good corporate governance - lkdi. · pdf filegood corporate governance was 24% in 2000 and 22%...

Konsep, Prinsip dan Praktik

GOOD CORPORATEGOVERNANCE


Disusun oleh:

Etty Retno Wulandari, PhD.

Disusun oleh:


Concept, Principles, and Practice


Prepared by:


TABLE OF CONTENTS

MESSAGE FROM CHAIRMAN LKDI

PROFILE OF LKDI

CHAPTER I. INTRODUCTION

A. Background

B. Definitions of Corporate Governance

C. The need for Good Corporate Governance

D. The Objective of Implementing Good Corporate

Governance

E. Summary

F. Questions

CHAPTER II. THEORY AND CONCEPT OF CORPORATE

GOVERNANCE

A. Theory of Firm

B. Concept of Corporate Governance: Shareholders'

Perspective

C. Concept of Corporate Governance: Stakeholders'

Perspective

D. Summary

E. Questions

CHAPTER III. CORPORATE GOVERNANCE ARRANGEMENTS

A .Firm-specific governance arrangements

B. Country-specific governance arrangements

C. Market governance arrangements

D. Interaction between Corporate Governance

Arrangements

E. Summary

F. Questions

TABLE OF CONTENTS

1GOOD CORPORATE GOVERNANCEKonsep, Prinsip dan Praktik

1

2

3

8

14

22

CHAPTER IV. PRINCIPLES OF GOOD CORPORATE

GOVERNANCE

A. The OECD Principles of Corporate Governance

B. The Indonesian Code of Good Corporate

Governance

C. Codes of Good Corporate Governance for Specific

Industries

D. Summary

E. Questions

CHAPTER V. IMPLEMENTATION OF GOOD CORPORATE

GOVERNANCE

A. Approaches to Implementing the Principles of

Good

B. Corporate Governance

C. Development of Corporate Governance in the

World

D. Development of Corporate Governance in

Indonesia

E. Practice of Corporate Governance in Indonesia

F. Summary

G. Questions

CASE STUDIES

PT MedcoEnergi Tbk.

PT Sari Husada Tbk.

REFERENCES


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58

63

47

Lembaga Komisaris dan Direktur Indonesia LKDI (Indonesian Institute for

Commissioners and Directors) was establish in 2001. LKDI was aimed to enchance

competent, knowledge and integrity for Commissioners and Directors on

implementation Good Corporate Governance (GCG). At the beginning on 2005, LKDI

intesivelly held a "Training and Directorship Certification for Commissioners and

Directors". Beside that, LKDI helding Continous Professional Education program for

Commissioners and Directors to emphasize fundamental and modern through GCG

practices in National and International level.

To enchance quality "Training and Directorship Certification for Commissioners and

Directors" program, LKDI supported by Center for International Private Enterprises

(CIPE) from US publishing a module. This support its part of cooperation with LKDI

to implementation a program with theme "Strengthening Corporate Governance in

Indonesia".

This module is a reference for facilitator and LKDI member training program. The

curriculum of the training is a brenchmarked to establishment of directorship

organization such as UK Institute of Directors, Australian Institute of Company

Directors, dan Singapore Institute of Directors.

The First step, LKDI was publishing 5 (five) module, the module are: "GCG Concepts,

Principles and Practices", "Boards' Duties, Liabilities and Responsibilities",

"Enterprise Risk Management", "Corporate Social Responsibility", dan "High Quality

Corporate Reporting". The writers this module from senior academy which joined

together Academic Network Indonesia on Governance (ANIG) was established under

National Committee Corporate Governance.

Finally, LKDI would say thank you for CIPE, KNKG, and ANIG for support established

this training module. Hopelly our relationship will continue for strengthening GCG

program in Indonesia.

Best Wishes

Hoesein Wiriadinata

Chairman

MESSAGE FROM CHAIRMAN LKDI


Directors and Commissioners have a strategic roles in the successful implementation

of good corporate governance. The crisis of 1997 brought valuable lessons for

Indonesia as it has shown beyond any reasonable doubt the fragility of economic

structure and prevalence of irregular corporate practices. However it is very

encouraging that many companies have taken the initiative to reform themselves

toward better governance.

To ensure business sustainability and to cope with international governance

challege, it is important that Directors and Commissioners are competent and

empowered in order to effectively complete their responsibility. Based on that

comprehension Lembaga Komisaris dan Direktur Indonesia LKDI (Indonesian

Institute for Commissioners and Directors) was established by the National

Committee of Corporate Governance in 2000. It was founded by notarial act of Notary

Imas Fatimah, SH No. on July 6, 2001.

LKDI was aimed to enchance the quality of members who become the avant garde of

corporate governance practices by providing networking opportunities and continous

professional education programs.

Founder : National Committee of Corporate Governance

Advisory Board : Mar'ie Muhammad

Amrin Siregar

I Nyoman Tjager

Gunarni Soeworo

Mas Achmad Daniri

Kartini Muljadi

Ratnawati Prasodjo

Executive Board : Hoesein Wiriadinata (Chairman)

Eva Riyanti Hutapea (Vice Chairperson)

Fachry Aly

Fred B.G.Tumbuan

Jos F. Luhukay

Partomuan Pohan

Irwan M. Habsjah

Adi Rahman Adiwoso

THE PROFILE OF LKDI


A. BACKGROUND

The importance of corporate governance for the success of a company and the

well-being of society is widely recognized. The fall of giant corporations in the

United States of America (USA) as a result of weaknesses in corporate

governance highlights the need to improve and reform corporate governance at

the international level.

Growing awareness of corporate governance in Indonesia came with the

economic crisis of 1997-1998. There is widespread belief that one of the main

reasons for the crisis was the poor governance practices of Indonesian

companies. ADB (2001) research in five Asian countries, including Indonesia,

which went through economy crises, reveals that poor corporate governance

create economic instability that eventually led to the economic crisis in 1997.

Furthermore, it showed that concentrated share ownership structure,

emerging capital markets and weak legal structures were among the factors

contributing to poor corporate governance in those countries. In addition, lack

of management accountability, low level of transparency, and the prevalence of

collusion, corruption, and nepotism are a reflection of weak governance

practices in both the public and private sectors (Husnan, 2001).

Other surveys conducted by international institutions also show that

corporate governance in Indonesia has not promoted optimal performance.

McKinsey's surveys of investors in 2002 and 2000 reveal that corporate

governance is an important factor in the investment decisions of international

institutional investors. Some investors are even willing to pay premium for

companies that are perceived to have good corporate governance. For

Indonesia, investors were willing to pay a premium of 27% in 2000 and 25% in

2002. While these figures suggest an improvement in investor perception of

corporate governance in Indonesia, they compare poorly with those for other

Asian countries. There, the average premium investors were willing to pay for

good corporate governance was 24% in 2000 and 22% in 2002

In response to this situation, the Indonesian government formed the National

Committee on Corporate Governance Policy (NCCGP) on August 19, 1998 by

CHAPTER I INTRODUCING

8 GOOD CORPORATE GOVERNANCE Konsep, Prinsip dan Praktik

Decree of the Coordinating Minister for the Economy No. Kep-

10/M.EKUIN/08/1999. The function of the NCCGP is to formulate, design,

and recommend national policy pertaining to corporate governance, and this

includes preparing a code of good corporate governance. NCCGP consists of 22

members from the public and private sectors.

These measures notwithstanding, poor corporate governance in Indonesia

raises questions about the management of Indonesian companies. To get a

better understanding of the situation, this module will discuss in detail the

theory and concept of corporate governance, and the mechanisms, principles

and practice of corporate governance.

B. DEFINITION OF CORPORATE GOVERNANCE

Many institutions and scholars have attempted to define corporate

governance. Following are definitions that have been widely used and cited in

discussions and papers.

The Organization for Economic Cooperation and Development (OECD) is an

international organization that actively supports implementation and

improvement in corporate governance around the globe. OECD defines

corporate governance as follows (quoted in Sutojo and Aldridge, 2005):

"Corporate governance is the system by which business corporations are

directed and controlled. The corporate governance structure specifies the

distribution of rights and responsibilities among different participants in the

corporation, such as the board, the managers, shareholders and other

stakeholders, and spells out the rules and procedures for making decisions on

corporate affairs. By doing this, it also provides the structure through which

the company objectives are set, and the means of attaining those objectives

and monitoring performance.”

The Asian Development Bank (ADB), as an organization that promotes

economic growth in Asia, also pays significant attention to corporate

governance. In its report of an assessment of the implementation of corporate

governance in five Asian countries, ADB (2001) defines corporate governance

as follows:

"A corporate governance system consists of (i) a set of rules that define the


relationships between shareholders, managers, creditors, the government and

other stakeholders (i.e., their respective rights and responsibilities) and (ii) a

set of mechanisms that help directly or indirectly to enforce these rules"(p.5).

British scholars Jill and Aris Solomon in their book "Corporate Governance

and Accountability" (2004) define corporate governance as follows:

"Corporate governance is the system of checks and balances, both internal and

external to companies, which ensures that companies discharge their

accountability to all their stakeholders and act in a socially responsible way in

all areas of their business activity."

Taking a different perspective, Shleifer and Vishny (1997) argue that:

"Corporate governance deals with the ways in which suppliers of finance to

corporations assure themselves of getting a return on their investment".

While corporate governance as defined by OECD, ADB, and Solomon and

Solomon focuses on relations between all the company's stakeholders, such as

managers, creditors, government, and shareholders, Shleifer and Vishny's

definition of corporate governance emphasises the relationship between

management and investors. Thus, the definition proposed by Shleifer and

Vishny focuses on and highlights the accountability of company management

to its shareholders. The definitions proposed by OECD, ADB, and Solomon and

Solomon are broader in nature and advocate accountability not only to

shareholders but to a wider group of stakeholders.

While recognising the differences in the definitions of corporate governance

mentioned above, in the broad sense, corporate governance is a system that

guides and controls the running of the company.

C. THE NEED FOR GOOD CORPORATE GOVERNANCE

Many reasons have been proposed to explain why companies should

implement the principles of good corporate governance. However, one of the

main reasons frequently cited is that corporate governance principles are

needed to overcome problems encountered in managing the company. Policy

makers, practitioners, and academicians believe that improvement in

corporate governance is vital. This can be done through formation of audit

committees, stronger relation with investors, and performance-based

remuneration, etc.


Others, however, debate the effectiveness of improvement in corporate

governance. Managers are reluctant to adopt policy to improve public

disclosure, and refuse to communicate company strategy and policy to their

main investors. There is a perception that the existence of independent

commissioners and implementation of other corporate governance

arrangements will impede decision-making processes and increase

bureaucratic procedures in the company. Having more procedures, they

argue, ultimately stifles creativity and innovation. Furthermore, the company

has to incur the additional cost of implementing corporate governance

arrangements. This argument should not be taken lightly. There should be a

balance between improvement in accountability and transparency and

improvement in the company's operating performance.

There is growing awareness in financial markets of the importance of good

corporate governance for larger firms. Solomon and Solomon (2004) found

that corporate governance is important for companies, regardless of their size.

Furthermore, institutional investors assume that improvement in corporate

governance tends to improve performance and to not hinder corporate growth

(Solomon and Solomon, 2004). This is a key factor for companies to consider if

they want continued funding from investors.

D. THE OBJECTIVES OF IMPLEMENTING GOOD CORPORATE

GOVERNANCE

Implementation of good corporate governance has numerous objectives.

Following are several of the objectives that can be achieved by implementing

good corporate governance.

Implementation of corporate governance arrangements could be expected to

mitigate difficulties arising from agency problems. This, in turn, will create a

secure and supportive environment, assuring all shareholders and other

investors that their rights are acknowledged and protected. Management,

blockholders and majority shareholders are expected to act in the best interest

of all shareholders and not to exploit the fact that investors lack information.

