The agency theory is the most dominant theory in business (Shankman, 1999). Jensen and Meckling (1976) defined the agency relationship as "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. 308), Where the manager is the 'agent' and the shareholder is the 'principal'. A basic assumption of agency theory is that the goal of the agent and the principal is divergent (Hill and Jones, 1992), which means that the agent will not always act in the best interests of the principal (Jensen and Meckling, 1976; Ross, 1973). As a consequence of interests divergent, the management would redirect the main goal of the shareholders, which is profit maximization, to their own interests. The agency problem was risen by Ross (1973) when the ownership was separated from the decision makers. In other words, the agency problem arises because principals delegate duties to agents as they do not have the ability to do it themselves which gives the opportunity to agents to divert resources for their own interests (Nilakant and Rao, 1994). However, just as the agency problem exists between managers and shareholders, so too does it exist between controlling and minority shareholders, creditors and shareholders, and shareholders and other stakeholders, such as potential investors, suppliers, employees, the media and the public as a whole. As a result, a corporate governance model should be customized to ensure a sufficient protection for shareholders and creditors investment.
Agency problem can be reduced. Agrawal and Knoeber (1996) point out a number of mechanisms that can reduce this problem, first, managerial shareholdings which is the most obvious one, where management ownership is broadly practiced in developed countries, particularly, in the UK and the US. Managerial shareholdings provide incentive to monitor and reward the chief executive effectively which improve firm performance. Second, the external labour market for managers can encourage them to focus on their reputations among potential employers and thus improve performance. Third, the threat of down-grading imposed by the market of corporate control that can produce a controlling discipline on managers with low performance in order to keep the firm on track. Finally, the role of the board of directors in monitoring management and supporting any strategic decisions before being implemented by the management.
Accordingly, the purpose of this research is to determine the most suitable governance model in the context of the Saudi stock market. The agency theory is therefore important to adopt an appropriate corporate governance model that enhance transparency in order to protect shareholders' rights and reflect a credible market to avoid crises and sharp market volatilities. Agency theory provides a system where the managers will be more involved in customizing the firm's practices that ensure the top management is acting in a way that serve shareholders' interests. Hence, the agency theory offers a great emphasis to reduce the conflict between the firm's owners and the top management.
Corporate Governance Definition, Framework, Theory, Models
( see below) - global / broader context
Corporate Governance in the Kingdom of Saudi Arabia
3.1 Institutional Theory in Saudi Arabia
institutional theory - more specific context
It has been generally noted that organizations are guided by rules and regulations that must be practiced in order to ensure their legitimacy and survival (AL Twaijry et al., 2003). However, these rules and regulations do not ensure continuous efficient operation of these organizations (Scott and Meyer, 1983) which create institutional pressures (AL Twaijry et al. 2003). As far as institutional theory is employed to examine systems ranging from micro interpersonal interactions to macro global frameworks (Scott, 2004), this theory appears to be adequate for the Saudi context. Thus, DiMaggio and Powell (1983) indicate that organizations may organize themselves to adopt similar characteristics to other organizations in similar environments. They describe three isomorphic processes: coercive, mimetic, and normative.
In terms of adopting a proper corporate governance model in any Saudi corporation, coercive isomorphism contains those pressures exerted to adopt a corporate governance model that suites the corporation. Coercion works through employing mechanisms such as, legitimateness, authority, and the power to force organizations to adopt a corporate governance model that improves transparency which serves investors' interests.
With regards to selecting the most suitable corporate governance model for the Saudi stock market, uncertainty plays a central role in the selection criteria, which can be treated through imitating similar contexts. This process is a mimetic isomorphism (DiMaggio and Powell, 1983).
A third approach is the normative isomorphism which stems primarily from professionalization. In the case of adopting an effective corporate governance model in the Saudi context, professionalization may increase amongst managers and members of the capital market. Such as, in education schemes where legitimation is treated in a cognitive base, produced by specialists such as, university specialists, training institutions specialists, or any professional networks (DiMaggio and Powell, 1983).
