BBR 3251- CORPORATE GOVERNANCE –Undergraduate

Introduction

Corporate governance involves a set of relationships between a company’s management, its

board, its shareholders and other stakeholders. Corporate governance also provides the structure
through which the objectives of the company are set, and the means of attaining those objectives
and monitoring performance are determined.

Corporate Governance - is the framework of rules and practices by which Board of Directors
ensures accountability, fairness, and transparency in a company's relationship with its
stakeholders

Definition

There are no single definitions that wholly encompasses the corporate governance for all purpose
and intent. These differences is occasioned by differences in national, international and
organization cultures that view the practice from different dimensions

A few sample definitions include:

1. “the process of supervision and control to ensure that a company management act in
accordance with the interests of stakeholders” (Parkinson 1984)

2. “giving overall direction to enterprise with overseeing and controlling the executive
action of management and with satisfying legitimate expectation of accountability and
regulation by interests beyond the corporate boundaries” (Tricker 1984)

3. "the system by which companies are directed and controlled" (Cadbury Committee,
1992).

Corporate governance is concerned with the direction (develop policies, regulations) and
performance (financial, non-financial) of Organizations (Monks, 1989).

key participants Corporate Governance

4 key participants in corporate governance are:

1) Shareholders, (investors)
2) Management (led by the CEO)
 3) Employees
4) The Board of Directors.

The corporate governance framework consists of :

a. Explicit and implicit contracts between the company and the stakeholders for distribution
of responsibilities, rights, and rewards,
b. procedures for reconciling the sometimes conflicting interests of stakeholders in
accordance with their duties, privileges, and roles, and
c. procedures for proper supervision, control, and information-flows to serve as a system of
checks-and-balances.
d. The transactional relationship which involves dealing with disclosure and authority

Corporate governance consist of five elements which the Board must consider:

1) long term strategic goals

2) staffing: present and future
3) business environment/community/markets/government
4) customers/suppliers
5) compliance (legal/regulatory) (Sir Adrian Cadbury, 1998)

Key functions of Corporate Governance

1. Provision of corporate directions

- vision, mission, core values

2. focus on organization structures

-flat/lean/tall structures

3. organization cultures
-conservatives/in ward looking /open door systems/ authoritative/participative

4. Wealth creation
-Shareholders /stakeholders/
-quick kill verse strategic approach

5. Managerial styles
-accommodative/dictatorial , micromanaging /hands off styles
6. strategic corporate development approaches
-growth oriented / consolidation/
- risk takers/risk aversions

The importance of Corporate Governance

There are five key issues in understanding the importance of corporate governance:

1. Separation of Ownership And Control

The corporation, separates ownership (investors) from operational control (management )
- this concept is commonly referred to as the agency issue, or Agency Theory. It is this
separation which creates the need for systems of independent monitoring and control.

2. The Issue of Integrity

Perception is in the eye of the beholder. The key point is whether the top management of
organizations practice integrity in the eyes of the general public. It is this integrity - perceived
and actual - which underlines the importance of corporate governance

3. The Bonus Culture

Principles of Corporate Governance, acknowledges that: "Good corporate governance should

provide proper incentives for the board and management to pursue objectives that are in the
interests of the company and its shareholders and should facilitate effective monitoring." the
board, management and shareholders needed to be sure that the remuneration is fair, it is clear
and that corporate policy is in line with public perception.

In a well-run companies, good performance is rewarded in order to attract talent and people who
are dedicated to improving performance.

4. The Regulatory Framework - better not more regulation

Prudent governance promotes good management and a failure of governance is a failure of

management.

Proactive reform is needed, since reactive regulations will always result in building a sledge
hammer to miss a nut.
The regulators have occasionally failed to understand the complex corporate governance
challenges. e.g capping of interest rate by banks in Kenya – reduced access to financial
borrowing by SMEs because of perceive risk by the banks, eg regulation requiring bottling local
brews – made cost of liquor to increase

Regulating authorities need to strike the right balance between encouraging innovation and
customer choice and enforcing a minimum set of standards.

Punitive tax regimes encourage tax evasion, avoidance or relocation, it has been proven that the
regulatory burden, while in many cases adding cost and confusion, has caused people to invent
more and more complex systems to avoid detection.

However, there are excellent regulation which has indeed improved the consumers' lot by forcing
companies to disclose information, reduce costs/charges and generally act in a fair manner eg
financial statements, money laundering Act

5. Directors' training in corporate governance

Attention is increasingly being paid to the qualification of senior managers to carry out their
responsibilities in organizations.

In UK Institute of Directors has introduced qualifications such as the Chartered Director

In Kenya professional bodies demand for certification for individuals to hold certain senior
positions in organizations eg IHRM, accountants, Engineers, etc

Principles of Good Corporate Governance

1. Ethical approach - culture, society; organizational paradigm

2. Balanced objectives - congruence of goals of all interested parties
3. Clear roles - roles of key players: owners/directors/staff
4. Balanced decision-making process –based on a model giving due weight to all
stakeholders
5. Equity and fairness - stakeholders are treated with equal concern
6. Accountability and transparency - to all stakeholders (reporting, dividends, elections)

Stakeholders Management In Corporate Governance

Stakeholders
 1. Board of directors
2. The shareholders
3. Government
4. Employees
5. Regulatory authorities
6. The media
7. Customers
8. Business partners
9. Financiers
10. Trade associations
11. Local communities
12. Suppliers
13. Trade unions
14. Management

Mendelow Model
It is important for organizations to understand which groups of stakeholders can influence the
organization in terms of,
 Power
 Interest

The Mendelow framework is used to understand the influence that each stakeholder has over the
organisation’s strategy and objectives.

The organization’s strategy for relating to its stakeholders depends on which part of the map the
stakeholder falls into.

This enables organizations to priorities which stakeholders are more important using the
following framework.

Mendelow framework
 1. Those stakeholders with high power and high interest are the most importance. These
are key plyers. They need to be actively managed by an organization. If there are a
several stakeholders in this category, competing claims may make it difficult for the
organization to manage them.

2. Stakeholders with high power and low interest must be kept satisfied as if they are
concerned about the organization’s operations. It would be easy for them to take an
interest and suddenly become influential.

3. Stakeholders with low power and high interest are interested in the organization but have
little power. They may be able to increase that power by forming alliances with other
stakeholders. The organization must keep them informed and watch their power base.