Trust between the owners and management of a company that is based on

good corporate governance mechanisms could be expected to promote

performance improvement. This, in turn, could benefit both the owners and

management of a company.


Awareness of good corporate governance practices also promotes

transparency. Investors will appreciate fully disclosure of information that

could help them evaluate the company's performance as well as its future

prospects. Even though little attention was paid to the role of shareholders in

the past, growing awareness of good corporate governance make companies

realise the importance of shareholders value in achieving their long-term goals.

Implementation of good corporate governance can also prevent bad practices

such as insider trading, internal acquisitions and insider transactions that

may be detrimental to minority shareholders. In addition, with full information

disclosure, implementation of good corporate governance can create a

favourable competitive environment. Therefore, if all Indonesian companies

implemented good corporate governance arrangements, an overall

improvement in the performance of these companies could be expected. This,

ultimately, will affect investors' perceptions regarding investment in Indonesia

as well as on the amount of premium they are willing to pay for a company that

implements good corporate governance.

E. SUMMARY

This chapter discussed some of the factors in support of good corporate

governance. For instance, implementation of good corporate governance will

affect the value that investors are willing to pay for company shares. Narrow

and broad definitions of corporate governance are discussed, emphasizing the

accountability of company management to all stakeholders. Decisions to

improve corporate governance should take into consideration the cost of

making these improvements. Despite debate as to its effectiveness,

implementation of good corporate governance could prevent bad practices in

corporate management that may lead to improved performance.

D. QUESTIONS

1. Some people believe that poor corporate governance was one of the main

contributors to the financial crisis in Indonesia. Do you agree with that

opinion? Why/why not?

2. Which of the definitions of corporate governance given in this chapter do

you prefer? Why?


3. Describe the factors that differentiate the ADB definition of corporate

governance from the definition proposed by Shleifer and Vishny.

4. In your opinion, why do some people believe that improvement in

corporate governance is not important?

5. Explain the main objectives of the implementation of good corporate

governance.


A. THE THEORY OF THE FIRM

There are as many concepts of corporate governance in economic literature as

there are definitions of 'firm' or 'business entity'. However, since the focus of

corporate governance is the 'corporation' or 'firm', we must first understand

the meaning of 'corporation'. The following paragraphs describe the three main

theories of the firm: neoclassical economic theory, transaction cost economic

theory or contracting theory and communitarian theory. In this chapter, these

theories are analyzed to help explain the corporate governance of modern

business entity.

A.1. Neoclassical Economic Theory

Neoclassical economics theory considers the firm a 'black box': a firm

operates to fulfil a certain condition whereby production planning varies

in accordance with input and output price (Jensen and Meckling, 1976;

Hart, 1995). This theory does not explain further how the firm's internal

mechanism works. Neoclassical theory assumes that a firm acts to

maximize an objective function of a few standard variables. However, there

are a number of groups within the firm that have different and conflicting

interests, and this theory does not explain the reason for these conflicts,

nor how these conflicts are brought into equilibrium (Jensen and Meckling,

1976; Woolf et al., 1985). In the real world, firms do not have complete and

certain information because markets are not perfect.

In addition, neoclassical theory focuses on the optimal design of an

organization at a certain point in time and does not consider a firm's

dynamic aspects, such as reorganization (Tirole, 1988). Reorganization is

generally characterized by stakeholder bargaining and the use of authority.

Neoclassical theory leaves many questions unanswered and as a result

alternative theories of the firm have been proposed to explain why firms

exist and how they function.


CHAPTER IITHEORY AND CONCEPT OF CORPORATE GOVERNANCE

A.2. Transaction Cost Economics or Contracting Theory

Transaction cost economics says that firms exist to minimize the costs of

trading in external markets (Coase, 1937). Coase argued that trading in

markets is costly, because there is a cost associated with using the price

mechanism and a cost associated with negotiating and concluding a

separate contract for each exchange transaction. These costs cannot be

eliminated, but can be lowered by establishing an organization within

which market transactions are replaced by a set of contracts that govern

transactions among the contracting parties. Furthermore, Coase adopted

a comparative institutional perspective in which firms and markets were

regarded as alternative modes for organizing transactions. Consequently,

he treated firms and markets as alternative modes of 'governance'.

Unlike neoclassical theory, issues of internal organization are important in

transaction cost economics. Hart and Moore (1990) provide a framework

for addressing the question of when transactions should be carried out

within a firm and when through the market by developing a theory of the

optimal assignment of assets to determine the boundaries of the firm. They

suggest that an agent who is crucial for the generation of surplus should

have ownership rights.

Alchian and Demsetz (1972) give greater operational content to

transaction cost economics. Explicitly, they stated the following:

" The essence of the classical firm is identified here as a contractual

structure with: 1) joint input production; 2) several input owners; 3) one

party who is common to all the contracts of the joint input; 4) who has right

to renegotiate any input's contract independently of contracts with other

input owners; 5) who holds the residual claim; and 6) who has the right to

sell his central contractual residual status." (p. 794)

Alchian and Demsetz viewed the firm as a nexus of contracts. Transaction

cost economics, from its contracting standpoint, further evolved into

agency theory and incomplete contracting theory.

A.2.1. Agency Theory

Agency theory states that the firm is a legal fiction that has important

role in the process of directing various individual objectives into

equilibrium within a contractual framework (Jensen and Meckling,


1976). Jensen and Meckling (1976) define an agency relationship as

follows:

"…an agency relationship is a contract under which one or more persons

(the principal(s)) engage another person (the agent) to perform some

service on their behalf which involves delegating some decision making

authority to the agent." (p.85)

Agency theory is based on the concept of separation of ownership and

management of the firm. Both the principal and agent are utility

maximisers; thus, they will act in their own best interest. According to

Jensen and Meckling (1976), the management as an agent of the owner

(principal) will not always act in the best interest of the principal. This

creates an agency problem. Furthermore, the agency problem creates

costs called agency costs. The agency costs are described as the sum of

the monitoring expenditures by the principal, the bonding expenditures

by the agent, and the residual loss (Jensen and Meckling, 1976).

Agency theory considers the essence of the firm as the contractual

relations with all parties, employees, creditors, customers, etc.

Therefore, Jensen and Meckling (1976) define the firm as follows:

"The private corporation or firm is simply one form of legal fiction which

serves as a nexus for contracting relationship and which is also

characterized by the existence of divisible residual claims on the assets

and cash flows of the organization which can generally be sold without

permission of the other contracting individuals."(p. 88)

Thus, according to agency theory, the firm is not an individual; rather it

is a legal fiction that serves as focus for a process in which the conflicting

objectives of individuals are brought into equilibrium within a

framework of contractual relations (Jensen and Meckling, 1976).

Agency theory is based on the notion of separation of ownership and

control. Fama (1980) suggests that the separation of security ownership

and control can be an efficient form of economic organization within the

"set of contracts" perspective. The firm is a set of contracts which

includes the way inputs are processed to create outputs and the way

receipts from outputs are shared among inputs. In this "nexus of

contracts" perspective, ownership of the firm is an irrelevant concept


and management function is to oversee the contracts among factors and

to ensure the viability of the firm.

A.2.2. Incomplete Contracting Theory

Transaction cost economics bases its premise on the contractual

relationship among individuals. These contracts are necessarily

incomplete. In practice, writing complete contracts is costly due to

uncertainty of events, and the cost of monitoring and enforcing the

contract (Hart, 1995a). The two contracting parties write ex ante

contracts specifying the process through which the amount of trade and

transfer are determined ex post. To ensure that the other party abides

by the contract, the first party has to incur monitoring costs.

Meanwhile, enforcing the contract may cause significant legal costs.

Since contracts contingent on future observable variables are too costly

or impossible to write, to avoid future hazards, parties should utilize the

authority structure or restricted contract (Tirole, 1988). The

incomplete-contracting view emphasises that firms and contracts are

different "governance modes" (Tirole, 1988). It considers the firm a

particular way of specifying what is to be done in the event of

contingencies not foreseen in a contract.

It can be inferred, then, that according to contracting theory, the firm is

a "nexus of contract" negotiated among self-interested parties without

separate entity status of its own. To align the interests of managers and

owners (stockholders), the contracting theory prefers to rely on

voluntary contract and market forces.

A.3. Communitarian Theory

According to communitarian theory, the firm is a "legal entity" with social,

political, historical and economic implications (Bradley, et al., 2000). This

means that the firm is an entity with rights and responsibilities of a natural

person with the capability to do both good and harm. Consequently, its

activities must be held accountable by legal rules and judicial reviews.

Communitarian theory emphasizes justice and cooperation among

members of society. This theory argues that legal rules and judicial review

are crucial to restrain the behaviour of managers. Without legal

constraints, there is a possibility that management will not be responsible

either to stockholders or to society. Communitarians care more about the


problem of negative externalities that occur when some stakeholders do

not have the opportunity to negotiate with the firm in the form of contracts.

Thus, this theory emphasizes that firms should be responsive to all

stakeholders. While contracting theory perceives law as a means of

ensuring ex ante freedom and efficiency of contracting, communitarian

theory views law as a vehicle to ensure distributive justice and equity from

the payoffs to contracts. Communitarian theory makes management

responsible to a wide set of stakeholders.

B. THE CONCEPT OF CORPORATE GOVERNANCE FROM THE

SHAREHOLDERS' PERSPECTIVE

The above suggests that neo-classical economics theory provides little

guidance for corporate governance within firms. Consequently, neo-classical

economics is excluded from further analysis of the concept of corporate

governance.

B.1. Agency Theory

Concerning governance of corporation, from the agency theory perspective,

Shleifer and Vishny (1997) argue that the managers have control of

running the firm, while investors provide the funds to finance the firm.

Corporate governance, in this regard, deals with the ways in which

investors can assure themselves of getting a return on their investment.

Jensen and Meckling (1976) argue that an agent does not always act in the

best interest of the principal, which then creates agency problems. In the

context of the corporation, the agency problem encountered by investors

(the principals) relates to the difficulty of ensuring that their funds are not

expropriated to unprofitable projects by the firm's managers (the agent). In

addition, investing in a firm is much more risky than investing in term

deposits. As the ultimate risk-bearer, investors (shareholders) bear the

risk that the firm may not have enough funds to provide dividends. As a

consequence, investors usually ask for additional returns on their

investments in the firm.

Agency problems arise from information asymmetry (Fama and Jensen,

1983). Managers as insiders of the firm have an information advantage

over the investors as outsiders. The managers can exploit this advantage

by manipulating information released to investors. This is known as an


adverse selection. Another type of information asymmetry is moral hazard.

Separation of ownership and control tempts managers to shirk on their

duties and blame others for decline in firm performance (Jensen and

Meckling, 1976).

Corporate governance could be employed to mitigate these problems.

Disclosure of accounting information can be used to mitigate the problem

of adverse selection. Greater financial accounting disclosure provides

investors with same information on which to base decisions as managers

have. Management opportunism resulting from moral hazard can be

reduced by performance-based incentive schemes for managers. In brief,

we can say that investors could expect corporate governance to help them

solve agency problems and ensure an appropriate return on their

investment. However, implementation of good corporate governance is not

without costs. Thus, to justify the cost of implementing corporate

governance, consideration should be given to corresponding improvement

in the firm's performance.

B.2. Incomplete Contracting Theory

Zingales (1998) examined corporate governance from the point of view of

incomplete contracts. He argues that corporate governance is "the

complex set of constraints that shape the ex-post bargaining over the

quasi rents generated by a firm." (p 4). In a world where some contracts

that are dependent on future observable variables are pricey to write ex-

ante, there is room for governance ex-post; otherwise all contracts are

resolved ex-ante. The main hurdles in the incomplete contracting theory

are the uncertainties that arise from an unforeseeable future and the high

cost of writing a complete contract. Corporate governance could reduce

the uncertainties of incomplete contracts and, at the same time, could also

minimize the transaction costs, in the form of contracting costs.