3.2 Corporate Governance in Saudi Arabia
The economy of Saudi Arabia has been booming since 1999 increasing the levels of liquidity in the market. The long-term investors have done extremely well over the years, where a basket of shares purchased on the Saudi market in 1999 has risen by more than 700 percent. Regardless of these encouraging facts, the Saudi Arabian's stock market has bounced back from the massive collapse of confidence it suffered between February and May of 2007, when it shed a third of its value, an estimated $350 billion.
Corporate governance policies and the transparency requirement deficiencies were considered as significant reasons for such collapse (ameinfo, 2007). Although thousands of small investors lost fortunes, there has been little sign that Saudis have lost their appetite for the financial market. Initial public offerings (IPOs) continue to be issued successfully. In a speech given by Mr. Hamad Al-Sayari, governor of Saudi Arabian Monetary Agency, on May, 22nd 2007 at The Institute of Banking on "Corporate Governance in Saudi Arabia", Mr. Al-Sayari stressed on the importance of adopting a proper corporate governance model for the enhancement of macro-economic development and growth stability of the Saudi economy (BIS, 2007).
The effective adaptation of a proper corporate governance model in any Saudi corporation appears to motivate the corporation to facilitate and achieve its objectives and assure its development and growth for the benefit of its shareholders, as Mr. Al-Sayari mentioned (BIS, 2007). It is also vital for Saudi Arabia to attract international investors. To do so, the market has to be ready in terms of the level of transparency and clear governance policies and regulations that would be tailored by regulatory agencies and adopted by the Saudi corporations. Such adaptation requires a legislative environment that enforces the implementation and the setting of a comprehensive strategy and business plans that ensure proper mechanisms of responsibility, accountability, and transparency (Reynolds, 2007).
The strategy, overseen by the board of directors and implemented by senior management, should ensure the total compliance of the adopted model to the requirements of proper corporate governance set by the regulatory authorities. To ensure financial stability, important objectives of corporate governance, such as operational and financial transparency, must be administered and supervised rigorously by the regulator such as The Capital Market Authority (CMA), which has a big role in promoting greater transparency, encouraging more companies to join the market and educating investors, particularly first-time and smaller ones, in the nuances of stock-market trading (Berglof and Pajuste, 2005).
Transparency and the ability of providing timely information by the firm would help determining and correcting errors rapidly limiting the negative impact of any operational or financial error. This would help the corporation to be market efficient and reveals the degree of compliance with market laws, policies, and regulations. It also shows the degree of effectiveness of its risk identification, risk management, internal controls, and market discipline, which also contributes considerably to good corporate governance (Sundararajan and Errico, 2002)
Timely, precise, rational and continuous performance data of a corporation obtained by the market can be a mean of incentives for managers and boards of directors if they successfully manage their corporation's investment and credit decisions soundly; otherwise, transparency can be a mean of pressure. This means that transparency would automatically force any corporation to adequately disclose and comply with sound accounting standards, avoiding the risk of being penalized by the market and enabling the investor in assessing the real financial value of the corporation in terms of efficiency, competitiveness, and profitability. These aspects of corporate governance in the Saudi private sector are yet to be modernized due to the fast expansion of the sector.
The goal of adopting an appropriate corporate governance model is to promote a governance culture that reflects a credible market to avoid economic crises and sharp market volatilities. The model should ensure adopting and implementing best international standards and principles that will positively reflect on fostering the risk management and corporate governance culture that is deemed crucial for meeting the challenges of globalization.
"Almost 64% of investors say that poor corporate governance is a significant barrier to market performance. Saudi Arabia and Dubai were cited as the worst markets for corporate governance. This is significant, given they are the region's two largest and most actively traded markets. Recent efforts in both countries to improve governance and disclosure levels appear not to be changing investors views just yet, corporate governance as critical" (ameinfo, 2007). This necessitates a serious remodeling of the current laws and regulation that are related to corporate governance.
Regulatory authorities in Saudi Arabia can overview two different models of corporate governance. The market-oriented model relies on modest mandatory law to protect the interests of the shareholder and depends mainly on official and unofficial mechanisms, such as incentive-based compensation and hostile takeovers, to hold managers and directors accountable (Loayza and Soto, 2003). In this case, the corporate law is crafted by managers and board members to fit the circumstances of the market. The transparency requirement could suffer under this model where critical performance data are shielded from stakeholders like employees, suppliers, customers, banks and other lenders, and regulators (Lutz, 2000).
