CORPORATE GOVERNANCE | Teehankee

Introduction

The overall system of directing a corporation, commonly referred to as corporate governance, has
become a foremost concern of businesses and governments all over the world. Although much of
the literature on corporate governance emphasize the rules (whether imposed by government,
industry organizations, or by the corporation itself) and technical roles which guide a corporate
board in directing a corporation’s affairs, this chapter focuses on the relatively less explored
ethical and behavioral aspects of corporate governance. In particular, it examines the essential
role of ethics in corporate governance as it guides top management through the myriad
complexities of business decisions towards building a corporation that can deliver long-term value
for the benefit of shareholders and, ultimately, society as a whole.

This chapter will briefly discuss definitions, emerging concerns, notable corporate governance
failures and various perspectives regarding corporate governance. This will be followed by a
discussion of the relevance of ethics and corporate ethical development to corporate governance.
The role of corporate culture in the promotion of ethics in the corporation is presented next. And
finally, the relevance of ethics-oriented corporate governance to the capital market investor is
explained.

Defining corporate governance

Broadly speaking, corporate governance refers to the processes which enable the top
management of a corporation—particularly the board of directors, most commonly elected by the
stockholders—to direct, monitor and control the activities of operating management in order to
achieve the strategic vision of the corporation.

In order to better understand the nature of corporate governance, it helps to review two well-
known definitions. The first is from the British government commissioned report by the Committee
on the Financial Aspects of Corporate Governance (known as the Cadbury Report after the
committee’s Chairman, Sir Adrian Cadbury) that defined corporate governance in the following
terms:

Corporate governance is the system by which companies are directed and controlled.
Boards of directors are responsible for the governance of their companies. The
shareholders’ role in governance is to appoint the directors and the auditors and to satisfy
themselves that an appropriate governance structure is in place. The responsibilities of
the board include setting the company’s strategic aims, providing the leadership to put
them into effect, supervising the management of the business and reporting to
shareholders on their stewardship. The board’s actions are subject to laws, regulations
and the shareholders in general meeting (Cadbury et al., 1992, p. 15).

The Cadbury definition emphasized the twin functions of direction and control of the corporation
by the board as the core mission of corporate governance.

The Organization for Economic Cooperation and Development (OECD) formulated its own view
of corporate governance in its OECD Principles of Corporate Governance (Organization for
Economic Cooperation and Development, 2004):

…corporate governance … involves a set of relationships between a company’s

management, its board, its shareholders and other stakeholders. Corporate governance
also provides the structure through which the objectives of the company are set, and the
means of attaining those objectives and monitoring performance are determined. Good
corporate governance should provide proper incentives for the board and management to
pursue objectives that are in the interests of the company and shareholders and should
facilitate effective monitoring. The presence of an effective corporate governance system,
within an individual company and across an economy as a whole, helps to provide a

Corporate Governance | Teehankee 1

 degree of confidence that is necessary for the proper functioning of a market economy. As
a result, the cost of capital is lower and firms are encouraged to use resources more
efficiently, thereby underpinning growth (p. 11).

Though similar in many respects to the Cadbury definition, the former definition emphasized the
board and management’s leadership, accountability and stewardship, while the latter definition
focused more on the economic efficiency and financial benefits of corporate governance and its
relationship with the growth of the economy as a whole.

In 2002, the Philippines’ Securities and Exchange Commission (SEC), defined corporate
governance as “a system whereby shareholders, creditors and other stakeholders of a
corporation ensure that management enhances the value of the corporation as it competes in an
increasingly global market place” (Securities and Exchange Commission, 2002, p.1). The
definition then explicitly included stakeholders as a concern of corporate governance and
recognized the far-reaching impacts of business activities on parties other than the managers and
owners of the corporation (Phillips, 1997). This is crucial in the fragile development environment
of the Philippines.

In 2009, the Securities and Exchange Commission (Securities and Exchange Commission, 2009,
p.1), in an apparent policy shift, revised its definition to refer to “the framework of rules, systems
and processes in the corporation that governs the performance by the Board of Directors and
Management of their respective duties and responsibilities to the stockholders” (underscoring
added). The SEC’s narrowing of the definition of corporate governance caught some local
observers by surprise. Ateneo Law School Dean Cesar L. Villanueva remarked that “instead of
being able to evolve the system of stakeholdership for Philippine public companies, the SEC
seems to have lost the heart and just decided to go back to the old corporate maxim that the duty
of the Board of Directors of every corporation is to maximize its profits" (BusinessWorld, July 15,
2009). In its defense, the SEC has stated that the revised Code “was the subject of extensive
research and lengthy consultations with the covered companies [and] in deciding its provisions,
the SEC struck a balance between the requirements of applicable laws and the interests of the
covered corporations and the public” (SEC, personal communication, January 11, 2019).

