GCG Englishversion

GO OD CORPORATE GOVERNANCE
Konsep, Prinsip dan Praktik
Disusun oleh: Etty Retno Wulandari, PhD.
GO OD CORPORATE GOVERNANCE
Concept, Principles, and Practice
Prepared by: Etty Retno Wulandari, PhD.
TABLE OF CONTENTS
TABLE OF CONTENTS MESSAGE FROM CHAIRMAN LKDI PROFILE OF LKDI CHAPTER I. A. B. C. D. INTRODUCTION Background Definitions of Corporate Governance The need for Good Corporate Governance The Objective of Implementing Good Corporate Governance E. Summary F. Questions
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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
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Konsep, Prinsip dan Praktik GOOD CORPORATE GOVERNANCE
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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MESSAGE FROM CHAIRMAN LKDI

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
THE PROFILE OF 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 Advisory Board : : National Committee of Corporate Governance Mar'ie Muhammad Amrin Siregar I Nyoman Tjager Gunarni Soeworo Mas Achmad Daniri Kartini Muljadi Ratnawati Prasodjo 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
Executive Board
CHAPTER I
A. BACKGROUND
INTRODUCING
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
GOOD CORPORATE GOVERNANCE Konsep, Prinsip dan Praktik
Decree of the Coordinating Minister for the Economy No. Kep10/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.
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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.
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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?
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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.
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CHAPTER II
THEORY AND CONCEPT OF 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.
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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,
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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
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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
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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
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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 exante, 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).
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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
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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?
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CHAPTER III
CORPORATE GOVERNANCE ARRANGEMENTS
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 firmspecific 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
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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,
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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).
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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
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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
26
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.
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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,
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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.
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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.
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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.
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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.
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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 governmentimposed 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
33
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
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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 MECHANISMS
BETWEEN
CORPORATE
GOVERNANCE
The above review of corporate governance reveals that corporate governance arrangements are of three types: firm-specific, country-specific, and marketspecific. 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
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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.
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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.
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CHAPTER IV
GO OD CORPORATE GOVERNANCE PRINCIPLES
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
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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.
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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
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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 GOVERNANCE
CODE
OF
GOOD
CORPORATE
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 governance situation to implement good corporate
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
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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.
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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 SPECIFIC INDUSTRIES
GOVERNANCE
FOR
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
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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'.
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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
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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.
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CHAPTER V
IMPLEMENTATION OF CORPORATE GOVERNANCE
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 principlebased 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
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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
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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.
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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
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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 INDONESIA
OF
CORPORATE
GOVERNANCE
IN
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
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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
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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 nonaudit 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
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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 triplebottom 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
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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.
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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
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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.
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CASE STUDIES I
PT MEDCOENERGI TBK.
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
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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 4. Rashid Mangunkusumo 5. Darmoyo Doyoatmojo 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: 1. Sudono Suryohudoyo 2. Yani Rodyat 3. Retno Dewi Arifin 4. Cyril Noerhadi 5. Rashid Mangunkusumo 6. Darmoyo Doyoatmojo 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 2. Sudono Suryohudoyo 3. Yani Rodyat 4. Cyril Noerhadi 5. Darmoyo Doyoatmojo
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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.
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CASE STUDIES II
PT SARI HUSADA 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.
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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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GO OD CORPORATE GOVERNANCE

Konsep, Prinsip dan Praktik

Disusun oleh: Etty Retno Wulandari, PhD.

Prepared by: Etty Retno Wulandari, PhD.