The regulatory authorities, in this model, play a fewer official roles leaving the unofficial market's mechanism regulate the process of governing. This model is best adopted in highly unrestricted economies where markets forces entirely determine and measure the performance of a corporation. One major requirement for such model to be applicable is the degree of awareness of market mechanisms in the part of stakeholders.
Emerging markets, such as the Saudi market, would be negatively impacted if such model is adopted. Nevertheless, this model was, in fact, adopted for a while in the emerging Saudi market and this involuntary adaptation was due to a shortage in coping with the fast evolution of the market in the recent years. This affected the transparency requirement tremendously and forced the regulatory agencies to take action and intervene to oversee performance data compliance with requirements. Saudi public companies are now subject to so many levels of overlapping regulations that many organizations are looking to create a more cost-effective corporate governance model.
The question becomes how to merge all requirements into a single process that satisfies multiple objectives. The answer is to develop a holistic, enterprise-wide corporate governance system that uses a single technology tool that can improve the effectiveness of corporate governance compliance by focusing management's attention to the transparency requirement importance. The possible lack of transparency could result in an exploitation of the shareholders interests in the hands of insiders. An extensive empirical study should be conducted to measure the impact of such period of performance opaqueness on the Saudi markets behavior in the long run.
The other model is a customized mandatory model of corporate law in which the regulatory authority, as opposed to the marketplace, plays a central role in protecting shareholder's interests by crafting mandatory rules that define shareholder rights (La Porta et al, 1998). Such model constitutes and mandates a high degree of transparency, enforced rigorously by the state, to enable the market to measure performance depending on reliable and accurate operation and financial data. The main goal of the transparency requirement is protect shareholders interests from abuses and mismanagement and to protect minority shareholders from the opportunism of controlling shareholders. Saudi Arabia should turn to a specifically tailored mandatory model of corporate governance instead of the market-oriented corporate governance model due to the shortage of capital market knowledge on the part of the market participants.
Stakeholders, such as shareholders (equity holders), bondholders, employees, and society at large.
Proposed Contribution:
CG Theory + Institutional Theory
Inst. Theory on CG and how CG in context relate to Inst. Theory
Item no. 2 is broken-down into:
Corporate Governance
Definition, theories, frameworks … etc (to be completed)
Solomon (2000) conducted a study to evaluate corporate governance by surveying a sample of large number of UK institutional investors. The study considered some published definitions of corporate governance. The most easily acceptable definition of corporate governance to UK institutional investors which received strongest support is the one that emphasize the relationship between a company and its shareholders. This definition by Parkinson (1994) of corporate governance is "the process of supervision and control intended to ensure that the company's management acts in accordance with the interests of shareholders". While Solomon (2007) has a broader definition of corporate governance that consider companies' accountability to the society, future generations, and the natural world. This view defines corporate governance as "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". This definition has included the influence of stakeholders to corporate governance which seems that countries are inclined towards this definition. For the purpose of this study, the second definition may suit our study.
Corporate Governance Models
The literature reveals that there is a number of corporate governance models which countries are inclined to adopt. In this section, different types of corporate governance models will be highlighted. According to Brezeanu and Stanculescu (2008, cited in Onofrei, 2007) there are three main models of corporate governance: traditional model, co-determination model, and stakeholder model. The traditional model is explicit to the North American system and includes three levels: directors, managers, and shareholders. Manager's authority is dependent on director's authority. Shareholders' rights are limited to election of members and make indirect decisions only. Management turnover can be applied by the board of directors in case of financial support absence by the shareholders. The co-determination model is explicit to the countries of Western Europe and includes four levels: directors, managers, shareholders, and employees. This model mainly represents Germany and compared to the traditional model the employees can make recommendations to the board of directors to reduce the risk. The stakeholder model is explicit to the countries in the Southeast of Asia and includes four levels too. The difference is in the complexity of the relationships. In this model there a due weight to each stakeholder but there is not a clear scope of rights and obligations which balances between the decision making process and the levels of on which it is based.
