The Arguments for and Against Mandatory System of Corporate Governance Essay

Introduction

Corporate governance refers to “a set of systems, principles and processes by which business entities are directed and controlled” (Angur 2009, pp. 66-70). These systems are essentially guidelines which define the best management practices that can facilitate value addition in a business organization. A company that is managed through effective corporate governance systems is often beneficial to all stakeholders. Concisely, it is able to achieve the objectives of the shareholders, employees, customers and the general public (Angur 2009, pp. 66-70). Corporate governance is an integral aspect of the contemporary business environment due to its ability to foster public confidence in a company. In a nutshell, it helps in minimizing malpractices such as fraud, insider trading and mismanagement of funds. Corporate governance is often implemented through industry regulations, market mechanisms and self-regulation initiatives (Angur 2009, pp. 66-70). Consequently, adopting these regulations can be mandatory of voluntary. This paper highlights the arguments for and against mandatory rather than voluntary systems of corporate governance.

Arguments for Mandatory Corporate Governance Systems

Mandatory corporate governance systems are used when the government or the industry regulator sets rules that must be followed by all companies (Alnasser 2012, pp. 269-276). The rules provide guidelines for executing functions such as financial reporting, corporate social responsibility and auditing among others. The application of mandatory corporate governance systems is justified by the following arguments. First, mandatory systems are used to protect investors’ interests. In most public companies, there is a clear separation of responsibilities between the shareholders and the management. The managers are responsible for investing the shareholders’ capital. However, the shareholders lack the capacity to influence managers to take actions that serve their (shareholders’) interests. Besides, most investors lack management skills and information about the market. Consequently, mandatory rules help in ensuring that the decisions taken by the management serves the interest of the shareholders. Investor protection helps in reducing the cost of raising capital through the stock market (Bose 2009, pp. 94-111). In this regard, bond issuers can reduce the cost of accessing capital by entering into contracts that ensures greater protection to investors. This benefits the investors and the bond issuers, thereby increasing the value of the firm.

Second, mandatory corporate governance systems help in reducing uncertainty (Eldomiaty & Choi 2006, pp. 281-295). In a voluntary system of corporate governance, companies are under no obligation to follow all governance regulations. Consequently, different companies will be managed under different sets of regulations or rules. These differences often create high uncertainty in the industry. In this context, uncertainty can exist in the application or interpretation of certain corporate laws. It is apparent that uncertainty discourages investments and often leads to poor financial performance. Uncertainty can be avoided by consistently applying mandatory corporate governance systems across the industry. Third, mandatory systems encourage companies to disclose financial information which influence the performance of stock markets (Eldomiaty & Choi 2006, pp. 281-295). The performance of capital markets depends on the availability of information about the companies whose stocks are being traded. Generally, an increase in availability of information improves the performance of the stock market. In this context, mandatory disclosures enhance rapid growth in capital markets.

Fourth, the problem of collective action can be solved effectively through mandatory corporate governance systems. In a company where ownership is concentrated, investors can easily access information about their business without requiring a mandatory disclosure system (Eldomiaty & Choi 2006, pp. 281-295). However, the problem of collective action is often encountered in companies where ownership is dispersed. In such cases, a mandatory disclosure system will be required to enable investors to access information about the company. Fifth, mandatory systems of corporate governance enable firms to be more responsible (Sven & Cleyn 2011, pp. 2-14). This premise is based on the fact that mandatory regulations force companies to engage in ethical behavior. For instance, the board of directors is likely to supervise the management more closely in industries where mandatory disclosures are used. Additionally, the companies will be more likely to focus on sustainability, as well as, staff training and development.

Finally, corporate scandals can be minimized through mandatory corporate governance systems. Empirical studies indicate that companies often adopt corporate governance standards voluntarily only if there are benefits to be enjoyed. Most companies often adopt domestic and international governance standards in order to access capital. Moreover, voluntary adoption of governance standards is determined by the firm’s ownership structure (Bose 2009, pp. 94-111). Generally, firms with a dominant shareholder (strategic investor) are less likely to voluntarily adopt corporate governance standards as compared to public companies. Consequently, voluntary corporate governance systems will fail in situations whereby the firms have growth opportunities or easy access to capital. Firms will focus on reducing costs by avoiding the implementation of expensive governance systems. Hence, managers will deviate from the existing governance standards and engage in malpractices such as fraud.