4. Stakeholders with low power and low interest require minimal effort to manage them.
Care must be taken to ensure that they are not ignored, least ethical issues arise out of
ignoring them.

Board of Directors
Board Structures
1. Two-tier board system
The two-tier Board of Directors systems has 2 types of boards viz,
a) executive board, made up of company executives – who generally runs day-to-day
operations o fhe organizations
b) supervisory board, made up entirely of non-executive directors who represent
shareholders and employees, hires and fires the members of the executive board,
determines their compensation, and reviews major business decisions.[45]
Some European countries, including Germany, Austria, and the Netherlands practice two-tier
boards
American model of corporate governance emphasizes the interests of shareholders. It relies on a
single-tiered board of directors that is normally dominated by non-executive directors elected by
shareholders. Within this system, many boards include some executives from the company (who
are ex officio members of the board).
Non-executive directors are expected to outnumber executive directors and hold key posts,
including audit and compensation committees.

Responsibilities of the board of director

The board is responsible for the successful perpetuation of the corporation. That responsibility
cannot be relegated to management (" John G. Smale, 1995, Former Chairman of the Board
of General Motors)
Board Committees
 Compensation committee
 Audit committee
 Finance committee
 HR committee
Number of committees may depend on the type of the businesses and size of the corporations.
Where committees of the board are established, their mandate, composition and working
procedures should be well-defined and disclosed in the organization policies.

Principles Responsibilities of the Board

1) Review and guide corporate strategy – mainly in objective setting, major plans of action,
risk policies and management , capital plans, and annual budgets.
2) Oversee major acquisitions and divestitures.
3) Select, compensate, monitor and replace key executives and oversee succession planning.
4) Align key executive and board remuneration (pay) with the longer-term interest of the
company and its shareholders.
5) Ensure a formal and transparent board member nomination and election process.
6) Ensure the integrity of the corporation's accounting and financial reporting systems,
including their independent audit.
7) established appropriate systems of internal control
8) Oversee the process of disclosure and communications.
9) providing feedback to management on the organization's strategy;
10) monitoring financial health and performance
11) Ensuring accountability of the organization to its investors and stakeholders

Compensation Management In Corporate Governance

Principle Determinant of compensation levels

1. The ability to pay
- Profitability
- Good cash flow
- Sufficient return on investment
 2. Comparability / going rate/market rate
- Employers and unions and staff compare their pay with similar players
in the industry in the economy
3. Bargaining power/strength of trade unions e.g CBA, strike
4. labour market conditions,
- Employees paradise e.g Europe
- Employers paradise e.g Kenya
1. Cost of living - when inflation is high employers are forced to raise their pay
2. Government Action minimum. Minimum wages e.g in Kenya 13,572 (2021)
2. Productivity. -Efficiency of production system may cause management to give extra pay
to workers
3. Existing differential/custom and practice,
- organization have their own culture of payment e.g world bank,
Microsoft are known well payers
- Encouragement of bonuses and over time by some organization
increases levels of pay
- Custom and practice- IT based firms are now high payers.
4. Organization and technology change.
- Stable organization with internal +external stability pay with ease and
fairly high
- BPR may involve restructuring of pay structures &levels
5. Regional laws
- Regional laws may demand certain level of compensation for certain
common jobs. E.g East African community, European union, etc

Types of compensation

1. Consolidated salary – payable per month on a structured basis. The main motivation for
higher performance is the end of the year bonuses/dividends
2. piece rate pays
This is where on top of a fixed salary and a price for every unit of some observable output is
paid. While piece rates provide very strong incentives to be productive in the particular task that
is being rewarded, they also encourage neglect of other, less measurable activities (e.g. quality
control) that may be important parts of the employee`s job.
3. sales commission
-sales commission is a percentage, rather than a fixed amount. Sales commissions may expose
the agents to significant risk because of,
 Reduced demand conditions,
 Nature of the product,
 Time and location,
 Promotions by competitors etc.

This implies that the expected income (assured income) may have to be much higher eg 75% of
basic pay
_ If the agent has better access to information about factors, unrelated to personal effort, that
affect sales performance, it may be optimal to offer a choice between contracts with different
strengths of incentives.
Then the agent can respond to a positive environment by choosing a greater variable component,
and to a negative environment with a greater fixed component. This should lower contracting
costs because the agent endogenously adjusts incentive provision to the drivers of the

_ A different approach is comparative performance evaluation (where the standard is set by

agents performing the same task independently). While this can be an effective and powerful
motivation, it will work best when the competing agents do not depend on each other and are
unable to collude. Else, agents may deny each other help (since a better performance by someone
else has a negative effect on one`s own pay

_ When tasks are interdependent or contributions are difficult to disentangle, the risk to
workers tends to be minimized if compensation is based on the observable group performance,
e.g. through division and team bonuses or employee stock options (which reward company-level
performance). Not only is risk kept to a minimum by avoiding imprecise performance measures,
but the remaining risk is also shared by team members: if one member underperforms at a given
point in time, the reduction in productivity can be offset by another member who is over
performing. Smoothing the stream of bonuses in this manner is valued by risk-averse individuals.

_ Moreover, team members are likely to be in a better position to monitor each other`s effort, and
since their pay depends on joint performance, they have an incentive to support each other.
Whether group bonuses are effective depends largely on whether self-monitoring and the
associated social rewards and punishments can counteract the incentive to free-ride on other
team member’s efforts (social loafing)
CEO Pay
A large component of CEO pay comes from incentives, short-term and long-term. The CEO is
directly responsible for the firms profitability, which is measureable (e.g. in the stock price,
which reflects the expected future stream of profits). Hence, compared to most other employees,
there is good information on CEO performance, CEO effort certainly has a significant impact on
performance.