While the impact of the local change in definition remains to be seen, it is clear that corporate
governance has no rigid agreed-upon definition. The concept means slightly different things to
different defining entities and in different countries. Alexander (1999) outlined the often widely
divergent expectations of different countries with respect to the role of the board:

In the United States, directors are generally more likely to define their role as running the
company for the benefit of the shareholders; in Germany, directors on the supervisory
board are more likely to frame this duty in terms of their allegiance to the company; and in
Japan, directors may give precedence to stakeholders’ interests representing employees,
suppliers, customers and the community in which a company operates (p. 7).1

Bebchuk and Hamdani (2009) further argue that “any attempt to assess the governance of public
firms around the world should depend critically on ownership structure … [and] some
arrangements that benefit outside investors in companies without a controlling shareholder are
either practically irrelevant or even counterproductive in the presence of a controlling shareholder,
and vice versa” (p. 5).2 As will be discussed below, many large Philippine corporations typically
have only a few controlling shareholders.

It is important for Philippine investors in the capital markets to be conscious of the cross-country
variations in defining corporate governance given the globalized corporate landscape. Here is
where the role of ethics in corporate governance becomes important because what may enhance
short-term value can, in the absence of ethical prudence, actually impair long-term value.

Scandals and collapses: The growing concern for corporate governance

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The spate of international high-profile business scandals and collapses since the opening of the
century has put the spotlight on corporate governance. Everyone has been reminded that issues
of dishonesty and imprudence by managers of private business concerns have very public
impacts such as the loss of general confidence in business, the downturn of the capital markets
and the loss of financial security for shareholders and employees of the affected corporations and
entire economies.

The case of Enron in 2001 highlighted the far-reaching dangers of corporate misdeeds resulting
from reckless management. Before the financial scandal broke out, the Houston-based energy
company was highly regarded by the business and public community. The company had been
voted as “Most Innovative” by Fortune magazine for several years in a row. Its spectacular growth
enabled it to land among the top 10 largest corporations in the Fortune 500.

Exposés by investigative journalists, however, revealed the less than ideal strategies used by
Enron to achieve their impressive results (McLean, 2001a; McLean, 2001b). Enron management,
through the initiation of chief financial officer Andrew Fastow, entered into several partnership
arrangements with a number of special purpose entities (SPEs) in order to mask the level of debt
held by the company. The strategy was calculated to promote the ever-rising trend in the
company’s stock price by convincing investors and creditors that the company was more
financially sound that it really was. While technically legal, some of the SPEs turned out to be
headed by Fastow himself. Under the arrangement, Fastow stood to make millions of dollars as
head of the SPEs. This arrangement was a clear conflict of interest and a serious breach of the
company’s code of ethics but the arrangement was given the blessing of the board. Following the
various revelations of financial malpractices, Enron eventually filed for bankruptcy at which time
its share price had already dropped to less than US$1 from more than US$60 when the media
attention began ten months earlier (Cruver, 2003; McLean, 2001a). Fastow has since pleaded
guilty to working with senior Enron management to fraudulently manipulate the company’s
publicly reported financial results to mislead investors while inflating the company’s stock price
(Associated Press, January 14, 2004). Because of his cooperation, he is serving a six-year term
and is scheduled for release in 2011 (Federal Bureau of Prisons, 2009). Enron president Kenneth
Lay was found guilty but died before sentencing in 2006 (Mulligan & Bustilloin, 2006).

While the Enron debacle and those which followed in its heels, such as WorldCom and Tyco
International, have caused huge financial losses, these have been suffered by specific groups
linked to these companies. In recent years, however, weaknesses in corporate governance
among financial institutions have caused a global financial crisis (Kirkpatrick, 2009). Awash in
funds from domestic and foreign sources, financial institutions competed aggressively for
borrowers by offering cheap housing credit. While this led to a housing boom in the US, the
eventual decline in housing prices triggered large defaults in housing mortgages, many of which
were imprudently given with little or no collateral (often referred to as “sub-prime”). The resulting
economic contraction led to the near-collapse of financial institutions such as Bear Stearns and
the American International Group in the US, Northern Rock in the United Kingdom and
Sachsenbank in Germany, to mention only a few. These institutions were saved only after
government help (Bernanke, 2009; Kirkpatrick, 2009). As a result unemployment in the US has
exceeded 10% and major economies in the world entered a recession. The crisis has been called
the worst business downturn since the Great Depression while analysts at the World Economic
Forum have estimated the loss of global wealth in 2008 at 40 percent (Gritten, 2009). As of
January 2010, the United Kingdom remained in recession while the other major economies had
already achieved growth.