Arguments against Mandatory Corporate Governance Systems

Mandatory corporate governance systems are often criticized due to the following reasons. First, mandatory regulations often prevent firms and investors from customizing the environment in which they operate (Bose 2009, pp. 94-111). It is apparent that different firms or investors have varying preferences and investment needs. Thus, corporate governance systems that are beneficial to a given firm might be undesirable to other firms. In this regard, a rigid disclosure or regulatory framework can hurt some firms in the industry by limiting their capacity to invest. Second, mandatory regulation is one of the major factors that impede improvements in corporate governance structures. In a voluntary corporate governance system, firms and investors have the incentive to adopt the governance structures which are most suitable to their needs. Consequently, the firms are able to provide investors with the assurance and protection that encourages investments.

Third, most mandatory governance systems focus on periodic disclosures such as annual financial reports. Periodic disclosures are often characterized by time lags which reduce the significance of the information contained in them (Bose 2009, pp. 94-111). For instance, annual financial reports are often released to the public, at least, three months after their preparation. Thus, they do not provide current information about the company’s financial position.

Fourth, poor enforcement always impedes effective application of mandatory governance systems. Enforcement of industry regulations is often difficult due to high monitoring costs, information asymmetry and lack of technical capabilities (Alnasser 2012, pp. 269-276). For instance, monitoring insider trading can be difficult due to inadequacy of information about the transactions that fund managers engage in. Besides, the process of reprimanding insider trading offenders often involves expensive and complicated litigations. In some cases, the problem of ‘regulator capture’ prevents the use of mandatory regulation. This problem occurs when some firms influence the regulator to enforce laws in a biased manner. In this regard, the regulator tends to favor dominant firms at the expense of new entrants due to corruption.

Finally, complying with mandatory governance standards is often expensive to most firms. The cost of generating the information that has to be disclosed to the regulator is always high (Alnasser 2012, pp. 269-276). For instance, the annual financial reports of listed companies must be audited by an independent auditor. Thus, listed companies spend a lot of financial resources to process information that is already available in their finance and accounting departments. The funds that are used to pay external auditors can be invested in other programs such as staff training.

Conclusion

Corporate governance systems are used to enhance confidence in public and private companies. They facilitate achievement of the goals and objectives of the company’s stakeholders (Alnasser 2012, pp. 269-276). Corporate governance systems can be adopted voluntarily or through mandatory regulations. The main strengths of mandatory corporate governance systems include effective investor protection and reduction of uncertainty. They can also help in reducing the occurrence of corporate malpractices such as fraud and insider trading. Mandatory corporate governance systems are often criticized due to their weaknesses. The most common weaknesses include poor enforcement and high cost of implementation. It also limits the ability of firms to adopt corporate governance structures that meet their needs. Due to these weaknesses, mandatory corporate governance systems should be used in conjunction with voluntary systems in order to achieve the best outcomes.

References

Alnasser, S 2012, ‘What has Changed? The Development of Corporate Governance in Malaysia’, Journal of Risk Finance, vol. 13 no. 3, pp. 269-276.

Angur, M 2009, ‘Are we Ignoring the Early Warning Signs in Our Corporate Governance Systems? Journal of Indian Business Research, vol. 1 no. 1, pp. 66-70.

Bose, I 2009, ‘Corporate Governance and Law: Role of Independent Directors’, Social Responsibility Journal, vol. 5 no. 1, pp. 94-111.

Eldomiaty, T & Choi, C 2006, ‘Corporate Governance and Strategic Transparency: East Asia in the International Business Systems’, Corporate Governance, vol. 6 no. 3, pp. 281-295.

Sven, H & Cleyn D 2011, ‘Compliance of Companies with Corporate Governance Codes: Case Study on Listed Belgian SMEs’, Journal of Business Systems, Governance and Ethics, vol. 3 no. 1, pp. 2-14.