Zingales (1998) elaborates further the objectives of a corporate governance

system, specifically on how the system affects economic efficiency. The

objectives of the system are:

"1) to maximize the incentives for value enhancing investments, while

minimizing inefficient power seeking; 2) to minimize inefficiency in ex-post

bargaining; 3) to minimize any 'governance' risk and allocate the residual

risk to the least risk-averse parties" (p 10).


C. THE CONCEPT OF CORPORATE GOVERNANCE FROM THE

STAKEHOLDERS' PERSPECTIVE

According to the communitarian theory, corporate governance functions to

enhance public interest by reducing social (public) costs, which subsequently

increases the efficiency of society. Charreaux et al. (2001) and Desbrieres

(2001) argue that the problem of the efficiency of corporate governance systems

can be addressed only within a framework that extends to all stakeholders.

To facilitate economic analysis of corporate governance, Tirole (2001)

described "…corporate governance as the design of institutions that induce or

force management to internalize the welfare of stakeholders" (p. 4).

Communitarian theory focuses on the externalities imposed by profit

maximizing choices on other stakeholders besides shareholders, such as on

the welfare of employees who have invested their human capital, on suppliers

who have sunk investment in the relationship, and on communities who suffer

from the closing of the plant. Some of those stakeholders do not have a

contractual relationship with the firm.

Having learnt from the Asian financial crisis, the Asian Development Bank

(ADB) concluded that the issue of corporate governance is important not only

for protecting investors' interest, but also for reducing systematic market risk

and maintaining financial stability. This means that not only firm shareholders

need to be taken into account, but that creditors, employees, government, and

other stakeholders also have to be carefully considered by the firm.

Consequently, corporate governance focuses on stakeholders' needs.

Turnbull (2000) used this broader meaning of corporate governance to

describe all influences affecting the processes for selecting those who decide

how operational control is employed to produce goods and services. He argued

that this definition can be applied to all types of firms, whether established

under civil or common law, owned by a government, institution or individuals,

or privately owned or publicly traded.

D. SUMMARY

Several theories of the firm are discussed in this chapter. Those theories try to

explain why firms exist and why they are necessary. Further, it discusses the

concept of corporate governance from two different perspectives: the


shareholders' and stakeholders'. Each concept has its own arguments and

advocates. Detailed explanation of theories of the firm and the concept of

corporate governance are expected to enhance understanding of the

importance and function of corporate governance to improve corporate

performance.

E. QUESTIONS

1. Which theory, in your opinion, provides a better explanation of the concept

of the firm? Why?

2. Explain the difference between agency theory and incomplete contracting

theory of the firm?

Clarify why corporate governance is needed from the agency theory point

of view?

3. According to communitarian theory, whose interest is protected with the

implementation of corporate governance?

4. In your opinion, which theory, agency theory or communitarian theory,

better describes corporate governance in Indonesia?


Accounting, finance, law, and economics literature suggests that investors can

be assured of getting returns on their investment through various corporate

governance arrangements. These governance arrangements can be classified

into three types, firm-specific, country, and market governance arrangements.

This classification allows us to better understand the role of specific corporate

governance arrangements within a wider corporate setting.

Firm-specific governance mechanisms can be arranged and controlled by the

firm to achieve its goal of maximizing shareholders' value. Common firm-

specific arrangements are ownership structure, corporate financing, auditing,

the audit committee, the board of directors, and managerial compensation.

Country-based arrangements are external to the firms, and are under the

control of government and widely recognized institutions such as professional

institutions. The specific country-based corporate governance arrangements

reviewed here are the legal, cultural environments and professional

arrangements pertinent to corporate disclosure, accounting standards and

practices. Market governance arrangements are based on the level of capital

market development. Market arrangements are found in the market for

corporate control.

The effect of changes in corporate governance on corporate performance is

generally considered the bottom line of the corporate governance debate

(Cadbury, 1999; Maher and Anderson, 2000). In this paper, two issues are

discussed in the analysis of each corporate governance arrangement. These

issues are: (1) how the corporate governance arrangement deals with agency

problems; (2) the impact of the corporate governance arrangement on the

firm's performance.

A. FIRM-SPECIFIC GOVERNANCE ARRANGEMENTS

A.1. Ownership Structure

The separation of ownership and control, the main thrust of agency theory,

is common practice in modern corporations. Shareholders as owners of the

firm have to rely on the managers, the agent, to run the firm. Since both


CHAPTER IIICORPORATE GOVERNANCE ARRANGEMENTS

parties are utility maximisers, there is a tendency that they will act in their

own best interest. The level of ownership concentration in a company

determines the sharing of power between its managers and shareholders.

When ownership is dispersed, shareholder control tends to be weak

because of poor shareholder monitoring. A small shareholder would not be

interested in monitoring because he would bear all the monitoring costs,

but share only a small proportion of the benefit. When ownership is

concentrated, large shareholders could play a significant role in

monitoring management. Fama and Jensen (1983) state that if share

ownership is dispersed, there is greater potential for conflict of interest

between principals and agents.

Ownership structure is an important corporate governance mechanism,

because it determines the nature of the agency problems within the firm.

When ownership is widely dispersed, as is typical in the US, an agency

problem arises from the conflict of interest between managers and

shareholders (Jensen and Meckling, 1976). When ownership is

concentrated, as is common in Asian countries, agency problems stem

from the conflict of interests between the controlling owners and minority

shareholders (Fan and Wong, 2002). This conflict of interests occurs

because the controlling shareholders hold more voting rights (right to

control the assets) than cash flow rights (right to get a share of the

generated profits). Large shareholders gain control through stock

pyramids, cross-holding ownership, and use of multiple classes of stocks.

The difference between cash flow rights and voting rights provides

controlling shareholders an incentive to expropriate minority

shareholders. This is because ultimately owners bear less cost but receive

a disproportionately high share of the benefit. This expropriation can take

the form of self-dealing transactions or the pursuit of goals that are not in

the best interest of all shareholders (ADB, 2001; Claessens et al., 2001;

Fan and Wong, 2002).

The presence of blockholders or controlling shareholders has an impact on

corporate performance. There is a positive correlation between increase in

both control rights and cash flow rights held by blockholders and increase

in firm value, especially during economic downturns (Lins, 2000; Mitton,

2000). The reason is that when both control rights and cash flow rights

held by blockholders increase, the cash flow consequences for the

blockholders to expropriate minority shareholders are substantial. Thus,


the incentives of blockholders and minority shareholders are aligned and

this will increase firm value. This implies that governance of large

blockholders is more important in emerging markets where investors are at

least protected by law against expropriation.

Another issue related to equity ownership structure is managerial

ownership of a firm's shares. On the one hand, managerial ownership will

mitigate the agency problem between managers and shareholders, which

can be achieved through alignment of the interests of the conflicting

parties. On the other hand, managers who own significant portions of their

firms' shares have more incentive to pursue their own interest rather than

pursuing the interest of all shareholders.

On the relationship between managerial ownership and firm performance,

Morck et al. (1988) provide evidence that firm value, reflected in Tobin's Q,

goes up as managerial ownership increases from 0% to 5%, goes down as

ownership increases further to 25%, and then continues to go up as

ownership increases beyond 25%. The increase in Tobin's Q with rising

managerial ownership reflects the convergence of interests between

managers and shareholders, and the decline reflects entrenchment of the

managers. However, other scholars could not conclude that changes in

managerial ownership influence firm performance (Coles et al., 2001;

Himmelberg et al., 1999).

A.2. Corporate Financing

Corporate financing is a form of governance mechanism. The agency

problemthe conflict of interest that occurs between equity and debt

holdersis one factor that influences corporate financing. The debt contract

provides that if an investment obtains returns well above the face value of

the debt, equity holders capture most of the gain. On the other hand, if the

investment fails, due to limited liability, debt holders bear the

consequence. Thus, equity holders may benefit from investing in very risky

projects by borrowing. Correspondingly, to cover the risk of failure, debt

holders may require higher returns. In other words, debt holders can be

distinguished from shareholders by their rights; contractual rights and

residual control rights, respectively (Hart, 1995). Thus, changing the

capital structure of the firm means changing the allocation of power

between the outside investors and the insiders (La Porta et al., 2000).


From a different perspective, there is no obligation for a company to

provide return to equity holders via dividends; whereas for debt holders,

the company has an obligation to provide return via interest and

repayment or it may lose its control rights. Therefore, debt can be used as a

means to reduce free cash flow as well as to bind management (Jensen,

1986). Consequently, corporate financing can be employed to mitigate

conflicts of interest between managers and shareholders, and is thus a

corporate governance arrangement.

Leverage buyouts (LBOs) are evidence of the use of debt to reduce agency

problems between managers and shareholders. The buyout companies

purchase enough equity to control the firm typically by borrowing money

from banks and issuing junk bonds. LBOs were prevalent in the 1980s in

the US market. There is evidence that LBOs that later went public

increased their profits (Kaplan, 1989).

There is some empirical evidence to suggest that corporate financing

decisions are also influenced by the environment in which the company

operates. This, ultimately, creates specific financing patterns within in a

particular region. Hackethal and Schmidt (2001) provide empirical

evidence that the financing patterns of the US, Germany and Japan differ

substantially from one another and that this influences their corporate

governance. In the US, equity is an important source of financing, while in

Germany and Japan debt is the dominant source of external financing. In

addition, heavy reliance on debt financing characterises most financing

decisions in East Asian companies (ADB, 2001).

A.3. Auditing

Agency theory points out that separation of ownership and control creates

conflict of interest between the principal and the agent. In this agency

relationship, to ensure that the agents (managers) will act in the best

interest of the principals (shareholders), the principals will incur

monitoring costs associated with hiring an auditor to audit the company's

financial statements produced by management. Auditors lend credibility

to the financial statements they audit, which in turn is expected to

alleviate the agency problem.

Rigorous audit quality enhances the credibility of accounting information,

which increases the reliance on accounting information by economic

agents. This will ultimately provide economic agents with better tools to

effectively monitor a firm and its management while allowing investors to


gauge a company's prospects and compare different investment

possibilities. Thus, auditing is an important corporate governance

arrangement that can be employed to reduce agency problems.

The monitoring role of the auditor is important to users of financial

statements because the users believe that the auditor will report a violation

should one occur. As a professional, the auditor works in compliance with a

professional code of ethics, and auditing and accounting standards.

Despite this, auditors may deliver audit services of varying quality. Audit

quality is the probability that the auditor will both notice and report a

breach in the accounting system (DeAngelo, 1981). Since the role of

auditing is to alleviate agency problems, the higher the extent of agency

conflict between managers and investors, the higher the demand for audit

quality. Demand for audit quality, reflected in the auditor's ability to

alleviate agency problems, is associated with changes in management

ownership and leverage (DeFond, 1992). Good audit quality will result in

rigorously audited accounting information, which will ultimately help

managers and investors to identify good and bad investment opportunities

in the market (Bushman and Smith, 2000).

A.4. The Audit Committee

Agency theory posits that the establishment of audit committee is a means

of alleviating agency problems. This is because the main function of an

audit committee is to review the company's internal control systems,

ensure the quality of financial reporting, and enhance the effectiveness of

audit functions. By helping to establishing good internal control in the

company, the audit committee can improve disclosure quality. Ho and

Wong (2001) found that voluntary disclosure is positively associated with

the existence of an audit committee. In other words, the audit committee

serves the shareholders' interests by protecting their rights through

monitoring of the agent's behaviour.

The audit committee has become an important corporate governance

mechanism. Since its inception, the audit committee has evolved

considerably, and today it is regarded as one of the features of effective

corporate governance. Birkett (1986) argues that the audit committee

safeguards the independence of the external auditors. Furthermore,

Knapp (1987) concludes that audit committees strengthen the auditor's

position in disputes with management. In this regard, the independence of


audit committees could be of help to external auditors in disputes with

management.