Thus, the subprime mortgage debacle that led to the global financial crisis had linkages to
corporate governance failure (Bicksler, 2008). A crucial failure was that the CEOs of several
players in the mortgage market were grossly overpaid. Minow (2008) names three companies
and their executives as examples: Angelo Mozilo of Countrywide Financial, Charles Prince of
Citigroup, and Stanley O’Neal of Merrill Lynch. Mozilo received compensation of $102m for 2006,
and then sold $ 127m in stock options before July 24, 2007 when Countrywide announced a write
down of earnings in the amount of $388m. Prince received $25.9m in 2006, and in 2007, due to
Citigroup’s subprime lending, there was a write down of $24.1bn. Shortly thereafter, he resigned

Corporate Governance | Teehankee 3

as CEO and left with a severance package of $40m, with the market price of Citigroup stock
decreasing by 45% by end of 2007. O’Neal received compensation of $91m in 2006 due to record
earnings of $7.6bn, a 50% increase over the 2005 figure. In October 2007, Merrill Lynch had a
subprime mortgage write down of $14.1bn and an additional write down of $8.4bn in January
2008, making a total write down of $22.5bn relating to the subprime mortgage debacle. O’Neal
retired in late 2007, receiving an excess of $160m in stock and benefits, in spite of the fact that
Merrill Lynch stock price decreased by 41% in 2007. Other mortgage firm examples that could be
cited for CEO pay without performance include New Century Financial Corp., Novastar Financial
Inc., and American Home Mortgage.

Critics of excessive compensation have pointed their fingers at the directors of public
corporations. Bebchuk (2007) argued that shareholders do not have enough power and, worse,
their elected representatives, particularly the independent directors, far too frequently make
decisions that are not in the best interest of the shareholders. Greenspan (2002) remarked that
directors are beholden to CEOs who appoint them while Welch & Welch (2006) similarly blame
the directors who approve such outlandish compensation packages.

The OECD Steering Group on Corporate Governance (Kirkpatrick, 2009) concluded that:

the financial crisis can be to an important extent attributed to failures and

weaknesses in corporate governance arrangements. … corporate
governance routines did not serve their purpose to safeguard against
excessive risk taking in a number of financial services companies. …The risk
management systems have failed in many cases due to corporate
governance procedures …. [and] information about [risk] exposures in a
number of cases did not reach the board and even senior levels of
management …. boards had approved strategy but then did not establish
suitable metrics to monitor its implementation (p.2).

In the local front, concerns about the trustworthiness of local business have also been expressed.
The Bureau of Internal Revenue reported that 80 percent of the companies it was monitoring
were delinquent on their taxes. Eighty-five percent of these companies were asked to correct their
tax payments and these included over 1,000 large taxpayers (Bañez, 2004). From a broader
perspective, Echanis (2006) analyzed the Philippine corporate governance system and identified
weaknesses in mechanisms with respect to: 1) decision processes; 2) violation of regulations; 3)
weaknesses of regulatory agencies; and 4) financial reporting standards.

The concern with ensuring that companies are run in a sound and trustworthy manner is, of
course, not new. The famous Cadbury Report (Cadbury et al., 1992) was itself triggered by a
wave of corporate failures and scandals in the United Kingdom in the late 80s. When the Report
was released, which included the Code of Best Practice, it reasoned that:

Had a Code such as ours been in existence in the past, we believe that a number of the
recent examples of unexpected company failures and cases of fraud would have received
attention earlier. It must, however, be recognized that no system of control can eliminate
the risk of fraud without so shackling companies as to impede their ability to compete in
the market place (p.12).

In the US, Enron and related business scandals prompted the passage of the Sarbanes-Oxley
Act in 2002. The Act requires, among others, that the company's executive and financial officers
certify the integrity of company financial reports. While stringent, doubts have been expressed on
whether it can positively affect corporate governance (Kuschnik, 2008).

The concern for corporate governance signals the growing need to ensure that business
corporations develop a corporate conscience and, through this, achieve the old dictum of “profit
with honor”. If corporate governance can incorporate ethical profit into its functions, government
regulation will not have to be excessive because ethical control will be mainly internal to the
corporation itself. The role of the Board in making sound financial decisions in relation to the long-
term value of the firm is vital.

