(originally published in CHARTERED SECRETARY Ed. March 2009)

*CS (Ms.) Shilpi Thapar.

Introduction

"Investor protection is a key to financial development and economic growth". This policy has augmented to the fore in international agencies such as OECD and World Bank as well as amongst the governments around the world. The increasing scandals of modern corporations globally have placed their corporate governance systems under close scrutiny. Failures and lapses in maintaining professional and personal code of management have led to undermining of confidence in capital markets. There is substantial erosion of trust of investors and regulators in companies thereby forcing companies to improve their corporate governance policies and to adopt" good" governance principles.

Concept of Corporate Governance

Corporate Governance has been traditionally associated with the "principal-agent" or "agency" problem. A "principal-agent" relationship arises when the owners of an organization (principal) are not the same as the persons who manages (agent), they hire managers and create a specialized human capital to run the organization on their behalf to generate capital of their own to invest. In this case, there is a separation between the financing and the management of the firm Le., there is a separation between ownership and control (see Berle and Means, 1932).

One of the most striking differences among corporate governance systems around the world is the level of disparity in ownership and control of organizations and identity of controlling shareholders therein. While some systems are characterized by wide dispersed ownership (outsider systems), others tend to be characterized by concentrated ownership or control (insider systems). In outsider systems of corporate governance (notably the US and UK) the basic conflict of interest is between strong managers and widely dispersed weak shareholders. In insider systems (notably Germany and Japan) on the other hand, the basic conflict is between controlling shareholders (or blockholders) and weak minority shareholders. [see Shleifer and Vishny,1997 and Becht, 1997].

There is no single model of corporate governance and each country over the period of time has developed a wide variety of mechanisms to overcome the agency problems arising out of separation of ownership and control. One of the challenges policy makers are facing is how to develop a good corporate governance framework which can secure the benefits associated with controlling shareholders acting as direct monitors, while at the same time ensuring that they do not impinge upon the development of equity markets. Corporate Governance affects the development and functioning of capital markets and exerts a strong influence on resource allocation. In era of increasing capital mobility and globalization, it has also become an important framework affecting the industrial competitiveness.

Effective Mechanisms of Good Corporate Governance

As per research conducted by Department of Trade and Industry & King's College, London there are 18 drivers of good corporate governance:

1. Board Independence.

2. Diversity, human and social capital within the board

3. High engagement in board processes

   4. Presence of large block shareholders

   5. Shareholder activism

   6. Breadth and depth of public information disclosure

   7. Breadth and depth of private information sharing

   8. Independence of the external auditors

   9. Competence of the audit committee

   10. Presence of internal control systems and support of whistle blowing.

   11. Long term performance-related incentives

   12. Transparent and independent control of the remuneration committee

   13. An active markets for corporate control

   14. Transparency and protection for shareholders and stakeholders during mergers and acquisitions

   15. Board power in takeover bids, subject to shareholder veto

   16. Shareholder involvement within corporate governance

   17. Voice mechanisms for debt holders

   18. Employee participation in financial outcomes and collective voice in decision making.

The efficiency of corporate governance in a particular organization depends upon a combination of drivers. These drivers may substitute or complement each other in terms of their efforts on organizational outcomes including business strategy and performance. Rediker and Seth(1995) suggest that a combination of various governance mechanisms is required to reduce principal-agent costs and align interests of principal and agents. The effectiveness and efficiency of these drivers depends upon a number of important industry level contingency factors such as organization's size, age, industry regulation/ growth/ decline phase, etc. (Dalton et al. 1999,2003, Deutsch 2005, Hermalin and Weisbach 2003).

Markets for Corporate Control: Important Controversial Mechanism of Corporate Governance

Markets for corporate control is thought to perform important governance functions in promoting a greater shareholder orientation among corporate managements, the economic function of which is' most clearly outlined by agency theory. This theory addresses the question as to how shareholders can assure that once they invest their funds, managements will act in their interests. This question arose in the context of the study by Berle and Means (1932) on the growing "Separation from ownership and control", in US corporations. They noted a decline in shareholder control over management as ownership stakes grew smaller and more fragmented among large number of individuals. Few incentives exist for fragmented owners toactively monitor management. Therefore, individuals diversify their portfolio and prefer exit over voice in response to poor performance. Moreover, small shareholders are rarely informed enough to make qualified decision or monitor management in detail. In sum, corporate control undergoes a "market failure" that needs to be remedied by several mechanisms to reduce agency cost: legal protection of shareholders, incentive Contracts for management, large block holders with capacity and incentives to monitor management or market for corporate control (Shleifer / Vishny 1996).