Independence is an important factor in the effectiveness of audit

committees. One of the recommendations of the Blue Ribbon Committee

(BRC) for improving the effectiveness of audit committees is to require that

independent directors sit on the committees (BRC, 1999). The

independence of audit committees is closely related to several economic

factors. Klein (2002) investigated the economic determinants behind

differences in audit committee independence. He concluded that audit

committee independence increases with board size and the percentage of

outsiders on the board, and decreases with a firm's growth opportunities

and consecutive losses. Accordingly, firms should modify the composition

of their audit committees fit their specific economic environments.

A.5. The Board of Directors

Separation of ownership and control, which is a core issue of agency

theory, raises a basic question for shareholders as to how they should

effectively monitor managers and exercise control so that the managers

will act in the best interest of the shareholders. Boards of directors exist

because diverse shareholdings make it difficult for minority shareholders

to adequately monitor and control the firm's managers. This limits the

shareholders' opportunity to diminish agency costs. The board of directors

is one mechanism for reducing agency problems because its role is to

monitor and discipline management on behalf of all shareholders. This

suggests that the board of directors is a corporate governance mechanism.

One topical debate about board structure in the US is whether the job of

chief executive officer (CEO) should be separated from the job of the

chairman of the board of directors. The Cadbury Committee on corporate

governance also raised this issue (Douma, 1997). It is argued that

separating the job titles will reduce agency costs in corporations and

increase oversight of corporate activity by the board of directors. It is

believed that this job separation will improve the firm's performance.

However, empirical studies show mixed results. Rechner and Dalton

(1991) found that firms with separate titles outperform firms with

combined titles, while Brickley et al. (1997) found no evidence that

combined titles is associated to inferior accounting and market returns.

They argue that the potential costs of separating the titles of CEO and

chairman of the board of directors that outweigh the benefits.


Common law countries, such as England and the US, adopt single board

systems, whereas code law countries, such as Germany and the

Netherlands, adopt the two-tier board system. In the two-tier system there

are two boards: a managing board and a supervisory board. Lo (1999)

argued that the two-tier model overcomes many of the problems that have

hindered the effectiveness of company monitoring. For example, a two-tier

board system will lead to more effective corporate monitoring than

separating the positions of chairman of the board of directors and chief

executive officer. According to Lo (1999), this is because managing

executives are not allowed to sit on the supervisory board. The adoption of a

single board or two board system, for the most part, is not a choice for

companies; it is part of the legal system of the country. It is difficult,

therefore, to make comparison of the performance of firms that adopt the

single board system and those that adopt a two-tier system.

A.6. Managerial Compensation

Alignment of the interests of principal and agent is crucial to mitigating

agency problems. The principal can bind the agent by means of a

compensation contract in order to align the incentives of the agent with

those of the principal. In doing so, the firm's management, as agent, would

be forced to act in the best interests of shareholders, the principals.

However, designing a complete contract is not feasible. Designing an

observable and enforceable contract, then, would be critical. In other

words, it can be presumed that managerial compensation is a form of

corporate governance arrangement.

Managerial compensation is closely related to corporate performance.

Wallace (1997) provides evidence regarding the impact of adopting residual

income performance measures by comparing the performance of sample

firms with that of the control firms. He found that firms that adopted

residual income performance measures, reduced new investment,

increased payouts to shareholders through share repurchase, and used

assets more intensively. These results are consistent with reduced agency

costs from the incentive use of residual income measures by decreasing the

agency conflict arising from the cash flow problem.

Compensation contracts are typically designed based on performance

easures. The performance measures that are widely employed in executive

compensation contracts are accounting-based performance measures,


such as accounting earnings, and stock price-based performance

measures. Bushman and Smith (2001 state that accounting profitability

measures have a lesser role in determining cash compensation of top

management. Additionally, cash compensation seems to have become a

less significant element of the overall pay-performance of top

management. This is because executives' stock and stock option portfolios

have dominated top executives pay. Accordingly, stock returns have

become more central than earnings in determining compensation.

B. COUNTRY-SPECIFIC GOVERNANCE ARRANGEMENTS

A corporation operates in a wider economic context. Thus, the corporate

governance framework is determined not only by the internal governance of

the corporation itself, but also on the external environment (ADB, 2001;

OECD, 1999). The legal, cultural and accounting institutional environments

are discussed in this sub-section.

B.1. Legal Environment

A legal approach to corporate governance argues that the protection of

investors (shareholders and creditors) is important (Beck et al., 2001;

Berndt, 2000; La Porta et al., 1997, 2000; Shleifer and Vishny, 1997).

Protection of investors is essential because expropriation of minority

shareholders and creditors by the controlling shareholders is extensive.

Expropriation is related to agency problems, where the agent consumes

the perquisites at the expense of the principal. To control this agent

behaviour, the legal approach emphasizes that the key mechanism in

corporate governance is the protection of outside investors through the

legal system (Beck et al., 2001; Berndt, 2000; La Porta et al., 1997, 2000).

The legal system or environment is influenced by its legal origins; and

different legal origins protect investor rights to differing degrees.

Using a sample from 49 countries, La Porta et al. (1997; 1998; 2000) divide

the legal rules in those countries according to their legal origins: English

(common law), French, German, and Scandinavian (civil law). In terms of

protection against expropriation by insiders, legal rules in common law

countries protect the creditors and shareholders' interests the most,

whereas French civil law countries provide the least protection. German

civil law countries are inclined towards the French civil law group and

Scandinavian civil law countries lie in the middle between German civil

law and common law countries.


In addition to legal rules, law enforcement is an important factor in the

legal environment. With regard to the quality of legal enforcement, La

Porta et al. (1998) ranks countries from the best to the worst as follows:

Scandinavian civil law, German civil law, common law and French civil law

countries. One way that a country can deal with poor investor protection is

to develop substitute mechanisms, such as mandatory dividends, legal

reserve requirements, and ownership concentration. Furthermore, Beck et

al. (2001) suggest that while a country cannot change its legal origin, it can

reform its judicial system by prioritising the rights of outside investors,

tightening law enforcement, and constructing a legal system that supports

changing economic conditions.

Strong investor protection is associated with effective corporate

governance. La Porta et al. (1997) found that the quality of the legal

environment has a significant effect on the ability of firms to raise external

finance. This is because common law countries provide stronger investor

protection than that of civil law countries. Since the law protects investors,

especially from expropriation by insiders, investors are more willing to

finance the firms, and pay more for securities. In return, this will

encourage more companies to issue securities. Accordingly, the

effectiveness of corporate governance is reflected in valuable and broad

financial markets, dispersed ownership of shares, and efficient allocation

of capital across firms (La Porta et al., 2000).

B.2. Cultural Environment

Culture is defined as a system of beliefs that shape the actions of

individuals within a society (Stulz and Williamson, 2001). This means the

behaviour of investors and managers is influenced by the culture they are

associated with. In a wider context, cultural environment determines the

shape of corporate governance mechanisms in any country. For instance,

ownership profiles in East Asian countries are characterized by

substantial family holdings (ADB, 2001), while in other countries, such as

USA, dispersed ownership characterizes most of the publicly listed

companies. Empirical evidence also shows that financing patterns of US,

German and Japanese companies differ substantially from one another

(Hackethal and Schmidt, 2001). Equity is an important source of financing

in the US, whereas debt is the dominant source of external financing in

Germany and Japan. This reflects the influence of culture on ownership

structure and corporate financing.


As a result of the interactions between culture and other governance

mechanisms, different regions experience different types of agency

problems. Mitigating the agency problem between controlling and

minority shareholders requires a different mechanism from that for the

agency problem between managers and shareholders. In other words,

cultural factors determine the agency problem type. Accordingly, cultural

environment is a governance arrangement that should be considered in

alleviating agency problems.

The cultural approach has been used to help explain differences in

investor protection across countries. Licht et al. (2001), examining the

relations between investor protection and national culture, found that

categorizing countries according to their legal origins provides only a

partial portrayal of the variation of corporate governance frameworks. In

certain cultural regions, such as the Far East, combining a cultural value

approach and legal approach gives a better picture in understanding its

corporate governance. This is because the superior investor protection of

common law in Far Eastern countries is not accompanied by effective

statutory law in these countries, which may be a result of cultural

influences.

B.3. Accounting Standard Setting

Financial accounting information as a major instrument for corporate

public disclosure can be employed as a solution to alleviate the

information asymmetry problem (Ball et al., 2000; Bushman and Smith,

2001). Standard setting can be considered a regulatory reaction to failures

in the supply of information to capital markets. Since managers as

insiders and information producers have an information advantage over

the investors as outsiders, there is a tendency that they will manipulate

the information supply. In response to this, accounting standard setters

need to take measures to mediate the conflicting interests of investors and

managers. By regulating the flow of information, the standard setter can

reduce the agency problems between managers and investors, and thus

level the playing field for investors and managers. Hence, the main

problem in accounting standard setting is how to balance the differing

information needs of managers and investors. In this regard, accounting

standard setting is a corporate governance mechanism that can be

employed to alleviate agency problems.


Many interests are considered in setting up acceptable accounting

standards. In a private sector standard setting system, the interests of the

preparer would come first. If a standard is prepared by government, it is

more likely to satisfy regulatory needs, for example to be in compliance

with government policies and macroeconomic plans (Choi and Mueller,

1992). If accounting standards are primarily determined by private sector,

in this case the accounting profession, then there is a tendency that the

purpose is to gather accounting thought and incorporate this into new

standards (Wyatt, 1997).

B.4. Accounting Practice

There is a growing awareness that international accounting diversity exists

across geographic boundaries. This diversity encompasses two

dimensions of financial accounting: measurement and disclosure.

Measurement is concerned with how financial reports should be prepared

and how assets and liabilities are to be valued, while disclosure is

concerned with the release of any piece of information about a certain

company, such as in annual reports and press releases (Mueller et al.,

1997).

Accounting practice in a country will influence how accounting

information is processed and reported by a firm (Rahman, Perera and

Ganesh, 2002). Accounting reports are directed towards the needs of

users, such as investors. As a result, accounting reports will influence the

investors' perception of the company's performance, ultimately affecting

their financing and investment decisions. Thus, differences in accounting

measurement practice reflect differences in the way these countries deal

with agency problems. Hence, accounting practice is a corporate

governance arrangement.

Although there are differences in accounting measurements, accounting

practices the world over can be grouped into several categories based on

similarities of business environment. This grouping also reflects the

agency problems that occur in those countries. Mueller et al. (1997)

grouped countries into four accounting categories: the British-American

Model, the Continental Model, the South American Model, and the Mixed

Economy Model. The British-American Model is characterized by the

orientation of accounting toward the decision needs of shareholders and

creditors. Most countries in this category have large and developed capital

markets, and users of accounting information tend to be sophisticated.


The agency problem occurs between shareholders, as principal, and

managers, as agent.

Countries following the Continental Model are identified by their close

relationship with the banks. Accounting is designed to fulfil government-

imposed requirements and tends to be highly conservative. The agency

problem in this cluster happens between banks as capital providers and

managers as agent. The South American Model typically employs a

persistent use of accounting adjustment for inflation. Countries in this

cluster have a lot of experience in dealing with inflation, and this is

mirrored in their accounting practice. In these countries, the credibility of

accounting information is questionable, and as a result, there is a

significant conflict of interests between management and investors.

Under the Mixed Economy Model, companies operate dual accounting

systems. The first system produces information aimed at the common

economy and relies on uniform charts of accounts and budgets. The

second system has a capital market orientation and provides information

for investors. There are three parties that have a keen interest in

accounting information: management, government, and investors. Their

interests will affect the type of agency problems in these countries.