Corporate Governance | Teehankee 4

Various perspectives on corporate governance

Much of the thinking in corporate governance has been influenced by agency theory (Fama,
1980; Fama and Jensen, 1983). Agency theory comes from the field of finance and economics
and emphasizes the need for boards (who represent stockholders as principals) to control
management (conceived agents of the stockholders) against the latter’s potential for excessive
self-interest to the detriment of stockholders. This theory, therefore, recommends ways by which
stockholders, through the board, can better monitor the activities of management. These
recommendations include the use of independent directors to improve monitoring and the use of
economic incentives for managers, such as stock options, to better align management’s interests
with that of stockholders.

Despite the popularity of agency theory, the empirical verification of the theory’s predictions has
not been very impressive. Specifically, no reliable link has been found between board incentives
to monitor management and firm financial performance (Hillman and Dalziel, 2003). Aside from
weak empirical support, agency theory exclusively emphasizes the individualistic and self-
interested motivations of managers and, thereby, ignores the broad motivations that humans are
capable of which can lead to better-run corporate institutions. To address the limitations of agency
theory, alternative perspectives in governance have been put forward, particularly, stewardship
theory, resource dependence theory and institutional theory. These alternative theories have
looked not only at the economic and financial aspects of corporate activities but also the
relational, social and community aspects (Lynall, Golden and Hillman, 2003).

Stewardship theory (Davis, Schoorman and Donaldson, 1997), in particular, builds on

psychological motivation theory and recognizes that individuals who are motivated by intrinsic
and intangible rewards such as affiliation, achievement and personal growth tend to align
themselves as stewards with the goals of an involvement and trust-oriented organization. This
provides an alternative model of man to the extrinsically motivated and opportunistic individual in
agency theory.

It is helpful to note that agency theory arose mainly from the intellectual traditions of the West,
particularly in its focus on individualistic behavior. The Asian countries, in contrast, are known for
collectivist cultures and management goals which differ from those in the West (Hofstede, 2007).
This consideration suggests the need to look beyond individual motivations in approaching
corporate governance. Washington Sycip, founder of the prominent Sycip, Gorres and Velayo
(SGV) auditing firm, has argued for taking into account the relationship-based aspects of
governance and being careful about the imposition of Western standards in Asian countries
(Adriano and Madrilejos-Reyes, 2003).

Thus, the board may be seen not only as a monitoring and control body but also as a resource-
generating and guidance-providing body (Carpenter and Westphal, 2001; Westphal, 1999). The
role of guidance, in particular, is where corporate governance as corporate conscience becomes
centrally important. As an example, Treviño and Nelson (2004) describe how the Chairman of
Lockheed Martin gives a “Chairman’s Award” to employees who practice exemplary and
exceptional work in the area of ethics. The first winner was Ron Covais, a vice president in
business development. Covais, during the course of bidding for a foreign customer, was
requested for a bribe by a foreign official. Covais not only rejected the bribe request, as routinely
required by the company code, but “removed Lockheed Martin from the bidding process (and,
consequently walked away from an important contract), reported the problem to senior officials,
and worked with both U.S. government officials and the foreign government to have the foreign
official removed from the decision-making process. The customer subsequently agreed to
conduct a new bidding process on ethical terms.

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With respect to the role of government in ensuring proper corporate governance, some countries
have been increasing the level of legal requirements defining what boards should do. This has
been partly triggered by the many scandals mentioned earlier. The Philippines has been pursuing
a similar tightening of governance rules (Securities and Exchange Commission, 2002, 2009)
patterned mostly on the regulatory trends in the United States.
The Bangko Sentral ng Pilipinas (BSP) has required that all bank board directors attend a special
seminar conducted by the BSP itself or training entities it has accredited (Bangko Sentral ng
Pilipinas, 2001). Among the accredited training institutions are the Institute of Corporate Directors,
De La Salle University-Graduate School of Business and the Asian Institute of Management.

As previously mentioned, the Securities and Exchange Commission (2002), for its part,
promulgated the Code of Corporate Governance which:

 Required corporations to submit a Manual on Corporate Governance for implementation

by January 1, 2003;
 Required full disclosure on any aspects of company activities which could affect share
price such as earnings results, related party transactions, etc., as well as related
information such as senior management compensation and off-balance sheet
transactions;
 Required the appointment of at least two independent directors or 20% of the
membership of the Board, whichever is lesser, and;
 Recommended the separation of the role of the Chairman of the Board and CEO.

The 2009 revision of the Code of Corporate Governance tightened corporate accountability by
requiring the appointment of compliance officers who report directly to the board chairman and
who has the duty to monitor the corporation’s compliance with the Code and to appear before the
SEC when summoned regarding the corporation’s compliance.