Henry Manne (1965) first described the possible governance function of a market for corporate control. "The lower the stock price, relative to what it could be more attractive the takeover becomes to those who believe that they can manage the company more efficiently". There is a strong relation between share prices and managerial performance and hence market for corporate control is a new corporate governance mechanism. As shareholders respond to poor managerial performance through exit, the lower share prices created incentives for outsiders to accumulate control rights, replace the management team and restructure the under performing company. These outsiders can recoup their investment through a share price premium.

Markets for corporate control can thus be defined in terms of transactions for control over a company's shares and occur through a variety of methods: open market purchases, block purchases, tender offers, negotiated share swaps or contest over the control of proxy rights (Bittlingmayer 1998).

Markets for corporate control- Substitute for Corporate Governance?

Markets for corporate control is an effective tool for disciplining poor management. It is a generalized threat of takeover which places management under greater discipline by institutionalizing a feed back mechanism between corporate decision making and the stock market. It increases the scope of shareholder voice, since shareholder exit leads to the threat of takeover. It is stronger in USA & UK resulting into more than 200 takeovers in the form of mergers in a year as compared to approx. 50 in Germany and Japan.

A. The impact of Markets for corporate control- Global Scenario

During the 1960's, U.S. companies pursued extensive unrelated corporate diversification through mergers and acquisitions but the performance of the new conglomerate firms was, on the whole, disappointing and under valued by stock markets. The Administration loosened the laws and widen the scope of takeovers contributing to an unprecedented wave of takeovers during 1980's in USA but it did not work long. Even, Manne (1965) anticipated the enormous impact of takeover 0 i distribution of wealth by staking: "Given the fact of special tax treatment for capital gains, we can see how this mechanism forcontrol of badly run corporations is one of the most important "get-rich-quick" opportunities in our economy today." The same situation is seen in India as well.

B. Implication of Markets for Corporate Control

Management may react negatively to takeover threats by implementing costly defensive strategies such as golden parachutes or poison pills and by seeking legal protection from takeover. It may adopt short term devices by increasing share prices thereby sacrificing beneficial long term projects and investments. Further, takeovers can change the position of other stakeholders and thus undermine trust and cooperative relations.

Further, a lot of criticisms are associated with markets for corporate control viz:

1. The Stock Market may often value corporation below their true market value.

2. Takeovers are often motivated by profit seeking redistribution of stakeholders' wealth that makes little positive contribution to long term company performance. The transfer of wealth from stakeholders to shareholders accounts for a large proportion of takeover premiums and leads to net losses of efficiency due to breaches of trust. Employees face the dangers of assets being stripped from target company, employment being rationalized and employment agreements being renegotiated.

Markets for corporate control are an effective disciplinary device than either monitoring by institutional investors or by the board of directors. But every time intensity of the mergers and acquisitions market is not by itself evidence of a powerful disciplinary device at work. It can be promoting empire building or tax minimization. As legal, advisory and financing costs constitute an average 4 per cent of purchase price, it is expensive way of implementing corporate governance. But it does not mean I that it should not be accepted. It is indeed difficult to comment that it is a substitute for corporate governance but indeed it is most effective tool for implementing corporate governance in organizations.

Further, besides markets for corporate control, product market competition can also be proved as an effective driver of corporate governance. Firms which will be incapable to adopt corporate governance policy will be replaced by competitors. Product market competition can, to some extent Act to reduce the scope for managerial inefficiency and opportunism. Competition can provide a benchmark by which performance of the company can be judged when compared to performance of other company in a similar sector but as its effects are slow, it forces inefficient company to file bankruptcy.

Two approaches are there to analyze the effects of markets for corporate control

1. To examine the share prices of target and acquiring firms around the announcement date of takeover.

2. To look at post take over performance of merged group Le., whether target firm shareholders in fact reap real gains or just reflects transfers of wealth from one economic agent to another.

If takeovers are a means of resolving problems associated with inefficient management, or with other efficiency gains then the ex-post performance of the merger group should be better than the weighted average of the ex-ante performance of the acquiring and target firm prior to the takeover.

To conclude, it is rather the threat of takeover of management than actual takeovers that seems to act as an effective device for improving performance.

References:

1999: OECD-Corporate Governance: Effects on firm performance and economic growth- Maria Maher and Thomas Andersson.

Sept.2001: An Emerging Market for Corporate Control? The Mannesmann Takeover and German Corporate Governance- Martin Hopner and Gregory Jackson MPlfG discussion paper 01/4.

2007- The Department of Trade and Industry & King's College, London- "Key drivers of "Good Corporate Governance and appropriateness of UK policy responses."

* About the author: The author is a commerce graduate, specialized in advance accounting and auditing and a law graduate with specialization. She is a fellow member of the Institute of Company Secretaries of India (FCS). She is also the Associate Member of The Institute of Chartered Secretaries and Administrators, UK (ACIS). 
She is editor of a couple of professional magazines and hold different positions as Chairman, Secretary, Director in various professional bodies. She has participated and contributed in various seminars and presented various professional papers.