C. MARKET GOVERNANCE ARRANGEMENTS

C.1. The Market for Corporate Control

The opportunism of the firm's managers arising from the separation of

ownership and control, could lead to managers failing to perform their

duties to maximize shareholder value. Managers can be disciplined

directly by the market for corporate control, where the shareholders can

sell their shares and the company can be taken over by shareholders who

may replace the managers (Collier and Esteban, 1999). Thus a market for

corporate control is created. This market is an essential corporate

governance mechanism that acts as a disciplinary mechanism upon

managers to make the company function more efficiently (Manne, 1965).

Jensen and Ruback (1983) defined the market for corporate control, or the

takeover market, as: …a market in which alternative managerial teams

compete for the rights to manage corporate resources (p.6). They argued

that takeovers act as an external control mechanism that discourages


managers from deviating from maximizing shareholder wealth. Takeovers

can take the form of mergers, tender offers, or proxy contests.

The likelihood that a takeover will occur is influenced by several attributes,

for instance the structure of the boards and equity ownership, the

defensive mechanisms available, adoption of anti-takeover charter

amendments, the ability of the bidder to expropriate value from minority

shareholders, and the voting structure of the firm (Hart, 1995). Shivdasani

(1993) provides evidence that additional outside directorship by board

members and ownership by affiliated blockholders decrease the

probability of a takeover, whereas ownership by blockholders unaffiliated

with management increases the likelihood of a hostile takeover attempt.

The decrease in the probability of hostile takeover is associated with the

better monitoring of outside directors and alignment of interests between

affiliated blockholders and the firm's management. Lange, Ramsay and

Woo (2000) found that poor performing firms are more likely to introduce

anti-takeover devices. This is because the firms that perform well are

unlikely to be threatened by takeovers, so their boards are unlikely to

propose anti-takeover charter amendments.

The activities of the market for corporate control or takeover market are

related to corporate performance. Jensen and Ruback (1983) provide

evidence that takeovers create value. Specifically, shareholders of target

firms receive substantial positive abnormal returns in completed

takeovers, while successful bidding firms in mergers earn zero returns and

bidders in successful tender offer receive small positive abnormal returns.

C.2. The Level of Capital Market Development

Asymmetry of information is a critical obstacle that stands between listed

companies and public investors in the securities market. Adverse selection

is a common problem in publicly listed companies. Investors do not have

the information to determine whether a company is issuing reliable

information or not, thus, they discount the stock offering price. Another

major obstacle in the securities market is self-dealing, which can take the

form of direct self-dealing (where the company engages in transactions

that enrich the company's insiders) and indirect self-dealing (where

insiders use information to transact with less informed investors) (Black,

2000). One of the functions of the capital market is to ensure, through

regulations and public institutions, that public investors have access to


reliable information, thereby reducing asymmetry of information and

mitigating the problem of self-dealing. The role of the capital market in

protecting public investors' interest varies with the level of capital market

development. In other words, the level of capital market development is a

significant corporate governance arrangement in alleviating agency

problems.

Empirical studies show that there is a direct relationship between the level

of capital market development and the degree of investor protection. Rajan

and Zingales (1988) state that legal protection of shareholder rights and

the strong accounting rules predict a strong capital market, and the extent

of this stock market development predicts future economic growth. La

Porta et al. (1997) emphasize that the more developed the capital market,

the better it protects investors' interest through regulations. Francis et al.

(2001) found that civil law countries with weak investor protection laws

have less developed financial markets than common law countries.

A well-developed capital market tends to have better regulations to ensure

that the market for corporate control functions in a fair and transparent

manner. Takeovers are much more common in the US and the UK, where

ownership is diffused (with well-developed capital markets), than in

continental Europe and East Asia where ownership is more concentrated

(ADB, 2001). The market governance mechanism described in the

previous section, the market for corporate control, also varies with the

level of capital market development. The market for corporate control

offers a device for disciplining the management of publicly listed

companies in the form of the threat of loss of control. Legal arrangements

for takeovers are usually written in company laws or capital market laws.

D. INTERACTIONS BETWEEN CORPORATE GOVERNANCE

MECHANISMS

The above review of corporate governance reveals that corporate governance

arrangements are of three types: firm-specific, country-specific, and market-

specific. These governance mechanisms are intricately linked. The linkages

exist between variables of similar categories and between those of different

categories. In this section, some of the key linkages examined in literature are

reviewed to highlight the nature and importance of these linkages. The review

shows that the nature of these linkages varies. In some cases, governance


arrangements can be substitutive, i.e., one arrangement can replace another;

in others, they are complementary, i.e., one arrangement supplements the

effectiveness of another; and in some, they play a supporting role, i.e., they do

not play a direct role, but they strengthen one another.

Shleifer and Vishny (1997) and Fan and Wong (2002) show that the strength of

the legal environment and ownership structure are substitutive in their

linkage. Put together, these studies demonstrate that in countries that have a

weak legal environment to protect shareholders there is a greater propensity

towards large block ownership such as family ownership.

Wurgler (2000) and Black (2000) linked the development of capital markets to

the nature of the legal environment. They showed that countries with more

developed capital markets had better legal environments. This suggests that

the improvement of the legal environment could be an important precursor to

having better governance at the market level.

Gray (1988), Doupnik and Salter (1995) and Nobes (1998) argue that the

cultural environment of a country influences the accounting practices of that

country directly or through intervening variables such as the nature of

financing in the capital markets. These studies indicate that some governance

arrangements at the country level support other governance arrangements at

the same level.

Core, Holthausen, and Larcker (1999) showed how managerial compensation

and the size of the board of directors complement each other to create an

effective governance setting. They found that CEO compensation is higher

when the CEO is also the board chair, the board is larger, a greater percentage

of the board comprises outside directors and the outside directors are

appointed by the CEO. This suggests that firms with weaker governance

structure face greater agency problems and that CEOs dealing with more

agency problems receive higher compensation. This is an example of

interactivity and complementarily of firm-specific arrangements.

These linkages between governance mechanisms indicate that the effects of

the governance variables of corporate performance are not necessarily linear.

Thus, caution is necessary in drawing conclusions from the associations

between corporate results and the governance mechanisms.


E. SUMMARY

The chapter identifies three types of corporate governance arrangements:

firm-specific, country-specific and market-specific. Firm-specific governance

arrangements consist of: ownership structure, corporate financing, auditing,

the audit committee, the board of directors, and managerial compensation.

Country-specific governance arrangements consist of the legal environment,

the cultural environment, accounting standard setting, and accounting

practice. Market-governance arrangements are found in the market for

corporate control and the level of capital market development. The chapter

concludes with a discussion of how these types of governance arrangements

interact within types and between types to provide a setting of effective

corporate governance.

F. QUESTIONS

1. Explain why share ownership structure can be considered a corporate

governance arrangement from the perspective of agency theory.

2. Do you think that the roles of the external auditor, audit committee, and

board of directors are as important as good corporate governance

mechanisms? If not, which mechanism do you think is the most

important?

3. Do you think that the existence of independent commissioners plays a

significant role in the management of a company? Why/Why not?

4. Explain why investors should pay a particular attention to the

independence of the external auditor.

5. Give examples of interaction between corporate governance arrangements

that are complementary in nature.


A. THE OECD PRINCIPLES OF CORPORATE GOVERNANCE

Steady economic growth requires a stable investment climate, which depends

on the creation of conditions that encourage companies to conduct their

business optimally. Therefore, a common perception is needed of the key

principles in managing companies to operate efficiently.

OECD developed corporate governance principles as long ago as 1998.

Announced in 1999, these principles have become a main reference in the

preparation of codes of good corporate governance in countries around the

world. Many international institutions, such as the World Bank, International

Monetary Fund (IMF), and International Organization for Securities

Commission (IOSCO) employ the OECD Principles of Corporate Governance as

a benchmark for assessment of corporate governance implementation in

particular countries.

Based on discussion and consultation with relevant parties and analysis of

current developments, the OECD Principles of Corporate Governance were

revised in 2004. The 2004 OECD Principles of Corporate Governance cover six

areas:

1. Ensuring the basis for an effective corporate governance framework

2. The rights of shareholders and key ownership functions

3. The equitable treatment of shareholders

4. The role of stakeholders in corporate governance

5. Disclosure and transparency

6. The responsibilities of the board

Following is a brief description of each of these principles:

1. Ensuring the basis for an effective corporate governance framework

To ensure an effective corporate governance framework, it is necessary to

establish a legal, regulatory and institutional foundation that can be

employed as a reference for market participants to conduct their business


CHAPTER IVGOOD CORPORATE GOVERNANCE PRINCIPLES

activities. This corporate governance framework should be developed and

its impact on economic performance, market integrity, and the incentives

it provides to market participants should be anticipated. In addition, the

legal and regulatory foundation of corporate governance practice should be

in line with the applicable regulatory framework, transparent, and

enforceable. Thus, every corporate governance principle should be

enforced by the relevant authorities with the objective of protecting the

public interest. Therefore, those relevant authorities should have the

authority, integrity, and resources to perform their duties professionally.

2. The rights of shareholders and key ownership functions

The corporate governance framework should protect and facilitate the

implementation of shareholders' rights. Basic shareholder rights should

consist of the right to: secure methods of ownership registration, transfer

shares, obtain regular and timely corporate information, participate in

general meetings of shareholders, elect the board of commissioners and

directors, and share proportionately in the profits of the corporation. The

exercising of the rights of shareholders, including institutional investors,

should be facilitated by the corporation. Thus, discussion among

shareholders regarding their rights should be allowed. In addition, the

market for corporate control mechanism should be allowed to function

efficiently and transparently. Anti-takeover devices should not be

employed to shield corporate management and the board from their

accountability to shareholders. Capital structure that enables certain

shareholders to obtain corporate control that is disproportionate to their

equity ownership should be disclosed.

3. The equitable treatment of shareholders

The corporate governance framework should ensure that all shareholders,

including minority and foreign shareholders, obtain equitable treatment.

This equitable treatment should be experienced by all shareholders of the

same series of a class. All shareholders should have the opportunity to

obtain effective redress for violation of their rights. In order to achieve

equitable treatment, insider trading and self-dealing should be prohibited.

Furthermore, members of the board commissioners and directors should

be required to disclose whether or not they are involved in any conflict of

interest transactions.


4. The role of stakeholders in corporate governance

The corporate governance framework should recognize stakeholders'

rights established in the applicable law. If those rights are violated, the

corporation should ensure that the stakeholders have the opportunity to

obtain effective redress. The corporation should encourage active

cooperation between corporation and stakeholders to improve the welfare

and sustainability of the corporation. Performance-enhancing

mechanisms for employee participation should be developed. All

stakeholders should have regular and timely access to relevant, sufficient

and reliable information. Mechanisms for stakeholders to raise their

concerns should be established by corporations. This is necessary to

ensure that all the rights of all stakeholders, including creditors, can be

exercised.

5. Disclosure and Transparency

The corporate governance framework should ensure transparency,

accuracy and timeliness of corporate information. Disclosure should

include, but is not limited to, material information pertaining to financial

performance, related party transactions, risk management, and the

corporation's governance structure and policy, especially corporate

governance principles. Information should be prepared and presented in

compliance with high quality accounting standards. Financial reports

should be audited by an independent, competent, and highly qualified

auditor. In practice, auditors should be held responsible to shareholders.

The corporate governance framework should be complemented by an

effective mechanism that promotes the provision of analysts, brokers, and

rating agencies that are free from conflict of interest. This is to ensure their

professional integrity when providing their services to the corporation.