Typical CEO compensation consists of:

1) base-pay (benchmarked against CEO incomes in comparable firms),
2) bonus (based on earnings adjusted for capital costs, i.e. share issues and interest
expenses,
3) perks (generous pensions, interest-free loans, club memberships, apartments, luxury cars
and drivers, corporate jets, etc.)
4) Exit packages- soft landing

The principle of 3Ps mainly applies in arriving at the CEOs pay

o Person - KSA levels
o Positon – designation – responsibility, risks
o Performance – output, outcome

Illustration:
-USA –fixed income is only a small fraction of pay, most of it is based on performance (options
and restricted stock)
-In Singapore, Canada and Australia - the greater part of CEO incomes tends to be contingent
on performance.
- In European, Japan and China - CEO income is fixed,
-In Indian - CEOs receive larger share of their benefits in perks,

The Role of Stock Options (ESOP)

stock options provide incentives to the holder as they become investors essentially. There is big
motivation of dividends and building up the share value for future sale

Five Golden Rules of corporate governance

1. Ethics

The business morality or ethic must permeate the entire operation from top to bottom.
Embrace all stakeholders. corporate governance practice best is an integral part of good
management practice also permeating the entire operation, and not an
esoteric(obscure/secret) specialism addressed by lawyers, auditors and sociologists.
 - Corporate ethics in governance is fundamental as it underpins the structures and
systems used to ensure good governance
-lack of a high standard of ethical behaviour in a company is a threat to trust and loyalty,
which in turn has a detrimental effect on the health of the company over the longer term.
-loyalty and trust have a significant value in terms of the efficiency and effectiveness
with which a business can be run, and the concomitant cost of control systems needed.
-highly ethical operation is likely to spend much less on protecting itself against fraud
and will probably have to spend much less on industrial relations to maintain morale and
common purpose

2) Align Business Goals:

-appropriate goals, arrived at through the creation of a suitable stakeholder decision
making model
There are two main dangers in failing to align business goals:

a. Lack of a common, clear goal and strategic direction. This leads at best to
inefficiencies and at worst business failure as decisions become increasingly difficult,
especially in reacting to competitive pressure.
b. Dissent among stakeholders. If the majority of interested parties in a business are not
aware (due to a lack of effective corporate communications) or disagree with the board's
view of the business goal, there are likely to be difficulties with stakeholder relations
which can disrupt the smooth running of the business.
Most companies align business goals instinctively through their relationships with key
stakeholders, industry knowledge and management information systems.
Think about the following questions in relation to your own organization or where you are
working
a) Do you have clear business goals, physically (or electronically) documented and
distributed within the organization?
b) Are your employees aware of and agree with the long term business goal(s)?
c) Is the outward expression of the goal a factor which helps or hinders sales?
d) Do you establish goals with your suppliers and trading partners?
e) Is the community in which you operate aware and supportive of your business goals?
Failure to align business goals is one of the most frequent yet undiagnosed causes of corporate
failures.
Few businesses spend sufficient time in defining and communicating a clear goal to their
stakeholders.
It is adviceable to spend resources on developing and communicating your brand and associated
values to customers and evaluate the same occasionally.
To fully align business goals, there is need to have a formal, well planned and inclusive approach
to setting, communicating and monitoring goals.
 It requires:
 full support of the CEO and board and for the programme to be linked to the strategy
process
 use of an objective, third party research company to ensure results are not distorted by
internal assumptions and prejudices
3) Strategic management: (an effective strategy process which incorporates stakeholder
value)
“Failures to plan is planning to fail” and "Good fortune is what happens when setting detailed
goals”
corporate governance should be an integral part of the strategy process viz,
a) Analyzing all internal resources – use SWOT, BSC , HRSC
b) Analyzing external environment - refer to PESTEL model
c) Analyzing stakeholder views - views of actual and prospective partners
d) Formulating a strategy - consider options/alternatives
e) Implementing the strategy – least cost , most feasible
f) Set up monitoring and reporting – feedback systems

4) Organization: an organization suitably structured to effect good corporate governance

Organizational effectiveness should not be seen as a goal in itself but rather the means to an end -
achieving your goals.
There are two key elements to be considered when designing for organizational effectiveness:

a) Shape: there are five basic types of organization structure:

o simple: an organization run by an individual, with little formal structure,

unworkable beyond a certain size
o functional: an organization based on the functional elements, sales and marketing,
production, finance, and found in smaller, more focused businesses, and the
divisions of larger ones, etc
o multi-divisional: an organization combining functional business units with central
support services, and requiring more sophisticated management techniques, but
useful to serve the development of product/market businesses in a larger company
o holding company: suitable for the larger organization in which the centre
exercises little day to day operational control but behaves more like an investment
company
o matrix: representing a significantly more complex way to organize, with business,
functional and geographical dimensions sharing responsibilities, and leading in
different circumstances; a structure praised for focusing skills and experience but
criticized for confusing ultimate responsibilities.
o Boundariless – global organizations with global products and global services.
Less concern for domestic orientation
 o Virtual structures – lacks physical locations. Operates around the globe and
connected through ICT.

b) Style: there are three basic aspects of styles in management:

o strategic planning: with the centre operating as an overall planner, developing a

detailed central plan and laying out roles for the divisions
o financial control: where the centre sees itself as a shareholder or banker for the
divisions with little desire to get involved in defining their individual
product/market strategies
o strategic control: where the centre allows the divisions to develop their own plans
and approves them against an objective to implement an overall strategy and
achieve a balance between the divisions
5) Reporting: reporting systems structured to provide transparency and accountability
corporation need to communicate regularly the following

a) organizational performance
b) stakeholders’ expectation
c) Directors' remuneration
d) Any disclosures required by law

Approaches to Corporate Governance

1. Environmental, Social And Governance (ESG)

Environmental, Social and Governance (ESG) considerations are the three foundational areas
of corporate sustainability.
 An ESG-centered approach to business considers non-financial factors that nonetheless
have financial consequences.
 ESG companies integrate environmental, ethical and social responsibilities into their
business strategies and corporate cultures.

Environmental criteria relevant to ESG include an organization’s

a) energy and natural resource consumption,
b) commitment to reducing carbon emissions
c) position on climate change,
d) effects of an organization’s activities on humans and wildlife.

Social criteria relevant to ESG include an organization’s

a) community and social impact;
b) level of civic engagement;
 c) workforce health and quality of life;
d) and diversity,
e) equity and inclusion efforts.

Governance criteria relevant to ESG include an organization’s

a) policies and procedures for business and board operations;
b) executive accountability;
c) legal and regulatory compliance;
d) supply chain diversity;
e) external stakeholder relationships.