While the impact of such increased regulation cannot be pre-judged before data and experience
on them can be gathered, it should be pointed out that regulations alone are not adequate in
ensuring responsible behavior among business corporations. In fact, at a certain point,
regulations can become counter-productive. The Cadbury Report (Cadbury et al., 1992) made a
cogent argument for a cautious approach towards regulation while emphasizing the need for
greater self-directed accountability among corporations. It said:

The country’s economy depends on the drive and efficiency of its companies. Thus the
effectiveness with which their boards discharge their responsibilities determines [the
country’s] competitive position. They must be free to drive their companies forward, but
exercise that freedom within a framework of effective accountability. This is the essence of
any system of good corporate governance. .… We believe that our approach, based on
compliance with a voluntary code coupled with disclosure, will prove more effective than a
statutory code (p. 11).

This chapter does not take sides on whether statutory codes or voluntary codes are better. It does
take the stand that codes alone are insufficient in ensuring that corporations are properly run.

The relevance of ethics and social responsibility to corporate governance

The popular view in finance and economics has emphasized the primacy of management’s duty
to satisfy the requirements for return by stockholders. Noted economist and Nobel laureate Milton
Friedman (Friedman, 1993) argued for this view most forcefully when he said:

… there is one, and only one social responsibility of business–to use its resources and
engage in activities designed to increase its profits so long as it stays within the rules of
the game, which is to say, engages in open and free competition without deception or
fraud (p. 167).

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This view of the social responsibility of the firm has been called the classical model of corporate
social responsibility (Desjardins, 2003). The classical model has been challenged on the grounds
that the single-minded pursuit of profit can lead to many harmful effects such as environmental
degradation (e.g., sale of vehicles without filters for fuel emissions), the neglect of employee
welfare (e.g., extensive labor contracting in core functions) and short-cuts in product safety
assurance (e.g., the Ford Pinto)—all of which may be legally “within the rules of the game” but
harm others or otherwise ignore their rights.

The main problem with defining what is ethical and socially responsible based purely on
established rules is that the rules themselves take time to develop – usually much longer than the
time it takes reasonable individuals to believe that a certain corporate behavior is wrong. For
example, in Metro Manila, companies favored putting up manufacturing plants beside the Pasig
River precisely because it was economically cheap to dump waste in the river, even if this would
harm other users of the river. The savings in waste disposal because of river dumping benefits
companies and their customers. The dumping, however, harms other users of the river who are
not part of the market transaction between the companies and their customers. This is the
“externality problem” that economists note as a major problem with relying exclusively on market
forces to guide business behavior. It was much later, when the pollution had exceeded humanly
tolerable levels, that legislation banning the dumping of waste in the river took effect.

Despite the increase in legal regulations on the conduct of corporate business following the
recognition of the limits of the market, it is useful to examine core principles that can guide
corporate governance in a proactive manner, i.e., even prior to invoking legal boundaries. After
all, Section II-4 of the Code of Corporate Governance (Securities and Exchange Commission,
2002) refers to “integrity and probity” as desirable qualifications for board directors. Integrity
presumes adherence to a set of principles.

Although an extensive discussion of ethics is beyond the scope of this chapter, it will be helpful to
outline some fundamental principles proposed by ethicists for justifying human, and therefore,
corporate action. From classical ethics literature, principles include duty to others (respect for
rights) and striving for good consequences for people (common good). An act would be ethical,
therefore, if it showed due respect for the rights of others and it benefited the most number of
people.

Beyond classical principles and with the growing globalization of business, various international
organizations have attempted to summarize commonly meaningful ethical guidelines. Dalla Costa
(1998) integrated the guidelines from the Parliament of the World’s Religions, the Interfaith
Declaration, Ad Hoc Inter-Faith Working Group and The Caux Principles, and he identified core
values which seem to converge. These convergent principles may be considered as a preliminary
set of ethical universals for business. They include the imperatives to respect life (in the sense of
assuring dignity for all), to be fair (especially when competing), to be honest and to strive for
justice (especially in caring for the weak), and to honor the environment. The ethical business
organization is one that pursues the above ethical imperatives alongside the financial imperative
to deliver returns to owners and investors.

The extent to which ethical principles are used in corporate governance depends on the
importance given to such principles by the members of the board themselves. In particular, it
matters a great deal whether the board views their responsibility exclusively to the stockholders
or recognizes the company’s responsibilities to a greater set of stakeholders. Figure 12.1 portrays
the company’s duty to earn the trust of various stakeholders by itself behaving in a trustworthy
manner towards these stakeholders. As the figure shows, the corporation is in the middle of a
network of mutual obligations with various stakeholder groups. While the obligation to deliver fair
and attractive returns is an important one, it does not detract from the equally important obligation
to deliver valuable products and services to customers, meet the needs of employees,
compensate suppliers, repay creditors, pay taxes and comply with society’s laws. The growing
concern over sustainability and climate change even point to the need for corporations to be
concerned for individuals yet unborn3.