6. The responsibilities of the board

The corporate governance framework should ensure strategic

management of the corporation, the monitoring of the board, and

accountability of the board to the corporation and shareholders. This

means that the board should act on a fully-informed basis, in good faith,

and with due care. The board should treat all groups of shareholders

equally and with high ethical standards. The board should perform certain

key functions, such as: review and set strategic corporate policy, decide


corporate plans and risk management policy, set and monitor the annual

budget, and evaluate and manage the possibility of conflicts of interests

among the member of the board, shareholders, and key management

executives. Additionally, the board should be able to perform its functions

independently. Thus, it should be ensured that members of the board have

access to accurate, relevant, and timely information.

B. THE INDONESIAN CODE OF GOOD CORPORATE

GOVERNANCE

To fulfil a request for the establishment of an organization that can coordinate

efforts to promote implementation of good corporate governance in Indonesia,

the Indonesian government created the National Committee for Corporate

Governance Policy (NCCGP). In order to carry out its duties, the NCCGP

prepared a Code of Good Corporate Governance. This code was launched in

1999 and received a good response from business communities. The code has

since undergone several revisions, and currently in effect is the 2006 Code of

Good Corporate Governance.

The 2006 Indonesian Code of Good Corporate Governance 2006 covers these

areas:

1. Creating conducive situation to implement good corporate governance

2. Good corporate governance principles

3. Business ethics and codes of conduct

4. Corporate components

5. Shareholders

6. Stakeholders

7. Statement regarding implementation of Code of Good Corporate

Governance

8. Practical guidance regarding implementation of good corporate

governance

Following is brief description of each of the areas covered by the code.

1. Creating conducive situation to implement good corporate

governance

Implementation of good corporate governance requires participation from

three main parties: government, business communities, and society. Each

party plays its own role. Government and its institutions act as a regulator


that functions to prepare regulation to promote a healthy, efficient, and

transparent business climate, and to enforce the law. Business

communities as market participants have to implement good corporate

governance in their activities, and society as product consumers have to

show concern for and perform their social control function objectively.

2. Good corporate governance principles

Five principles of corporate governance should be implemented by

business communities in their business activities. These principles are

transparency, accountability, responsibility, independency, and fairness.

3. Business ethics and codes of conduct

Implementation of good corporate governance needs to take into account

current business ethics. Thus, further elaboration of business ethics into a

code of conduct for all employees is necessary to achieve corporate goals.

4. Corporate components

The components of a corporation include the general meeting of

shareholders, and the boards of commissioners and directors. Each

component has its own function as laid down by the applicable rules and

regulations. In the context of good corporate governance, each component

has to perform its duties independently and in the interest of the firm.

5. Shareholders

As the owners of the corporation, shareholders have their rights and

responsibilities to the company. In exercising their rights and executing

their responsibilities, shareholders have to consider the sustainability of

the company. The company, meanwhile, must ensure that shareholders'

rights and responsibilities are fulfilled.

6. Stakeholders

There should be a fair and mutually beneficial relationship between the

corporation and its stakeholders, i.e. employees, business partners, and

society. Therefore, the corporation must ensure that these relationships

are impartial, mutually beneficial, and in the public interest.


7. Statement regarding implementation of the Code of Good Corporate

Governance

In its annual report, a corporation is required to make a statement of

compliance to the Code of Good Corporate Governance in all aspect of the

company's business activities.

8. Practical guidance regarding implementation of good corporate

governance

The company has to prepare practical guidance regarding implementation

of good corporate governance that refers to the Code of Good Corporate

Governance. This guideline is needed to ensure the systematic and

continuous implementation of good corporate governance.

C. CODES OF GOOD CORPORATE GOVERNANCE FOR

SPECIFIC INDUSTRIES

Each industry has its own characteristics which differentiate it from other

industries. The uniqueness of a certain industry means that general

regulations are not applicable to certain industries. In view of this, the

National Committee on Governance Policy, a metamorphosis of the National

Committee on Corporate Governance Policy, prepared codes of good corporate

governance for certain industries. These codes were developed to provide

accurate and clear guidance for businesses operating in those industries.

Currently, there are three industry-specific codes of good corporate

governance, for:

1. Banking

2. Insurance

3. Pension Funds

The unique nature of each of these codes of good corporate governance is

discussed below.

The Indonesian Banking Sector Code

The code of good corporate governance for the banking sector, commonly

known as the "Indonesian Banking Sector Code", was issued in January 2004

by the National Committee on Corporate Governance Policy. Banking in

Indonesia is a highly regulated industry that manages public fund. To restore


public trust in the banking industry in Indonesia following the banking crisis

in 1997, it was necessary to introduce significant policy measures, which

included implementation of good corporate governance. In light of this, the

Indonesian Banking Sector Code was issued to complement the Code of Good

Corporate Governance, and is applicable to both conventional and shariah

banks...

As a highly regulated industry, compliance to regulations is paramount in the

banking sector. Therefore, the function of Compliance Officer in banks is

established in the Indonesian Banking Sector Code. For shariah banks,

compliance to shariah principles as established by Islamic shariah law is

regulated by the Shariah Supervisory Board, which is an independent body.

The Code of Good Corporate Governance for the Insurance Industry

The Code of Good Corporate Governance for the Insurance Industry was issued

by the NCGP in April 2006. The main reason for the issuance of a specific code

for this industry is that insurance is characterized as a "trust business". The

insurance industry provides protection to people, in return for which they pay

premiums. To be able to conduct their business properly, insurance

companies must adopt the insurance principle of utmost good faith, and at the

same time implement good corporate governance.

The Code of Good Corporate Governance for the Insurance Industry is

intended as a reference for insurance and re-insurance companies in

developing manuals for good corporate governance to ensure consistent and

continuous implementation of good corporate governance principles --

transparency, accountability, responsibility, independency and fairness. For

shariah-based insurance and re-insurance, good corporate governance

principles are implemented with reference to sidiq, tabliq, fathonah, and

amanah principles. In addition, a shariah-based insurance firm is required to

have a Sharia Supervisory Board, which is an independent body that has the

function to ensuring compliance with shariah-principles.

Since insurance businesses may take the form of joint enterprises or

cooperatives, instead of using the term shareholders as for a corporation, the

Code of Good Corporate Governance for the Insurance Industry uses the term

'member' instead. Similarly, for joint enterprises and cooperatives, the terms

'members' meeting' and 'member representative board meeting' are used

instead of 'general meeting of shareholders'.


The Code of Good Pension Fund Governance

Unlike the codes of good corporate governance for the other two industries, the

Code of Good Corporate Governance for Pension Funds, better known as the

Code of Good Pension Fund Governance, was issued in the form of a Capital

Market Supervisory Board and Directorate General of Financial Institutions

regulation. As an institution within the Ministry of Finance, the Capital Market

Supervisory Agency and Directorate General of Financial Institutions

supervises the Pension Fund Bureau, which is regulator for pension funds in

Indonesia. The code was issued in December 2006.

For a pension programme to operate, a fund is set up into which employers

(companies) and employees (members) pay. In the pension fund industry in

Indonesia, there are two types of pension fund management: Employer

Pension Funds (Dana Pensiun Pemberi Kerja/ DPPK) and Financial

Institution Pension Funds (Dana Pensiun Lembaga Keuangan/DPLK). A

pension fund is a legal entity that manages and run pension programmes. An

Employer Pension Fund is a pension fund that is formed by an individual or

institution that has employees, as owner, to run a defined benefit plan or

defined contribution plan for the employees as members. The Code of Good

Pension Fund Governance was developed for Employer Pension Funds, and

regulates all parties directly involved in the management of pension funds,

which include founders, founder partners, the supervisory board,

management, members, employees, other relevant parties, and other

business partners.

The Code of Good Pension Fund Governance requires transparency,

accountability, responsibility, independency, and fairness. These are the

principles regulating the position, duties, functions, authorities,

responsibilities, rights and responsibilities, and relationships between parties

involved in the management of pension funds. The Code of Good Pension Fund

Governance also includes practical guidance for its implementation.

D. SUMMARY

This chapter describes good corporate governance principles that companies

can use a reference when preparing manuals for good corporate governance.

The OECD Principles of Corporate Governance is one of the main references

used in assessing corporate governance in any country. Compliance with the

OECD Principles has become the main indicator of whether or not corporate


governance in a certain country has been implemented well. In Indonesia, the

Code of Good Corporate Governance, besides explaining the main principles of

corporate governance, also provides practical guidance for the implementation

of good corporate governance, and requires a corporation to make a statement

on its implementation of good corporate governance. While this code is used a

reference in the preparation of codes of good corporate governance in most

industries, the specific characteristics of certain industries, such as banking,

insurance, and pension funds, require that industry-specific codes of good

corporate governance be developed to accommodate their needs.

E. QUESTIONS

1. Explain whether the four main pillars of good corporate governance

(transparency, accountability, responsibility, and fairness) have been

incorporated in the OECD Principles of Corporate Governance.

2. Do you think that the content of the NCCGP Code of Good Corporate

Governance is in line with the OECD Principles of Corporate Governance?

3. In your opinion, does the compliance officer function as regulated in

Indonesian Banking Sector Code address a unique characteristic of the

banking industry, and is thus not relevant for other industries? Why/Why

not?

4. Describe the characteristics of insurance industry that differentiate it from

other industries and make it deserving of a specific code of good corporate

governance.

5. Explain the differences in function of a supervisory board of a pension

fund and a board of commissioners of a limited liability company.


A. APPROACHES TO IMPLEMENTING THE PRINCIPLES OF

GOOD CORPORATE GOVERNANCE

There are two approaches that can be employed to implement corporate

governance principles: the legal and regulatory instruments approach and the

voluntary code and principle approach. The latter may be backed by legal or

regulatory obligations to 'comply or explain'. OECD (2002) research in its

member countries shows that implementation of governance principles varies

depending on the history, tradition, culture, efficiency of the courts, and

political structure of the country and its stage of economic development.

The first approach, which is implementation of principles based on law, is

generally supported by detailed best practice guidelines. Setting out detailed

requirements in legislation could lead market participants seeking loopholes

in the law. This could change the focus to just complying with the rules rather

than with the underlying policy.

In practice, principle-based laws could make corporate governance principles

redundant, since the substance of the principles is incorporated into laws and

regulations. One country that adopts this approach is Austria (OECD, 2002).

Indonesia also adopts this approach in implementing governance principles.

Even though the NCCGP has issued a Code of Good Corporate Governance,

implementation of the principles is voluntary. As capital market regulator, the

Capital Market Supervisory Agency and Directorate General of Financial

Institutions, which has authority to enforce its regulations, is of the opinion

that the content of good corporate governance principles has been

incorporated into current capital market regulations, thus eliminating the

need for specific rules on corporate governance.

Voluntary implementation of codes or principles can be justified by changes in

direction as well as the fact that one size does not fit all. Thus, in this approach,

the cost of compliance can expected to be lower than under the principle-

based law approach. In addition, many countries may require financial

reports, transparency, etc by law to support implementation of voluntary

codes. This approach has been widely adopted in many countries, including


CHAPTER VIMPLEMENTATION OFCORPORATE GOVERNANCE

Austria, Belgium, Germany, Italy, South Korea, the Netherlands, Poland, and

Portugal (OECD, 2002).

In practice, there is also a tendency for regulators to entrust rule setting to

private groups, which means that the regulator simply accepts standards

established by others. This, in turn restricts their voluntary nature but

provides political legitimacy to the standards. This approach has been

implemented in Germany and the UK (OECD, 2002).

There is great variation in the voluntary implementation of governance

principles across countries. In some countries, 'comply or explain' is a

requirement for listing on the stock exchange, though it is not clear how

'comply or explain' is enforced or monitored. In other countries, investors feel

that 'comply or explain' gives management the option to not implement the

principles, but only explain the reasons for not implementing them. Even

though the effectiveness of the voluntary principles is questionable, this

approach offers greater flexibility and avoids the substantial costs associated

with preparation and enforcement of regulatory measures. The UK, through

London Stock Exchange, adopts the Cadbury Committee report as corporate

governance principles, which are then enforced through 'comply or explain',

with verification from an external auditor.