2. Corporate Social Responsibility - CSR

Corporate social responsibility is a form of business self-regulation which aims to contribute
to societal goals of a philanthropic, activist, or charitable nature by engaging in or supporting
volunteering or ethically-oriented practices.
Major CSR areas are ,

Processes of CSR

3. Corporate citizenship
 Corporate citizenship is described as the rights, obligations, privileges, and overall corporate
responsibility within local and global environments. Key activities in corporate citizenship
are part of CSR

4. Managing corporate risks

Corporate risk refers to the liabilities and dangers that a corporation faces.
Risk management is a set of procedures that minimizes risks and costs of doing businesses.
corporate risk management department identify potential sources of risks, analyze and take the
necessary steps to prevent losses.
Types of risks
a) Strategic risk – entering new market, rolling out new products
b) Compliance risks – new laws, regulations
c) Financial risks - limited cash flows, risky investment
d) Operational risk – machine break downs , down time , obsolete technology

Causes of business risks

a) Natural cause - natural disasters including flooding, earthquakes, etc
b) human - eg negligence at work, strikes, work stoppages, and mismanagement, election
violences
c) Economic – including rising prices of raw materials or labor costs, rising interest rates for
borrowing, and competition etc

Managing Business Risks

Organizations have 3 main options in managing risks viz,
a) Avoid risks – through meticulous planning and operations, proper risks assessment and
management
b) Prevent risks – strategic decisions not to do business in risk prone environment.
 c) Contain the risks - putting up safety nets to reduce the negative effects of risks on the
businesses. Eg firewalls against internet hacking, aggressive promotion against stiff
competitions

Theories of corporate governance

1. Agency theory
-This theory states that shareholders of firms (the owners ) delegates the responsibility of day to
day running of firm to managers (the agents) . One of the principle problem of agency theory is
that the agent and the owner interests conflicts
A basic conclusion of agency theory is that the value of a firm cannot be maximized because
managers possess discretions which allow them to expropriate value to themselves.
-In an ideal world, managers would sign a complete contract that specifies exactly what they
could do under all states of the world and how profits would be allocated. 'The problem is that
most future contingencies are too hard to describe and foresee, and as a result, complete
contracts are technologically unfeasible' ( Shleifer & Vishny 1996).
-As a result, managers obtain the right to make decisions which are not defined or anticipated in
the contract under which debt or equity finance is contributed (Grossman & Hart 1986; Hart &
Moore 1990). The 'agency problem' is particularly acute in Anglo cultures with dispersed
ownership where corporations do not have a supervisory board . When all shareholders own
small minority interests to create diverse ownership it is not rational for any investor to spend
time and incur costs to supervise management as this provides a 'free ride' for other investors.
2. The stewardship model
In the stewardship model, 'managers are good stewards of the corporations and diligently work to
attain high levels of corporate profit and shareholders returns' (Donaldson & Davis 1994).
-Under this model, Managers are principally motivated by achievement and responsibility needs'
and 'given the needs of managers for responsible, self-directed work, organizations may be better
served to free managers from subservience to non-executive director dominated boards'.
-Boards can become redundant when there is a dominant active shareholder, especially when the
major shareholder is a family or government. One could speculate that some boards are
established from cultural habit, blind faith in their efficacy, or to make government or family
firms look 'more business like'.
-However, research by Pfeffer (1972) has shown that the value of external directors is not so
much how they influence managers but how they influence constituencies of the firm. He found
that the more regulated an industry then the more outsiders were present on the board to reassure
the regulators, bankers, and other interest groups.
3. The stakeholder model
-In defining 'Stakeholder Theory' Clarkson (1994) states: '"The firm" is a system of stake holders
operating within the larger system of the host society that provides the necessary legal and
market infrastructure for the firm's activities.
-The purpose of the firm is to create wealth or value for its stake holders by converting their
stakes into goods and services'.
-The goal of directors and management should be maximizing total wealth creation by the firm.
The key to achieving this is to enhance the voice of and provide ownership-like incentives to
those participants in the firm who contribute or control critical, specialized inputs (firm specific
human capital) and to align the interests of these critical stakeholders with the interests of
outside, passive shareholders, Blair (1995:322)
It 'encourage long-term employee ownership' and 'encourage board representation by significant
customers, suppliers, financial advisers, employees, and community representatives. Porter
(1992:17) also recommended that corporations 'seek long-term owners and give them a direct
voice in governance' (i.e. relationship investors) and to 'nominate significant owners, customers,
suppliers, employees, and community representatives to the board of directors'.
-However 'Membership of the board should be restricted to informational participation'. Such
information participation is achieved in Japan through a Keiretsu Council and in continental
Europe through works council and supervisory boards. These provide the model for establishing
'stakeholder councils' as described by Guthrie & Turnbull (1995) and Turnbull (1994d;
1997c,e,f).
5. The political model
-The political model recognizes that the allocation of corporate power, privileges and profits
between owners, managers and other stakeholders is determined by how governments favour
their various constituencies.
-The ability of corporate stakeholders to influence allocations between themselves at the micro
level is subject to the macro framework, which is interactively subjected to the influence of the
corporate sector.
-Hawley & Williams (1996:29) focused on the micro level of the political model and defined the
'political model of governance' as an approach, '... in which active investors seek to change
corporate policy by developing voting support from dispersed shareholders, rather than by
simply purchasing voting power or control
-The political model of corporate governance places severe limits on the traditional economic
analysis of the corporate governance problem, and locates the performance-governance issue
squarely in a broader political context. Political does not mean necessarily imply a government
role, merely that it is non-market.

CHALLENGES OF CONTRACTS/AGENCY

1. Managerial Self-Serving

a) Misdirected investments - managers may pursue pet projects, eg exploration of US oil

fields in the 1970s, when buying oil from over-seas was much cheaper, white elephant
 projects for contract kick backs, 6 mega water dams in Kenya, infrastructure projects in
kenya.

b) Entrenchment - managers try to secure their positions e.g. by manipulating the timing of
cash flows, being conservative when their performance is satisfactory and taking
excessive risk when it is not, and by resisting takeovers.

c) Self-dealing (managers consume perks and may try to hire relatives or appoint friendly
successors, sponsor political parties or sports teams according to personal preference, or
even conduct illegal activities to enrich themselves

2. The Contracting issues

a) Managers are self-interested; they will not act on behalf of the firm unless they have a stake in
its success or failure. In a corporation, managers are motivated through incentive.
Contract employment offer rewards for observable outcomes.
They are designed to achieve desirable outcomes at minimal cost, typically (in practice) through
a mix of incentives and monitoring.