Cernat (2004) conducted a study on the European corporate governance and whether it falls into the Anglo-Saxon model, the continental model, or it is still a debatable issue. There are various variables and concepts used to describe corporate governance and the main two categories are: capital related and labour related. The first model is the Anglo-Saxon model, which based on a relationship between managers and shareholders. With regard to capital related aspects, the Anglo-Saxon model is characterized by dispersed equity holding (individuals) and a broad delegation to management of corporate responsibility. With regard to labour related aspects, the labour is not allowed to participate in strategic management decisions. A number of firms in America have delegated more decisions to workers through employee involvement programmes and team decision making. However, this participation is limited to operations management only which is not comparable to strategic management decisions. The other model of corporate governance is the continental model, which considers not only shareholders but also stakeholders. The most important stakeholders that can have an effect on decision making are employees through trade unions and works council. In this model, there are two tier board: the board of directors and the supervisory board. The employees have the right in the selection of members in the supervisory board. With regard to capital related aspects, the continental model is based on the role of banks and cross ownership in corporate finance. Banks are often own shares as a way of controlling customers' economic activities. Moreover, banks are allowed to make businesses in banks' branches (universal banking) while this feature is separated in the Anglo-Saxon model. With regard to labour related aspects, there is a significant importance at both macro level and firm level through workers' councils and co-determination practice. In Western European countries, works councils participate in decision making process, while trade unions are engaged in working conditions and wage bargaining.
In an article by Portolano (2003) the old model of corporate governance requires only a board of directors and a panel of statutory auditors. The duties of the panel of statutory auditors are to monitor companies compliance with the law and with accounting principles but the law did not provide for an internal body to supervise the management. The three new models have modified the audit functions which are: monitor compliance with the law and by-laws, particularly to monitor the adequacy of the organizational, administrative and accounting structure of the corporation. Moreover, the accounting control function is also separated and monitored by external auditors. The accounting control function is to maintain the accounting books correctly and to comply with accounting principles and practice. The three corporate governance models are: traditional model, which provides a board of directors and a panel of auditors; German model, which provides a board of directors and a supervisory panel; Anglo-Saxon model, which provides a board of directors and an internal audit committee. Since 1998, the three corporate governance models had already been implemented for companies. However, the fact that those corporations had to continue to use the available board of directors and the panel of statutory auditors implied that the new rules did not impact on how each corporation perceived the roles and duties of the panel of statutory auditors. Such management, audit, and accounting control separation will produce a larger impact on corporations and will change the behaviours of managers, investors, and lawyers.
Most of the studies in corporate governance systems have been conducted in developed countries and few studies have discussed corporate governance institutions in developing countries. Mueller (2006) have discussed the applicability of Anglo-Saxon model to emerging markets. In emerging markets there is a wide probability for firms to have attractive investment opportunities which can be financed by internal funds, banks loans, issuing bonds, or issuing equity. However, lack of experience and weak corporate governance laws may result in investing in a kind of high-risk projects that many companies in developing countries use equity as an attractive source of finance. These countries will probably pay for their weak governance in the form of less investment which may lead to slower economic growth. While when corporate governance systems are strong, like in developed countries, shareholders are protected and managers will issue shares only when they have attractive investment opportunities since these opportunities are much fewer than that in developing countries.