B. DEVELOPMENT OF CORPORATE GOVERNANCE IN THE

WORLD

The concept of corporate governance has been discussed in previous chapters

from a finance-dominated, agency theory perspective. Agency theory discusses

how corporate governance mechanisms, such as audit committees and

managerial compensation, play a role in aligning shareholders and

management interests. This concept is developing continuously. Recent years

have witnessed a growing interest in corporate social responsibility. The

consequences of global warming, terrorism, and nuclear war have heightened

public awareness of environmental and social issues.

Policies and corporate governance initiatives of international institutions have

emphasized the importance of broadening the coverage of corporate

governance. This approach focuses not only on shareholders' interest, but also

on the wider stakeholders' interest. Stakeholder theory has attracted more

attention from business community and the needs and interests of

stakeholders are being taken more seriously. In addition, contrary to the


traditional perception that shareholder and stakeholder theories are

contradictory, the two have demonstrated many commonalities.

Growing awareness of corporate social responsibility has emerged since the

global spread of industrialization that first started in the UK. The terrible lives

and working conditions of industrial workers stimulated the heart and

consciousness of 'high-class' society to write about and spread their stories

(Solomon and Solomon, 2004). Corporate social responsibility as a discipline,

according to Boatright (1999), originated in the 1950s. The concept of

corporate social responsibility is based on the belief that the larger the

company, the greater their potential impact on society; thus, the greater the

need for them to act in a socially responsible way.

Recent years have witnessed growing global concern for environmental issue.

The term 'corporate environmental reporting' (CER) was introduced by the

Coalition for Environmentally Responsible Economics (CERES), which

developed initial guiding principles for companies willing to fulfil their

accountability to the environment (Solomon and Solomon, 2004). The CERES

agenda to make business managers more aware of their business environment

was prompted by a series of corporate disasters. First was the Exxon Valdez

disaster, in which an oil tanker spilled thousands of gallons crude oil into the

ocean, destroying habitats and killing wildlife. Second was explosion of the

Union Carbide plant in Bhopal (India), which released toxic gases that had

terrible consequences for local communities (Solomon and Solomon, 2004).

People around the world were shocked to see the harm that corporate activities

can do to local communities and the environment. But these two disasters

made corporations start to realize that their reputations largely hung on their

ability to manage their impact on the environment and stakeholders.

Interest in concept of sustainability has encouraged companies to focus their

disclosure toward a sustainability objective (Solomon and Solomon, 2004).

Organizations such as Global Reporting Initiative (GRI) have produced

guidelines on sustainability reporting, which focuses on disclosure of

economic, environmental, and social performance (commonly known as 'triple

bottom line'). Various initiatives have been proposed to encourage

sustainability reporting, including by the Association of Chartered Certified

Accountants (ACCA) United of Kingdom (UK). In 1991, ACCA UK began

presenting sustainability reporting awards, which initially focused on

environmental reporting. Now there are three categories of awards:

environmental reporting, social reporting, and sustainability reporting.


Disclosure is not the only way for companies to discharge their accountability

to their stakeholders. Companies can also engage directly with their

stakeholders through dialogue. Here, the participation of institutional

investors and the companies they invest in plays a significant role in social,

ethical, and environmental disclosure. CalPERS (California Public Employees'

Retirement System), the largest and most influential investment institution in

the US, applies social criteria to all its investment decisions. They feel that

investment in companies with poor social and ethical records presents a

fiduciary duty risk due to possible lawsuits, boycotts, and labour issues.

Another large institution, Friends Provident in the UK, has also opted for

socially responsible investment or SRI. They believe that SRI leads to enhanced

returns for shareholders.

With the growing awareness of institutional investors of the need to perform

socially responsible investment through investment in companies that are

socially responsible, there is an incentive for companies to conduct their

business in a socially responsible manner. This indicates that institutional

investors can influence companies to act in a socially responsible manner

through their investment choices. From a different perspective, this also

demonstrates that institutional investors can behave as responsible owners of

the company in which they invested.

The term 'socially responsible investment', or what is known in the UK as

'ethical investment', refers to an investment approach that integrates

individual values and social values into investment decision-making processes

(Scheuth, 2002). Development of socially responsible investment has been

driven by a wide range of factors. Basically, there are two main drivers of

socially responsible investment: internal factors and external factors (Solomon

and Solomon, 2004).

External factors driving socially responsible investment include government,

lobbyists, public interest in corporate social responsibility, incentives for the

company to improve its reputation, and business associations. Internal factors

include investment managers of institutional investors, supervisory boards of

pension funds, the investment manager's concern for corporate social

responsibility, and SRI disclosure requirements. Furthermore, both internal

and external factors push institutional investors to invest in a socially

responsible way. This, in turn, may encourage companies to perform corporate

social responsibility.

Another question arising from implementation of socially responsible


investment by institutional investors is whether or not socially responsible

investment funds perform as well as funds without socially responsible

characteristics. There is a strong evidence of a growing perception among

institutional investors that socially responsible investment, as part of main

investment strategy, enhances financial performance in the long term

(Solomon and Solomon, 2002). However, there is no empirical evidence that

can show statistically significant differences in the return on socially

responsible funds (e.g. Mallin et al, 1995).

All this indicates a shift in the attitude of business and financial institutions

towards social responsibility. This reflects a recognition of the broader concept

of corporate governance, which emphasizes the relationship between

shareholders and company management, as proposed by agency theory. The

broader agenda of corporate governance posited by stakeholder theory may no

longer be viewed as inconsistent with value creation in the long run. Therefore,

differences between shareholder and stakeholder theory may not be as great

as they were once perceived to be.

C. DEVELOPMENT OF CORPORATE GOVERNANCE IN

INDONESIA

Development of corporate governance in Indonesia was initiated by awareness

of the need to improve economic situation in the wake of the economic crisis.

Wulandari and Rahman (2004) research on 100 companies listed on Jakarta

Stock Exchange showed that their corporate governance was weak. This was

identified with the complex structure of companies, their dependency on bank

finance, and inefficient supervision by boards of commissioners. To address

this situation, the government facilitated the establishment of the NCCGP in

1999.

In addition to preparing the Code of Good Corporate Governance, the NCCGP

acts as an umbrella organization, coordinating promotion of implementation

of good corporate governance in Indonesia. In other words, the NCCGP

coordinates activities performed by organizations such as FCGI (Forum for

Corporate Governance in Indonesia), ICGI (Institute for Corporate Governance

in Indonesia), IICD (Indonesian Institute of Corporate Directors), Lembaga

Komisaris and Direktur Indonesia (LKDI) and Ikatan Komite Audit Indonesia

(IKAI). At the outset, the NCCGP focused its activities on promoting corporate

governance. However, in 2004, it was realized that improvement in corporate


governance should be supported by improvement in public governance. Thus,

the name NCCGP was changed to National Committee on Governance Policy

(NCGP).

Besides initiatives by institutions that promote corporate governance,

government also promotes corporate governance by requiring companies to

implement several corporate governance mechanisms.

In relation to share ownership, in 2000, the government through the Capital

Market Advisory Agency and Directorate General for Financial Institutions as

capital market regulator, required companies to disclose the names of

shareholders with holdings of 5% or more. In addition, the names of

commissioners and directors who make changes to their ownership of

company shares are to be reported within 10 days of the transaction date.

Since 2001, the Jakarta Stock Exchange (JSX) has required all listed

companies to have audit committees. Furthermore, the Capital Market

Advisory Agency and Directorate General for Financial Institutions has

implemented similar requirements for all listed and public companies since

December 2004. Audit committees are established by and responsible to the

board of commissioners. Audit committees should have at least one

independent commissioner, who acts as chairman, and two members from

outside the company. One of the members should have financial expertise.

Indonesia, as a code law country, adopts a two-tier board system comprising a

board of commissioners and a board of directors. The directors act as the

management of the company, while the board of commissioners as supervisory

board acts as the board of directors in a one-tier system. There are clear

differences between the functions of directors and commissioners: directors

cannot sit on or chair the board of commissioners. Since July 2001, the JSX

has required listed companies to have independent commissioners. This

requirement is based on the view that independent commissioners can protect

not only minority shareholder interests, but also other stakeholders' interests

equally and transparently. The number of independent commissioners should

be in proportion to the number of shares owned by minority shareholders, but

account for at least 30% of the total number of members of the board of

commissioners.

Realising the important role of the auditor as a corporate governance

arrangement, the Capital Market Advisory Agency and Directorate General for


Financial Institutions issued a regulation in 2002 aimed at enhancing the

independence of auditors. Auditors and public accountants must be rotated.

Auditors should be rotated after three consecutive years auditing one client,

while for public accountants the provision is five years. Auditors and public

accountants that provide audit services to one client for three consecutive

years are not permitted to do so thereafter. Mandatory rotation of auditors and

public accountants firm is needed to protect auditors from the negative

implications of having too close a relationship with their clients. In addition,

mandatory rotation will force auditors and public accounting firm to maintain

good audit quality because of possibility that their work will be examined by

successive auditors. Consequently, it is expected that audit quality will

improve, which in turn will enhance the credibility of audited financial reports.

The Capital Market Advisory Agency and Directorate General for Financial

Institutions also prohibit public accounting firms from providing certain non-

audit services to their audit clients in the same period. These include

accounting services, management consulting, taxation, internal auditing, and

investment advisory service. Providing non-audit services to audit clients in

the same period is considered detrimental to the independence of public

accounting firms because it may give rise to doubts in the public's mind about

the firm's independence.

Public companies are also required to disclose remuneration to directors and

commissioners in their annual reports. This has been a Capital Market

Advisory Agency and Directorate General for Financial Institutions regulation

since 1997, and was revised in 2006. If remuneration is performance based,

shareholders can expect that management will work hard to maximize

corporate performance, which in turn means an increase in shareholders'

wealth.

Since 2002, working with seven other institutions, the NCGP has tried to

improve corporate awareness of the importance of corporate governance by

offering Annual Report Awards (ARAs). The other institutions involved in this

initiative are the Capital Market Advisory Agency and Directorate General for

Financial Institutions, the Ministry of State Enterprises, Bank Indonesia, the

JSX, Directorate General of Taxation, and the Indonesian Institute of

Accountant. Disclosure. Reporting on the activities and remuneration of

directors and commissioners, audit committee, risk management committee

and other governance arrangements is main criterion for assessment.

Participation in the ARAs is not limited to public companies; it is open to all


types of companies: state-owned, private, financial and non-financial. Review

of the winners of ARAs indicates a significant improvement in disclosure

quality

Since 2005, the management accountant division of the Indonesian Institute of

Accountants, together with NCGP, JSX, the Capital Market Advisory Agency

and Directorate General for Financial Institutions, and the Ministry of

Environment, has run the Indonesian Sustainability Reporting Awards

(ISRAs). ISRAs are intended to promote sustainability reporting or triple-

bottom line reporting, where the focus is on reporting economic, social, and

environmental performance. In 2006, four participants prepared corporate

social responsibility (CSR) and sustainability reports separate from their

annual reports. This demonstrated their awareness of the importance of social

responsibility and sustainability information to their stakeholders.

D. CORPORATE GOVERNANCE PRACTICE IN INDONESIA

As explained above, corporate governance in Indonesia has improved

significantly. To provide a clearer picture of corporate governance practice in

Indonesia, this section describes implementation of corporate governance

arrangements. For implementation of firm-specific governance arrangements,

PT Antam Tbk is used as example. In 2006, PT Antam Tbk a mining company

listed on the JSX, Surabaya Stock Exchange, and Australian Stock Exchange.

PT Antam Tbk was the winner of 2005 ARA for good corporate governance.