_ This is the basic trade off: stronger incentives elicit better behaviour, but they also make the
contract more risky to accept. The art of contract design is to create the strongest incentives
without losing agreement on the contract eg high performance level

b. Incomplete Contracts
_ Complete contracts specify exactly what is to be done under all circumstances as well as
appropriate rewards / punishment for performance /non-performance.
_ Such contracts are difficult to write because of language problem to describe situations
unambiguously(especially in international assignments) or monitoring capability to verify that a
particular situation has occurred.

c. Implicit Contracts
_ An implicit contract is a contract that exists in expectations, rather than on paper. When you do
someone a favour, you might expect a reciprocal favour some day. Because this is not an explicit
agreement, it may be based on mistaken perceptions of other people`s beliefs and attitudes and
lead to conflicts.
Corporate culture is an implicit contract. You may never sign an agreement that requires you to
wear a business suit, but if you dress unconventionally you will probably never get promoted or
even be asked to leave. e.g Adverse selection may occur when individuals with unobserved
negative characteristics can self-select into contracts such as lazy people apply for .fixed-wage
jobs.
_ E.g. a corporation might attempt to attract a CEO or other top managerial talent with a
particular pay package but instead get incompetent CEO.

3. The Revelation Principle

_ The revelation principle says: if a given outcome can be implemented through a contract, then
it must be possible to implement this outcome in such a way that parties to the contract have an
incentive to reveal their private information truthfully. If this cannot be done, then the outcome
cannot be implemented eg oil marketer prices in Kenya, 2011

4. Moral Hazard
_ In the typical moral hazard problem, a principal contracts with an agent to perform a task, but
cannot directly observe the agent`s effort. The effects of the agent`s actions are, however,
reflected in another variable that is observable. E.g. the unobservable care with which an
employee operates and maintains a machine affects the number of breakdowns.
_ Basing pay entirely on the realization of a variable the agent cannot fully control would expose
the agent to excessive risk. We usually assume that agents are more risk-averse than the
principals. Hence it is not really desirable for risk to be shifted from the principal to the agent,
yet it is necessary in order to provide incentives for effort.

_ One aspect of minimizing risk is to tie payments to the observable variable that is most closely
related to effort. E.g. rather than pay employees a bonus based on the firm`s overall profits, it
would be preferable to base the bonus on individual sales.
_ Seniority pay (that increases with tenure in the company) can be explained as a response to a
moral hazard problem. The risk spread that is required to incentivize employees can be achieved
either through a performance-based bonus or a bond that the worker forfeits in case of non-
performance (the bond is not practical)

5. Risk-Bearing and Risk-Sharing

_ Risk aversion is a property of preferences: namely, the tendency to value "money lost" more
than "money gained," which implies a preference for a fixed income to uncertain income that
yields the same amount on average.
_ Risk Sharing can be expressed as each individual receiving a fraction of total income and a
possible transfer of some fixed cost from one individual to another.

_ In general, the risk premium declines in proportion to the size of the group: the larger the
group, the smaller the risk borne by each member: this is how insurance created value.

6. Incentives
_ With , nonlinear contract forms, the agent might commit unequal effort to tasks for which there
are different incentives, without neglecting any task entirely. Incentives attached to a task induce
greater performance in that task to the detriment of other tasks.

_ Thus, if it is a salesman`s job to both make the sale and keep customers happy, for the long-
term health of the business, then it is not a good idea to pay him both base and commission. He
will try to talk customers into sales they might later regret. OR An airport franchise of a
restaurant chain should value cleanliness and service as much as volume (since other franchises
are affected by the impression it makes on customers) but it rarely does, since these things are
difficult to evaluate and reward.

_ One of the arguments for fixed compensation is that it does not distort the allocation of effort
by providing stronger incentives for tasks (such as sales) where achievements are more easily
measurable. Instead, performance is induced through long-term career prospects - when a
promotion is being considered, managers might be able to comprehensively assess the employee
with respect to all other important tasks appropriately.

CORPORATE CONTROLS

_ The general principle is that control rights over a particular decision should be assigned to the
party to whom the decision matters most or affects most. These are stakeholders.

-management effectively makes decisions in practice, but get rubber-stamped/ratified by the

boards approval
-Economics predicts that rubber-stamping tends to happen when management is known to have
strong incentives to act in the interest of the firm, so that its recommendations can be trusted.

_ In US corporations, typically around ten directors are elected by share-holders to monitor

management on their behalf. Boards usually meet eight times a year.

Some European countries (Germany, Netherlands, France) have two-tier board structures, where
the management board is responsible for operations, and the supervisory board monitors
appointments to the management board, compliance with laws, and major strategic decisions.
This is similar to kenya.

_ In principle, the Board represents shareholder interests and is legally obligated to do so to the
best of its ability.
_ While Directors can be sued by shareholders for failing to carry out their duties, such suits tend
to be successful only when there is a case of evident fraud.

- In practice, the board faces some conflicting incentives and constraints. The CEO sits on the
board and somehow influence appointment of the board members

_ Outside directors are often individuals with many commitments, who will not be able to
prepare carefully for board meetings and therefore depend on the information presented by
management.

-Directors often have multiple engagements (including being the CEO of another company or
sitting on other boards) and therefore little time to review proposals in detail.

_ Shareholders, who in principle monitor corporate management, are themselves not necessarily
properly incentivized or monitored.

_ While individual shareholders and the board of directors are clearly imperfect monitors, a
corporation’s top management is also under scrutiny by other institutions that are part of the
economy’s financial infrastructure (e.g. auditors, credit and stock analysts).