Corporate Governance | Teehankee 7

Figure 12.1 also shows that the board plays a central balancing role in meeting the corporation’s
obligations to all significant stakeholders. Major business scandals, including Enron, were a result
of a gross disregard for the rights of one or more stakeholders.

Figure 12.1 The company and its main stakeholders

Source: Partly based on Phillips, 2003, pp. 126-127.

Donaldson and Preston (1995) emphasize that corporations should recognize, respect and
address the legitimate interests of stakeholders as worthy in themselves, over and beyond the
instrumental profit value of addressing such interests. For example, while meeting the basic
needs of employees (e.g. dignity, subsistence, security, recognition, growth, etc.) can increase a
company’s competitiveness due to increased motivation, productivity, and reduced turnover, such
needs must be met because they are fundamental human rights. Thus, respecting stakeholder
rights is good in itself separate from its potential for producing corporate profits.

Levels of corporate ethical development

In evaluating the level of trustworthiness of a corporation, it is useful to look at the level of ethical
culture that has been developed by the system of corporate governance and the daily leadership
of management. In an interesting extension of the cognitive moral development model for
individuals, Reidenbach and Robin (1991) developed a model describing the stages of moral
development of a corporation (Table 12.1).

Table 12.1 Stages of corporate moral development

Stage One: The Amoral Corporation
Stage Two: The Legalistic Corporation
Stage Three: The Responsive Corporation
Stage Four: The Emergent Ethical
Corporation
Stage Five: The Ethical Corporation
Source: Based on Reidenbach and Robin, 1991.
Pursues winning at any cost; views employees
merely as economic units of production.
Concerned with the letter of the law, but not its spirit;
adopts legalistic codes of conduct.
Interested in being a responsible corporate citizen,
but primarily because it is expedient, not because it
is right; beginnings of codes of ethics.
Recognizes the existence of a social contract
between business and society, and seeks to instill
that attitude throughout the corporation.
Balances profits and ethics so completely that
employees are rewarded for walking away from a
compromising action; includes ethical issues in
training; has mentors to give moral guidance to new
employees.

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For the Amoral Corporation, ethical considerations do not arise at all, except the imperative to
compete. A corporation who sets up sweatshop operations to achieve profit goals while being
unmindful of the basic needs of employees would be at this level. Such corporations may not
intend to be unethical–they are simply oblivious to the ethical considerations inherent in running a
business.

The Legalistic Corporation defines ethics as complying with the letter of the law and nothing
more. In Friedman’s (1993) language, the law defines the “rules of the game” and, therefore, any
act, which is not illegal, is de facto ethical. At this level, the board would caution management to
ensure that the corporation breaks no laws.

The Responsive Corporation realizes that there are expectations from parties other than the
owners and management of the corporation. Such expectations can impact on the success of the
corporation. The corporation begins to take these expectations into account in order to achieve a
smoother implementation of corporate strategies. A corporation who participates in corporate
social responsibility programs in the community to support various projects and thus improves
community relations would be working at this level. At this level, the board would encourage
management to reach out to important stakeholders.

The Emergent Ethical Corporation recognizes that its legitimacy is based almost entirely on the
consent of society. It ensures that such a “social contract” is honored by making all its members
aware of its inherent duty to be a trustworthy corporate citizen. At this level, the board would
encourage management to imbue the corporation with the value of social responsibility.

The Ethical Corporation so completely integrates ethics into its goals and systems that corporate
rewards and substantial leadership time are allocated to its pursuit. At this level, the board
requires management to always pursue “profit with honor”.

From the point of view of the long term value of a firm, it can be argued that as long as the
company has an essentially sound economic footing, it will have a higher chance of survival the
more advanced the stage of moral development it has achieved. This is because the company
builds a valuable reputation with its stakeholders–-not just its shareholders–-that include
customers, employees, suppliers and the community at large. Thus, the moral stewardship of the
board becomes a nurturing guide in the company’s journey towards becoming an ethical
corporation.

Corporate culture and governance

Corporate leaders are now better able to understand that the core values of a company are
crucial for its proper governance. Manuel Pangilinan, former CEO and now Chairman of
Philippine Long Distance Telephone Company, emphasized the importance of "old-fashioned core
values" such as honesty, diligence, commitment and hard work (“What the ‘Love’ bug teaches
about business ethics, 2000, p. 8).