Konsep, Prinsip dan Praktik GOOD CORPORATE GOVERNANCE

Konsep, Prinsip dan Praktik GOOD CORPORATE GOVERNANCE

MESSAGE FROM CHAIRMAN LKDI

Hoesein Wiriadinata Chairman

Konsep, Prinsip dan Praktik GOOD CORPORATE GOVERNANCE

THE PROFILE OF LKDI

Konsep, Prinsip dan Praktik GOOD CORPORATE GOVERNANCE

GOOD CORPORATE GOVERNANCE Konsep, Prinsip dan Praktik

B. DEFINITION OF CORPORATE GOVERNANCE

Konsep, Prinsip dan Praktik GOOD CORPORATE GOVERNANCE

C. THE NEED FOR GOOD CORPORATE GOVERNANCE

GOOD CORPORATE GOVERNANCE Konsep, Prinsip dan Praktik

D. THE OBJECTIVES OF IMPLEMENTING GOOD CORPORATE GOVERNANCE

Konsep, Prinsip dan Praktik GOOD CORPORATE GOVERNANCE

GOOD CORPORATE GOVERNANCE Konsep, Prinsip dan Praktik

Konsep, Prinsip dan Praktik GOOD CORPORATE GOVERNANCE

THEORY AND CONCEPT OF CORPORATE GOVERNANCE

A. THE THEORY OF THE FIRM

GOOD CORPORATE GOVERNANCE Konsep, Prinsip dan Praktik

Konsep, Prinsip dan Praktik GOOD CORPORATE GOVERNANCE

GOOD CORPORATE GOVERNANCE Konsep, Prinsip dan Praktik

Konsep, Prinsip dan Praktik GOOD CORPORATE GOVERNANCE

B. THE CONCEPT OF CORPORATE GOVERNANCE FROM THE SHAREHOLDERS' PERSPECTIVE

GOOD CORPORATE GOVERNANCE Konsep, Prinsip dan Praktik

Konsep, Prinsip dan Praktik GOOD CORPORATE GOVERNANCE

C. THE CONCEPT OF CORPORATE GOVERNANCE FROM THE STAKEHOLDERS' PERSPECTIVE

GOOD CORPORATE GOVERNANCE Konsep, Prinsip dan Praktik

Konsep, Prinsip dan Praktik GOOD CORPORATE GOVERNANCE

CORPORATE GOVERNANCE ARRANGEMENTS

A. FIRM-SPECIFIC GOVERNANCE ARRANGEMENTS

GOOD CORPORATE GOVERNANCE Konsep, Prinsip dan Praktik

Konsep, Prinsip dan Praktik GOOD CORPORATE GOVERNANCE

GOOD CORPORATE GOVERNANCE Konsep, Prinsip dan Praktik

Konsep, Prinsip dan Praktik GOOD CORPORATE GOVERNANCE

GOOD CORPORATE GOVERNANCE Konsep, Prinsip dan Praktik

Konsep, Prinsip dan Praktik GOOD CORPORATE GOVERNANCE

GOOD CORPORATE GOVERNANCE Konsep, Prinsip dan Praktik

B. COUNTRY-SPECIFIC GOVERNANCE ARRANGEMENTS

Konsep, Prinsip dan Praktik GOOD CORPORATE GOVERNANCE

GOOD CORPORATE GOVERNANCE Konsep, Prinsip dan Praktik

Konsep, Prinsip dan Praktik GOOD CORPORATE GOVERNANCE

GOOD CORPORATE GOVERNANCE Konsep, Prinsip dan Praktik

C. MARKET GOVERNANCE ARRANGEMENTS

Konsep, Prinsip dan Praktik GOOD CORPORATE GOVERNANCE

GOOD CORPORATE GOVERNANCE Konsep, Prinsip dan Praktik

Konsep, Prinsip dan Praktik GOOD CORPORATE GOVERNANCE

GOOD CORPORATE GOVERNANCE Konsep, Prinsip dan Praktik

Konsep, Prinsip dan Praktik GOOD CORPORATE GOVERNANCE

GO OD CORPORATE GOVERNANCE PRINCIPLES

A. THE OECD PRINCIPLES OF CORPORATE GOVERNANCE

GOOD CORPORATE GOVERNANCE Konsep, Prinsip dan Praktik

Konsep, Prinsip dan Praktik GOOD CORPORATE GOVERNANCE

GOOD CORPORATE GOVERNANCE Konsep, Prinsip dan Praktik

B. THE INDONESIAN GOVERNANCE

Konsep, Prinsip dan Praktik GOOD CORPORATE GOVERNANCE

GOOD CORPORATE GOVERNANCE Konsep, Prinsip dan Praktik

C. CODES OF GOOD CORPORATE SPECIFIC INDUSTRIES

Konsep, Prinsip dan Praktik GOOD CORPORATE GOVERNANCE

GOOD CORPORATE GOVERNANCE Konsep, Prinsip dan Praktik