Internal Corporate Governance Controls

This includes

a) Rights and equitable treatment of shareholders: Organizations should respect the

rights of shareholders and help shareholders to exercise those rights. They can help
shareholders exercise their rights by effectively communicating information that is
understandable and accessible and encouraging shareholders to participate in general
meetings.
b) Interests of other stakeholders: Organizations should recognize that they have legal and
other obligations to all legitimate stakeholders eg the society
c) Role and responsibilities of the Board: The board needs a range of skills and
understanding to be able to deal with various business issues and have the ability to
review and challenge management performance. It needs to be of sufficient size and have
an appropriate level of commitment to fulfill its responsibilities and duties. There are
issues about the appropriate mix of executive and non-executive directors.
d) Integrity and ethical behavior: Ethical and responsible decision making is not only
important for public relations, but it is also a necessary element in risk management and
avoiding lawsuits. Organizations should develop a code of conduct for their directors and
 executives that promotes ethical and responsible decision making. many organizations
establish Compliance and Ethics Programs to minimize the risk that the firm steps
outside of ethical and legal boundaries.
e) Disclosure and transparency: Organizations should clarify and make publicly known
the roles and responsibilities of board and management to provide shareholders with a
level of accountability. They should also implement procedures to independently verify
and safeguard the integrity of the company's financial reporting. Disclosure of material
matters concerning the organization should be timely and balanced to ensure that all
investors have access to clear, factual information.
f) Monitoring by the board of directors: The board of directors, with its legal authority to
hire, fire and compensate top management, safeguards invested capital. Regular board
meetings allow potential problems to be identified, discussed and avoided. Whilst non-
executive directors are thought to be more independent, they may not always result in
more effective corporate governance and may not increase performance. Different board
structures are optimal for different firms. Moreover, the ability of the board to monitor
the firm's executives is a function of its access to information. Executive directors
possess superior knowledge of the decision-making process and therefore evaluate top
management on the basis of the quality of its decisions that lead to financial performance
outcomes.
g) Internal control procedures and internal auditors: Internal control procedures are
policies implemented by an entity's board of directors, audit committee, management, and
other personnel to provide reasonable assurance of the entity achieving its objectives
related to reliable financial reporting, operating efficiency, and compliance with laws and
regulations. Internal auditors are personnel within an organization who test the design
and implementation of the entity's internal control procedures and the reliability of its
financial reporting
h) Balance of power: The simplest balance of power require that the President be a
different person from the Treasurer. This application of separation of power is further
developed in companies where separate divisions check and balance each other's actions.
One group may propose company-wide administrative changes, another group review
and can veto the changes, and a third group check that the interests of people (customers,
shareholders, employees) outside the three groups are being met.
i) Remuneration: Performance-based remuneration is designed to relate some proportion
of salary to individual performance.

External Corporate Governance Controls

External corporate governance controls encompass the controls of external stakeholders exercise
over the organization. Examples include:

a) competition
 b) debt covenants – requirement placed by lenders on borrowers with a view of protecting
the interests of the principal/investors
c) demand for and assessment of performance information eg balance score card
d) government regulations
e) managerial labour market
f) media pressure
g) civil society pressure

Corporate Governance and Ethics

Ethics Defined
Ethics refer to the study of good and evil, right and wrong, and just and unjust actions. Business
ethics is same in principles with other tenets of ethics, right and wrong dimensions, just and
unjust practices etc.
Ethics is understood from societal point of view. Societies culture determines what is ethical and
unethical because individuals anchor their conducts in culture of the group to which they belong

Kantian theory
Discrimination is unethical because it violates a person's basic moral rights. Kantian theory,
for example, holds that human beings should be treated as ends and never used merely as
means. Thus Kantian principle implies that each individual has a moral right to be treated as
a free person equal to any other person, and that all individuals have a correlative moral
duty to treat each individual as a free and equal person.

Ethical Dilemmas
Unethical practices in business related world were found even in our ancient culture. Not only
rates of interest were exorbitant (60 per cent, 120 per cent and 240 per cent) but were charged
differently to different customers. Debtors were imprisoned or enslaved by creditors until they
paid off their debts. There were instances of debtors committing suicide who were unable to bear
the harassment by creditors
Source of ethical dilemmas
The ethical dilemmas arise from three sources namely
1. Face-to-face Ethics
These arise mainly because there is a human element in most business transactions. For example,
a purchasing agent of a company develops personal relationship with the sales representative
who sells supplies to the company. They may address one another on first name basis, have
lunch together, and talk often on the phone. A company's best customers may be well-known to
people in the production department as it helps to ensure that the company's products fit the
customer needs.
Because business is composed of these human transactions, it should not be surprising that face-
to-face ethical dilemmas arise often.
It is likely that the quality assurance man overlooks a minor defect and approves a lot delivered
by a supplier because of the personal relationship that the two enjoy. It is also not unlikely that a
supervisor over-rates the performance of an employee because of the similar relationship that
exists between the two.
2. Corporate policy Ethics
Companies are often faced with ethical dilemmas that affect their operations across all
departments and divisions. Following conflicting situations are typical:
i) Your R&D department has modernized one of your products. It is not really 'new and
improved'. But you know printing these statements on the package and using it in
advertisement will increase its sales. What would you do?
ii) You are interviewing a former product manager who just left a competitor's company.
You are thinking of hiring him. He would be more than happy to tell you the competitor's
plans for the coming years. What would you do?
iii) You have a chance to win a big account that will mean a lot to you and your company
assistant recommends sending a colour television set to his home. What would you do?
iv) You produce an anti-dandruff shampoo that is effective with one application. The
purchasing agent hinted that he would be influenced by a gift. Your assistant says that the
product would turn over faster if the instructions on the label recommended two
applications. What would you do?
v) You work for a cigarette company and till now you have not been convinced that
smoking cigarettes causes cancer. A recent report has come across your desk that clearly
establishes the connection between smoking and cancer. What would you do?

vi) consequences of employment contraction in labour intensive basic industries because of

the improved methods of production. Modern technology has replaced older methods of
production which has in turn resulted in hundreds being rendered jobless. The issue
therefore is—global economic competitiveness or local social-psychological stability?

vii) The ethical burden of deciding corporate policy matters normally rests upon a company's
HR management. The HR managers and directors are responsible for making policies and
implementing them too. The ethical content of their policies can have enormous impact
throughout the company. It can set an ethical tone and send right signals to all employees
as well as external stakeholders.
3. Functional-area Ethics
Functional areas of a business are likely to confront ethical issues.
Accounting - Accounting statements reveal to the manager and owners the financial soundness
of a company. Managers, investors, regulating agencies, tax collectors, and trade unions rely on
accounting data to make decisions.
Honesty, integrity and accuracy are absolute requirements of the accounting functions.
Professional accounting organizations have evolved generally accepted accounting standards
(GAAPs) whose purpose is to establish uniform standards for reporting accounting data. When
they are followed, these standards ensure a high level of honest and ethical accounting
disclosures. Rarely are they followed in factories.

Purchasing - Ethical dilemmas arising from strong pressures to obtain the lowest possible prices
from suppliers and where suppliers too feel a similar need to bag lucrative contracts. Bribes,
kickbacks, and discriminatory pricing are temptations to both the parties.