Corporate Transparency
In a rapidly changing world, many corporate governance reforms aim at increasing transparency. This objective has been uncontroversial, as transparency and disclosure practices are important factors and key indicators of corporate governance quality. Bushman et al. (2001) define corporate transparency as "the widespread availability of relevant, reliable information about the periodic performance, financial position, investment opportunities, governance, value, and risk of publicly traded firms". Bushman et al. (2004) indicate that there are two main dimensions of corporate transparency; governance transparency, which is "the availability of governance information to those outside of the firm" (Bhat et al, 2006) and financial transparency. Both dimensions are no less than other factors for companies success and stakeholders satisfaction. The work of Holm and Scholer (2010) on 100 listed companies in Denmark show that transparency is an essential mechanism for companies with exposure to the international capital market. A transparency and disclosure (T&D) Standard and Poor (S&P) ranking used to conduct a study by Wei-Peng et al (2007), the economic costs of equity liquidity are larger for those companies who have poor information transparency and disclosure practices. Bhat et al (2006) in a study across 21 countries observe that governance transparency for a country-level proxy is positively associated with analyst forecast accuracy after controlling for financial transparency. Moreover, they report that governance transparency has significant importance in jurisdictions with poor legal enforcement. Millar et al (2005) focus on Asia's emerging markets and indicate that the success of a corporate governance structure is measured by the extent to which it is transparent to market forces. Kolk (2006) considers fortune global 250 companies and claims that the call for transparency comes from two angles, accountability requirements which discuss staff and ethical aspects; and sustainability reporting which has been emerged from environment to social issues. A study conducted by Berglof and Pajuste (2005) in Central and Eastern Europe shows that increasing transparency in firms is one of the most important objectives not only about ownership and control structures, but also about what managers and controlling owners do, in particular how they reward each other. Reference to Mitton (2002) in a study carried out on the East Asian financial crisis reveals that companies offered greater transparency and disclosure quality, appear to have provided higher protection to their minority shareholders. Using both primary and archival data from Taiwan, Hsiang-Tsai and Li-Jen (2010) point out that compensation of board of directors, when there is greater board independence, can motivate them to act in the best way of shareholders interests. Besides, continuing education is a significant element in improving transparency of a firm.
The previous studies show only the importance of transparency in a positive way; however, Hermalin and Weisbach (2007) argue that increasing transparency can reduce firm profits, raise executive compensation, and inefficiently increase the rate of CEO turnover. Likewise, Perotti and Thadden (2003) highlight the impact of dominant investors on the cost of information collection, where lenders prefer less transparency as this protects firms that are positioned in a weak competition situation.
Robert et al. (2003) point out that corporate transparency vary across countries and over time and have classified corporate transparency measures into three categories: i) quality of corporate reporting, comprises credibility of disclosures by firms, timeliness, strength, principles dimensions, ii) intensity of private information acquisition, involves insider trading activities, analyst following up, dominance of pooled investment methods, iii) quality of information dissemination, covers penetration and private versus state ownership of the media.
Corporate Disclosure
There is a positive relation between disclosure and transparency. The greater disclosure offered by companies, the higher transparency gained. Disclosure definition (to be defined later). Bauwhede and Willekens (2008) examine the level of disclosure on corporate governance in the European Union and find the level of disclosure: i) is lower for firms with greater ownership concentration, ii) is greater for firms from common-law countries, iii) enhances with the level of working capital accruals. Markarian et al. (2007) examine disclosure practices across Anglo-Saxon and non-Anglo-Saxon firms using a dataset of 75 world's largest firms in two different time periods, 1995 and 2002. The study indicates that there are still considerable differences in disclosure aspects across regimes as of 2002, where Anglo-Saxon companies provide more disclosures. Though, the study reports that disclosure practices have been evolving and converging for both Anglo-Saxon and none-Anglo-Saxon companies towards more disclosures. Berglof and Pajuste (2005) examine disclosure in 370 listed companies in Central and Eastern Europe. They claim that the level of disclosure varies across firms and there is a strong country effect on companies disclosures.
Codes of Corporate Governance
Aguilera and Cuervo-Cazurra (2009) conduct a review study on codes of good governance and handle best practices on governance and recommendations on codes. The United Stated was the first country that issued a code of good governance in 1978, then Hong Kong was the second country in 1989, after that Ireland, the United Kingdom, and Canada in 1991, 1992, and 1993 respectively. By the middle of 2008, both the United States and the United Kingdom have issued 25 codes for each and the total number of codes is 200 from 64 countries. Findings from this study reveal that codes of good governance appear to have commonly improved the governance of countries that have adopted them. There have been a noticeable encouragement by transnational institutions, such as the World Bank or the Organization for Economic Co-operation and Development (OECD), to adopt global standards of governance practices, which are almost in line with the Anglo-Saxon model. It has been also noticed that codes of good governance push convergence in governance practices towards the Anglo-Saxon model in areas such as the audit committee, which is a strategic governance practice in the Anglo-Saxon model, but was rather uncommon in the Continental Europe model before the early 1990s.