In implementation of the principle of transparency, share ownership is

disclosed regularly, both in annual reports and financial statements. The

company's 2006 annual report disclosed the names not only of shareholders

who have holdings of 5% or more, but also or those who have holdings of less

than 5%. A state-owned enterprise, the majority (65%) of PT Antam Tbk shares

are owned by the government. JP Morgan owns 8.8%, and the remaining

shares are owned by a large number of shareholders, each with a holding of

less than 5%.

Corporate financing in 2006 was dominated by the banking sector. Financing

from the capital market was in the form of share issue made in 1997. Company

subsidiaries issued bonds in 2003, which were fully paid up in 2005.

The company's financial reports, both annual and semi-annual, were audited

by public accounting firms listed by the Capital Market Advisory Agency and

Directorate General for Financial Institutions. Audit fees paid by the company


were disclosed in annual report, which also contained a disclosure that the

auditor did not provide other services to the company.

The company has an audit committee, chaired by independent commissioner.

The chairman was assisted by four independent members, two of whom are

accountants. The charter of PT Antam's audit committee describes its

function, authority and responsibilities, as well as the composition and

criteria for membership of the audit committee. This charter is regularly

reviewed. The audit committee report was disclosed in the 2006 annual report.

The report described the supervisory duties performed by the audit committee

in 2006, and disclosed the frequency of meetings and the attendance for each

member at these meetings.

As a company domiciled in a country that adopts a two-board system, PT

Antam Tbk has a board of directors and a board of commissioners. The

directors manage the day-to-day running of the company and the board of

commissioners supervises the management of the company. In 2006, PT

Antam had five directors and five commissioners, including 2 independent

commissioners. Five committees were set up to assist the board of

commissioners in the execution of its duties: audit committee, risk

management committee, corporate governance committee, nomination,

remuneration and human resources committee, and post-production

committee. Each committee was chaired by a commissioner.

Directors' remuneration was reviewed regularly by the nomination,

remuneration and human resources committee. Decisions pertaining to

directors' remuneration were then made by a general meeting of shareholders.

The remuneration packages of the directors and commissioners comprise

fixed salaries and incentives. The nominal amount of remuneration received

by each director and commissioner, including details of salaries, bonuses, and

incentives were disclosed in the 2006 annual report.

Implementation of country-specific governance arrangements in Indonesia

could be pictured as follows. According to La Porta et al. (1997;1998; 2000),

Indonesia is categorised as a country that has a French civil law legal system.

French civil law is characterized by weak legal protection for investors. From

the law enforcement point of view, countries that have French civil law legal

systems have the weakest law enforcement of all legal systems. Therefore,

according La Porta et al., both the legal system and law enforcement in

Indonesia are weak.


In terms of cultural environment, Indonesia is similar to other Asian countries.

In terms of share ownership, this is characterized by significant family

holdings (ADB, 2001). Corporate financing was also dominated by bank loans

(Hackethal and Schmidt, 2001).

Preparation of financial statements in Indonesia is based on the accounting

standards issued by Financial Accounting Standards Board under the

Indonesian Institute of Accountants. This is an independent body and its

member come from various institutions, including the regulators (Capital

Market Advisory Agency and Directorate General for Financial Institutions,

Bank Indonesia), the Directorate General of Taxation and the government's

internal auditor (BPKP), as well as academics and public accountants.

Accounting practice in Indonesia, according to Mueller et al. (1997) follows the

British-American Model. In this model, the purpose of accounting is to provide

shareholders and creditors the information they need to make decisions.

However, other research, including research by Rahman (1998), concluded

that the level of accounting disclosure in Indonesia was low before the

economic crisis in 1997.

Market governance arrangements in Indonesia are evident in the market for

corporate control. Takeovers are quite rare, indicating that devices for

disciplining to management for not maximising their performance in the form

of the threat of loss of control over the company do not work well. The

Indonesian capital market, according to several researches, is an emerging

market, as evidenced by the level of legal protection of investor rights.

E. SUMMARY

The main approaches adopted by countries to implement good corporate

governance principles have been described in this chapter. The choice of

approach depends on many factors; however, whatever the approach used, the

objective is to ensure that companies implement good corporate governance

principles to improve corporate performance and maximize stakeholders'

wealth. Development of the concept of corporate governance has seen an

expansion in its coverage, from a focus on the relationship between

management and shareholders to include the relationships between

management and all stakeholders. In the same vein, the concept of corporate

social started out with the environmental report, before expanding to embrace

the concept of sustainability. The concept of sustainability encourages

companies to issue sustainability reports as part of its accountability to its


stakeholders. In Indonesia, development of corporate governance has been in

line with its development worldwide, though sustainability reporting is still in

its early stages. Implementation of corporate governance arrangements

remains the main priority for both government and corporations.

F. QUESTIONS

1. Explain the costs and benefits to a country from adopting the 'comply or

explain'approach in implementing good corporate governance.

2. Explain why a company should prepare a corporate social responsibility

report separate from its annual report, rather than just reporting on

corporate social responsibility in its annual report.

3. Do you think that institutional investors pay attention to the concept of

socially responsible investment? Why/Why not?

4. Which corporate governance mechanism in Indonesia do you think is most

effective in aligning the interests of management and shareholders? Give

reasons.

5. Do you think that sustainability concept, which emphasizes corporate

responsibility to its stakeholders, will develop in Indonesia? Give

reasons.


PT MedcoEnegi Tbk (PT ME) is an energy company involved in exploration and

production of oil and gas, methanol, LPG, and electricity. In 2006, PT ME had

2,373 employees in 21 locations in Indonesian, Oman, Libya, and the US. PT

ME was established in 1980 and has been listed on the JSX since 1994.

PT ME is committed to implementing good corporate governance. Investors

appreciate what the company has done, and its share price increased

continually up until 2005, when it reached Rp 4,100, its highest price since

2002.

To support company strategy to increase implementation the principles of good

corporate governance, PT ME decided to use that implementation as one of its

performance indicators. PT ME also supports implementation of codes of

ethics and good corporate governance principles as embedded values and

cultures in its workforce. As part of that program, PT ME created several

committees to support the work of board of commissioners.

At the end of 2005, the composition of Board of Commissioner and Directors of

PT ME was as follows:

Board of Commissioners:

1. John Karamoy - Chairman and Independent Commissioner

2. Sudono Suryohudoyo - Independent Commissioner

3. Gustiaman Deru - Independent Commissioner

4. Yani Rodyat

5. Retno Dewi Arifin

Directors:

1. Hilmi Panigoro - President Director

2. Cyril Noerhadi - Financial Director

3. Rashid Mangunkusumo

4. Darmoyo Doyoatmojo

An audit committee was established by PT ME to assist the board of

commissioners in evaluating the integrity of operational and financial reports

prepared by the directors, and to identify any non-compliance with applicable


CASE STUDIES I PT MEDCOENERGI TBK.

rules and regulations in regard to the business of PT ME and its subsidiaries.

The composition of audit committee is as follows:

1. Sudono Suryohudoyo

2. Gustiaman Deru

3. Zulfikri Aboebakar

4. Djoko Sutardjo

The nomination committee functions to assist the board of commissioner to

choose new members of the board of commissioner and directors and to

conduct performance assessments of the individual commissioners and

directors. The composition of the nomination committee of PT ME is as follows:

1. Yani Rodyat

2. John Karamoy

3. Gustiaman Deru



The remuneration committee was established to assist the board of

commissioners in preparing remuneration policy for commissioners and

directors. The composition of the remuneration committee is as follows:


2. Yani Rodyat

3. Retno Dewi Arifin

4. Cyril Noerhadi



The risk management committee is responsible for helping the board of

commissioners to evaluate risk management policy implemented by directors

and to ensure that all risks are manageable and that high-risk assets are

insured properly. The composition of the risk management committee is as

follows:

1. John Karamoy


3. Yani Rodyat

4. Cyril Noerhadi



Questions:

1. Explain whether PT ME, as a public company, has fulfilled its obligation to

its investors by establishing several committees to assist the board of

commissioners?

2. Do you think that functions of the audit committee, nomination

committee, remuneration committee, and risk management committee in

PT ME are equally important as corporate governance mechanisms? If

not, which committee is the most important?

3. Based on their composition, do you think that all the committees

established will be able to function as intended? If not, describe what

improvements should be made.

4. NCGP, JSX, and the Capital Market Advisory Agency and Directorate

General for Financial Institutions, as capital market regulators, have

published principles and regulations pertaining to corporate governance,

specifically regarding committees that assist the board of commissioners.

Do you think that committees in PT ME have complied with these rules and

regulations? If not, explain what improvements should be made?

Resource: Annual Report 2005 of PT MedcoEnergi Tbk.


PT Sari Husada Tbk (PT SH) is manufacturer of milk products for infants,

children and expectant mothers. PT SH also produces a range of food for

infants and children. PT SH was established in 1954, and its shares traded

on the JSX for the first time in 1983.

An extraordinary general meeting of shareholders on October 24, 2004 made

the following decisions:

1. To implement an employee stock ownership programme (ESOP), providing

an option to buy new shares amounting to 5% of paid-up capital or the

equivalent to 94,175,670 shares. Each option gives its holder the right to

buy one new share at Rp 1,034.40 during the five-year period, 2003-2008.

The execution period was from May 1, 2004 to October 24, 2008.

2. To buy back shares to a maximum of 10% of paid-up capital or

188,350,000 shares in the 18 months from October 27, 2003 to April 28,

2005.

The parties that obtained rights under the ESOP are as follows:

A. Board of Commissioners:

Johnny Widjaja Chairman => 1,967,000 shares

Peter Kroes Vice Chairman => 1,250,000 shares

Suad Husnan Independent commissioner => 1,000,000 shares

B. Directors:

Soeloeng HS President Director => 800,000 shares

Felix PM Vice President Director => 800,000 shares

Setyanto Director => 800,000 shares

Rachmat S Director => 800,000 shares

Jenny Go - Director => 800,000 shares

Thirty-five managers of PT SH obtained ESOP rights amounting to 1,106,000

shares.

PT SH, as a listed company, disclosed information about the ESOP programme

and share buy back in the national press.

CASE STUDIES II PT SARI HUSADA TBK.


On October 28, 2004, Johnny Widjaja, chairman of the board of

commissioners, traded shares in PT SH to a value of Rp 600 million, and on

February 8, 2005 to a value of Rp 713,773,000. On the same dates, October 28,

2004 and February 8, 2005, PT SH bought back shares. On February 21, 2005,

Felix PM, vice president director, traded PT SH shares valued at Rp 981 million,

and on the same day, PT SH conducted a share buy back.

To ensure that share buybacks are in compliance with the rules concerning

market manipulation, insider trading, and conflict of interest transactions, the

Capital Market Advisory Agency and Directorate General for Financial

Institutions, as capital market regulator, issued rule No. XI.B.2 concerning

share buybacks, which states (Rule XI.B.2, point 4) that:

"If the share buyback is conducted through a stock exchange, then it must

fulfil the following requirements: Insiders of the issuer or public company are

prohibited from trading in the company's shares on the same day as the share

buyback conducted by the company through stock exchange".

For violating that rule, Johnny Widjaja and Felix PM were fined an amount

equal to the value of their share transactions. Since September 2005, neither

has held seats on the boards of PT SH.

Questions:

1. From an investors' point of view, what is your opinion of PT SH conducting

ESOP transactions on the same day as share buybacks?

2. From a corporate governance perspective, what do you think about the

chairman of the board of commissioner and the vice president director,

members of the company's governance boards, making share transactions

and at the same time representing the company to buyback shares? Did

any party suffer as a result of the transactions? If so, who?

3. From a disclosure point of view, was there any obligation for PT SH to

disclose the above case to their public shareholders? Why/why not?

Resource: 2005 Annual Report of PT Sari Husada Tbk, Capital Market Advisory Agency

Report on the Case of PT Sari Husada Tbk, 2005 Annual Report of the Capital Market

Advisory Agency


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