The core values of a corporation comprise its culture. Corporate culture is the combined beliefs of
members about what is right and wrong to do in going about its business activities. It is the
corporation’s “way of life”. More precisely, organizational psychologists define it as “a pattern of
shared basic assumptions that the group learned as it solved its problems of external adaptation
and internal integration, that has worked well enough to be considered valid and, therefore, to be
taught to new members as the correct way to perceive, think, and feel in relation to those
problems” (Schein, 1992).

Therefore, an ethical business organization is one where a tried-and-tested culture motivates its
members to act in the most balanced interest of its various stakeholders, including owners,
employees, customers, creditors, suppliers, the community at large and government. Such an
organization is said to have an ethical culture.

Corporate Governance | Teehankee 9

The formation of corporate culture is strongly influenced by the leadership of the business,
especially during times of crises when survival is an issue. Thus, if top management emphasizes
ethical principles such as duties to stakeholders and seeking the common good while achieving
profitable operations, these principles will be embedded in the corporate culture as well.

Johnson & Johnson demonstrated how a corporate culture founded on ethical values helped its
top management to deal with a major corporate crisis (Shaw and Barry, 2001). In 1982, seven
people died in the Chicago area from cyanide-laced Extra-Strength Tylenol capsules. Though it
was not responsible in any way for the contamination, the company was guided by its self-
declared duty to protect the safety of consumers to quickly recall 30 million bottles of Tylenol from
store shelves nationwide and to notify 500,000 doctors and hospitals about the contamination
incidents. The recall cost the company US$50 million and yet Tylenol recovered its market share
within one year after releasing an improved contamination-resistant packaging for the drug. The
company showed that a corporation who pursues ethical principles could achieve financial
success.

Unfortunately, financial success without a foundation in ethical values can be a self-reinforcing

source for the unethical culture itself. Enron was voted “Most Innovative” among the “Most
Admired Companies” for six years in a row by Fortune magazine. Yet, analysts noted that a
“culture of arrogance” had formed, leading members to believe that there was unlimited profit to
be made from commoditizing and monetizing the most varied products and services, from
electricity to advertising space. Because Enron believed it was pursuing revolutionary business
practices, its top management produced a culture that encouraged ignoring established business
rules (McLean, 2001).

How is ethical corporate governance linked to firm financial and stock performance?

Investors concerned about the economic return on their investments would be interested in how
corporate governance links with financial and stock performance. Research has, therefore,
looked into various aspects of corporate governance and its link with various indicators of firm
performance; especially accounting returns and stock price.

Lemmon and Lins (2003) found evidence linking ownership structure with firm value among
companies in eight East Asian countries affected by the financial crisis of the late 90s, including
Hong Kong, Indonesia, Malaysia, Philippines, Singapore, S. Korea, Taiwan and Thailand. They
found evidence that in companies where top management has greater management control but
proportionately lower ownership, the firm value dips. They interpreted this to mean that the
controlling management tended to expropriate wealth from other shareholders to the latter’s
detriment. In the Philippines, they noted the mean management control percentage to be 44
percent, the highest among Southeast Asian countries.

The link of corporate governance practices and financial firm performance is not simple and has
not been clearly demonstrated, at least in the short-term. However, there is some foreign
evidence that ethics-guided corporate governance has reduced accounting manipulation and has
led to top executives being disciplined for poor performance (Dedman, 2000).

In the related area of corporate social responsibility, recent research has linked social
responsibility practices of Philippine companies with higher return on equity and stock price
(Subido, 2003). Such a phenomenon has been observed elsewhere, leading Small and Zivin
(2002) to theorize that when enough investors prefer corporate philanthropy over direct charitable
giving (e.g., to avoid taxation of corporate profits), a company can improve its stock valuations by
following social policies that involve positive levels of corporate altruism. A share in a
“responsible” firm, therefore, becomes a charity-investment bundle.

A study by Chen, Chen and Wei (2003) showed that in Asia’s emerging markets, which includes
that of Hong Kong, India, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan and
Thailand, good corporate governance practices tend to coincide with significantly lower cost of

Corporate Governance | Teehankee 10

equity capital for corporations. In particular, companies in the 75 th percentile in rankings of
corporate governance practices tend to have a cost of equity capital 1.26 percentage points lower
than those in the 25th percentile. The study used corporate governance surveys released by
Credit Lyonnais Securities Asia (CLSA).

While a positive link between proper corporate governance and financial performance has not
been conclusively demonstrated by research, plenty of case evidence demonstrates that its
absence has tended to precede spectacular plunges in corporate market value as in the case of
Enron. In the European business arena, Parmalat, one of Europe’s biggest food firms employing
36,000 employees in 30 countries, experienced a plunge in share value of more than 50% after
revelations of US$5 billion in fictitious assets in its balance sheet (Parmalat admits $5bn black
hole, 2003).