Marketing - ethical dilemmas arising from relation between the ad agencies and their clients
affects Pricing, promotions, advertising, product information, and marketing research findings.

ICT -Modern sophisticated communication technology which is grossly abused or misused to

realize one's ambitions.

COMMON ETHICAL ISSUES AND MITIGATION S

1.HR Ethical Issues

Ethical issues abound in HR activities. Areas of ethical misconduct in the HR functions include
the following
Cash and Incentive Plans
Base Salaries: The HR function is often presumed to justify a higher level of base salaries, or a
higher percentage increase than what competitive practice calls for. In some cases, pressure is
exerted to reevaluate the position to a higher grade for the purpose of justifying a larger-than-
normal increase.
Annual Incentive Plans : The HR manager is often forced to design and administer top-
management incentive plans, at higher rates than what the individuals deserve. A common
rationale presented to the HR executive for bending the rules is the fear of losing the outstanding
executives, if higher incentives are not paid.
Long-term Incentive Plans: Just as with annual incentive plan, many HR executives have the
responsibility of designing and administering the firm's long-term incentive plans, but in
consultation with the CEO and an external consultant. Ethical issues arise when the HR
executive is put to pressure to favour top management interests over those of other employees
and investors.
Executive Perquisites: Executive perquisites make the ethical stand of the HR executive difficult
because their cost is often out-of-proportion to the value added. The responsibility of
administrating these programs falls on the HR executives who must live with the excesses that
often are practiced.
Performance Appraisal
Performance appraisal lends itself to ethical issues. Assessment of an individual's performance is
based on observation and judgment. HR managers are expected to observe the performance (or
understand the potentials) in order to judge its effectiveness. Yet, some HR managers assign
performance rating based on unrelated factors
for examples,
 The employee is not loyal to the rator, or
 The ratee belongs to a different community or religion.
 Pressure to reduce cost of recognition awards or promotion after the appraisal
 Similarity factor
 Stereotyping
Ways to improve effective rating
a) Use standardized rating instruments
b) Train the appraisers/raters
c) Use multiple raters
d) Use 3600 appraisal method

Discrimination based on Race, Gender, Age and Disability

Globally, the practice of treatment of employees according to their race, ethnic origin, sex, or
disability have largely been stopped.
A framework of laws and regulations has evolved that has significantly improved workplace
behaviour.

Job Discrimination
Job discrimination refers to making adverse decisions against employees or job applicants
based on their membership in a certain group.

Three tests decide whether a decision is discriminatory or not:

(i) Decision is based on the group membership and not on individual merit,
(ii) Decision is the result of prejudice, or false stereotype, and
(iii) Decision somehow harms those it is aimed at.

The role of HR function regarding discrimination

1. Monitor the principles and norms of the enterprise to ensure that they reflect the values of
the society as expressed in its laws.
2. Monitor the selection, reward, development, and appraisal systems to ensure that they are
consistent with the principles and norms of the society and company goals
3. Vigorously pursue cases of discrimination and sanction it.
4. Have policies that openly dissuade employees and managers to discriminate each other
5. Ensure open and safe reporting systems
 6. Affirmative actions - Hiring a minimum number of people belonging to disadvantaged
sections,
7. equal pay for equal work.

1. Sexual Harassment
According to the U.S. Equal Employment Opportunity Commission (EEOC - 2018), there were
more than 7,600 allegations of sexual harassment made. The resulting monetary benefits for
those plaintiffs were in excess of $56.6 million – an indication of the validity of those claims.
Further, 54% of women report having experienced unwanted sexual advances in the workplace
and 23% said that the instance of sexual harassment actually involved a superior.
Mitigations
 employee training
 enforcing a zero-tolerance policy for sexual harassment eg sanctions
 Business leaders to set enviable examples
 provide employees with a safe and discrete avenue for reporting cases of harassment
 Establish standing committee on sexual harassment
 employees sign agreements code of conducts
2. Diversity & Discrimination
Discrimination in the workplace is essentially any aspect about the job itself or the duties related
to it which are treated differently with respect to any of the categories listed below. Ensuring
diversity and actively preventing discrimination are critical aspects of resolving ethical dilemmas
in business.
The Equal Employment Opportunity Commission (EEOC ) , USA, lists the following types of
discrimination:
a) Age
b) Disability
c) Equal Pay/Compensation
d) Genetic Information
e) Harassment
f) National Origin
g) Pregnancy
h) Race/Color
i) Religion
j) Retaliation
k) Sex
-61% of American employees report having witnessed or experienced discrimination based on
any one of the above
Mitigation

1. educate employees – this prevents the occurrence.

2. Have rules and regulation – including disciplinary action when needed
3. hire people with different characteristics and backgrounds - this brings in a variety of
perspectives into the workplace
4. open and flexible policies - that allows different orientations regardless of their personal
characteristics or circumstances.
3. Social Media
One of the more current ethical issues in business is the question of employees’ personal
behavior on social media outside of work hours.
This is a gray area of situations that may or may not make it ethically justifiable to fire an
employee for their social media conduct.
Examples
a) Is it right to punish employees for certain types of social media posts?
b) Are you obligated to keep an employee who holds distasteful views and expresses them
online?
c) Should you fill the role of a mediator if employees get into a disagreement with each
other on social media?
Bottom line - employee can be justifiably fired if the activity is deemed disloyal or financially
harmful to the company.
Mitigation
 set of rules and policies - outlining what is acceptable or not
 training sessions and periodic company-wide reminders via email
 instance of severe misconduct on social media – sanction needed
4. Health & Safety
-In 2018, the U.S. Bureau of Labor Statistics reported 5,250 fatal injuries, the causes of which
included injuries by animals to falls/slips/trips to transportation incidents etc. The most fatal
injuries are transportation (1,379 fatalities) and construction (1,008 fatalities).
psychological well-being is a core component of creating a safe and healthy workspace.
Approximately 63% of the U.S. population is part of the labor force and roughly 71% of adult
Americans report at least one symptom of stress (like headaches or anxiety).
-Several incidences of crumbling building construction in Kenya cause fatalities
Mitigation
The World Health Organization fundamental advice on how to promote safety and health in the
workplace:
a) Regularly inspect workplace for any potential hazards
b) Train employees on safety protocols
c) Promote healthy living - eg provide amenities like kitchen, health clubs
d) Industrial counselling - Inform employees that help is available
e) Recognize and reward hard work
f) Create opportunities for employees to grow
g) Hold periodic meetings with employees to understand their needs

