not only lead to poor firm performance and risky financing patterns, but are also conducive for macroeconomic crises like the 1997 East Asia crisis. Other researchers contend that good corporate governance is important for increasing investor confidence and market liquidity (Donaldson 2003).

Capital market regulation – insures transparency and accountability

Mitigates corporation failures

Prevention fraud and ensuring the effective allocation and usage of resources

An important theme of corporate governance is accountability and fiduciary role advocating for the implementation of guidelines and mechanisms to ensure good behaviour and protect shareholders (Otero 1998). Another key focus is the economic efficiency view through which the corporate governance system should aim to optimise the economic results with a strong emphasis to shareholder welfare. There are yet other sides to the corporate governance subject such as the stakeholder’s view, which calls for more attention and accountability to players other than the shareholders for example employees and environment (Singh 2005). Recently there has been considerable interest in the corporate governance practices of modern corporations since the collapse of large US firms such as Enron Corporation and Worldcom (Knell 2006).

Conclusion – relationship between the CG and the development


Conclusion – overall conclusion about the CG

“Agency Problems and the Theory of the Firm” The journal of political economy [0022-3808] Fama yr:1980 vol:88 iss:2 pg:288 -307 Musikali, Lois M., “The Law Affecting Corporate Governance in Kenya: A Need for Review.” International Company and Commercial Law Review, Vol. 19, No. 7, pp. 213-227, 2008. Available from Social Science Research Network website. Accessed on April 6, 2009. (Musikali 2008) New Partnership for Africa’s Development (NEPAD), “African Peer Review Mechanism: Country Review Report of the Republic of Kenya,” May 2006. Available from NEPAD website. Accessed on April 9, 2009. (NEPAD 2006) Nganga, S., et al., “Corporate Governance in Africa – A Survey of Publicly Listed Companies,” December 2003. Available from London Business School website. Accessed on March 27, 2009. (Nganga et al. 2003)

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