5. Environmental Responsibility
-Every business owner is responsible for clean environment. Includes air quality, water
cleanliness, the safety of endangered species, the use & conservation of natural resources, etc
Compliance with regulatory requirement are vital eg NEMA in kenya
Mitigation
a) Assess environmental areas to improve
b) Choose the ways to go green
c) Define the goals for your environmental management systems (EMS)
d) Create an EMS team to implement and oversee changes
e) Consider CSR activity on environment as a larger good for the society
f) Going paperless to save trees
g) using renewable energy eg solar power
6. Accounting Practices
Key issues include
 manipulating a business’s financial data to make the company look more successful
 taking and giving bribes for contracts
 evading taxation
 exaggerating project cost
mitigation
 personality check – at recruitment and selection
 use accounting software to minimize human manipulations
 have sound financial policies and regulation
 sanction offenders
7. Data Privacy
The issues may arise regarding employees` conduct with company computers, smartphones, and
tablets, accessing personal data of employees by unauthorized person, sharing employee persaol
data with outside firms, etc
Mitigation
 develop business cybersecurity plan
 Continuous education and awareness on data privacy
 monitor employees’ behavior on company devices
examples from USA
 66% of businesses monitor Internet connections
 45% track content, keystrokes, and time at keyboard
 43% save and review files on your computer
 10% monitor social media

8. Nepotism
Nepotism, is a form of favoritism (lacks merits) for family members or close friends.
Mitigation
 Develop conflict of interest policy
 Establish conflict of interest registers
 Make decision making open and verifiable by stakeholders

9. Theft
According to a survey by Finance Online, 39% of businesses have experienced more than one
case of employee theft. Employee theft includes violating some other ethical issues, like stealing
time.
Mitigations
 Strengthen recruitment and selection process
 Establish and enforce integrity code of conducts in the organization

Characteristics Of Highly Ethical Organizations

1) most ethical organizations develop four abilities in their employees viz,
 moral awareness,
 moral courage,
 moral reasoning
 moral effectiveness.
2) Strong Values Statement - A values statement is a short, concise encapsulation of what
the organization stands for, the values that its employees are expected to embody and
 what its products/services are intended to contribute to the world. In the most ethical
organizations, these statements become deeply ingrained principles that serve as
guideposts for employee and organizational decisions and actions.
3) Well-Crafted Code of Conduct - A code of conduct is a written set of principles that
works in tandem with the values statement to serve as an ethical roadmap for the
organization. The best codes of conduct are comprehensive and well-organized
documents written in plain understandable language. It is important to review the ethical
standards at periodic intervals to ensure they continue to meet the organization’s needs
and to gain a fresh perspective on the overall effectiveness of all ethics initiatives
4) Executive Leading by Example Model - It is often said that ethics starts at the top. Top
management must demonstrate unequivocal commitment to up holding integrity
5) Comprehensive Ongoing Ethics Training – Continuous training is essential for firmly
embedding ethics into the culture. The training should encompass a thorough review of
the code of conduct and the organization’s specific ethics policies and procedures. It
should also include case studies and real-world scenarios that enlighten employees about
values-driven decisions relative to their specific job functions.
6) Integration of Values into Work Processes - All work process of the organization to
include values components. Incorporate ethics/values component into the employee
performance evaluation process with a focus on how workers have applied ethics to their
decision-making processes.
7) Establishment of a Confidential Reporting Mechanism - A hotline is extremely
effective tool for stopping misbehavior in the early stages, before it can escalate into a
major issue.
8) Transparent Investigative Process for Ethics Violations - The administration of fair,
just disciplinary action is critical. Providing protection for whistleblowers against
retaliation is also essential component of the investigative process
9) Effective Ethics Governance - Best practices stipulate the appointment of a dedicated
corporate ethics and compliance officer (CECO), a senior executive who oversees the
ethics function and plays a key role in establishing the organization’s ethical compass.
This individual should be given wide latitude to develop and implement ethics policies
and procedures. Creating an ethics committee that reports to the board of directors is
another effective corporate governance step.
10) Unwavering Focus on Constant Improvement - organization should not be satisfied
with the status quo in terms of ethics, especially when no significant breaches have
occurred over an extended period of time

Guidelines For Managing Ethics In Workplaces,

According to National Business Ethics Survey of the U.S. Workforce (2017) statistics,
 More than 40 percent of workers said they had observed on-the-job misconduct that
violated their employers’ standards or rules.
 Of those who witnessed misconduct, 63 percent reported what they saw.
 Of those who reported misconduct, 21 percent said they experienced some form of
retaliation.
  Sixty percent of misconduct involved someone with managerial authority. Roughly a
quarter of observed misconduct involved senior managers.

Managerial roles
1) Be a Role Model - Employees look at top managers to understand what behavior is
acceptable. Senior management sets the tone for ethics in the workplace. Managers
should remember that a code of ethics is worthless if leaders fail to model ethical
behaviors.
2) Communicate Ethical Expectations - An organizational code of ethics can reduce
ethical ambiguities. The code of ethics should state the organization’s primary values and
the ethical rules that employees are expected to follow.
3) Offer Ethics Training - Managers should set up seminars, workshops and similar
programs to promote ethics in the workplace. Training sessions reinforce the
organization’s standards of conduct, to clarify what practices are and are not permissible,
and to address possible ethical dilemmas.

4) Visibly Reward Ethical Acts and Punish Unethical Ones - Performance appraisals of
managers should include evaluations of how actions measure up against the
organization’s code of ethics. Appraisals need to include how managers achieve these
goals, as well as the goals themselves.

5) Provide Protective Mechanisms - The organization needs to provide formal

mechanisms that allow employees to discuss ethical dilemmas and report unethical
behavior without fear of reprimand. This could include developing roles for ethical
counselors, ombudsmen or ethical officers.

6) Group decision making - Make ethics decisions in groups, and make decisions public,
as appropriate. This usually produces better quality decisions by including diverse
interests and perspectives, and increases the credibility of the decision process and
outcome by reducing suspicion of unfair bias.
7) Integrate ethics management with other management practices - When developing
the values statement during strategic planning, include ethical values preferred in the
workplace. When developing personnel policies, reflect on what ethical values is most
prominent in the organization’s culture and then design policies to produce these
behaviors.