In the Philippine setting, a questionable stock market practice involving one company negatively
impacted on the performance of the stock market as a whole. BW Resources, a little-known
company with no profitability track record saw its share price soar from less than Php 2 to over
Php 100 in 1999. Revelations of stock price manipulation eventually caused the price to fall below
Php 1 but the negative publicity also caused the overall market to substantially drop in value
(Sanchez and Flores, 2001).

The Ayala group leads the local field in embracing transparency practices. Manila Water, a
member of the group, was the first local company to file a report under the Global Reporting
Initiative (GRI) which is based on the triple bottom-line approach in corporate reporting. The
group recently announced that all its member companies will be filing GRI reports
(Inquirer.net, 2009).

Clearly, the transparency of management is a key issue in the above cases. Thus, experienced
investors consider the importance of board and managerial integrity when making investment
decisions. Warren Buffet, well-known and highly successful value investor and head of Berkshire
Hathaway, recognizes that the honesty and integrity of top management is a pre-requisite for
sustainable financial performance of corporations. He insists that, for all businesses in which he
will invest, top managers live up to, among others, the following statements:

I am candid with everybody with whom I have dealings—shareholders, colleagues,

employees, customers, and others. I do what I think is right, rather than what others are
doing (Heller, 2000).

Corporate governance in the Philippines: Observations and levels of compliance

Researchers and academics have looked closely at some aspects of corporate governance in the
Philippines, especially in terms of ownership and board structure (Hills Program on Governance,
2009). One notable feature is that publicly listed companies are not widely held by the public.
Saldaña (2001), citing 1997 data, reported that an average of only five shareholders hold majority
control over publicly listed companies in the Philippines. In the domestic banking industry, Unite
and Sullivan (2003) reported that insider ownership (i.e., by directors, officers, and related
interests as well as by group-affiliated companies) of publicly traded banks declined from 55.34%
in 1992 to a still substantial 43.25% in 1998.

Such concentrated ownership of publicly listed corporations leads to certain features of Philippine
corporate governance as reported by the Institute of Corporate Directors (2000):

1. The controlling shareholders, belonging to one family or one group of closely

interconnected business interests, generally control both the Board of Directors and
management.
2. There are few, if any, outside independent directors in a corporate board.
3. Management, which tends to be increasingly professional, has to clear with the
controlling shareholders any major (and still, even minor) corporate decisions.

Corporate Governance | Teehankee 11

 4. Minority shareholders, in practice, have neither voice nor effective vote. Activism on the
part of minority shareholders does not lead anywhere.
5. Standards of disclosure are low. Based on recent experience, even audited financial
statements by internationally connected public accounting firms can not be taken at face
value.
6. The regulatory regime is weak to enforce an otherwise modern corporation law.
7. Banks can serve as external controllers of companies, given the practice of relationship
finance. But in practice, when payments are suspended or when a corporate
rehabilitation has to be undertaken, banks have limited power under the law (PD 902-A).
8. There is no effective market for corporate control to discipline inefficient management
and constrain self-dealing. The Philippine stock market has not been attractive for long-
term institutional investors.

Dumlao (2006) described the dynamics resulting from the concentration of ownership in
Philippine corporations often achieved through webs of family businesses. Such concentration
tends to create excessive control rights and private remuneration. Controlling stockholders
become disproportionately powerful in appointing executive managers, which often include
themselves, who then gain from greater income and perquisites. This leads to executive
decisions not necessarily benefiting all stockholders. This has been termed as the “expropriation
problem” since the controlling shareholders could secure a disproportionately bigger share of the
benefits at the expense of minority shareholders. The risk of expropriation increases in cases
where minority shareholders achieve control through corporate pyramiding and related
arrangements. Bebchuk and Hamdani (2009) echo this point when they argue that “concerns
about insider opportunism should increase when control is locked in the hands of controlling
minority shareholders” (p. 52). Corporate pyramids are commonly practiced by the largest
corporations in the Philippines (Dumlao, 2006)

The above features make Philippine corporate governance distinct from that of the United States,
Germany or Japan and similar to that of many other developing countries as described by
Schleifer and Vishny (1997) “which provide extremely limited protection of investors, and are
stuck with family and insider-dominated firms receiving little external financing.” It is likely that the
growth of the Philippine capital market will be limited and shares not widely held until more
protection for investors can be generated from the courts, government agencies and the market
participants themselves (La Porta et al., 2000).

With regard to the earlier-mentioned Code of Corporate Governance which the SEC promulgated,
a study on the trends in the corporate governance practices of the 100 largest publicly listed
companies in the Philippines from 2002 to 2007 (Hills Program on Governance, 2009) revealed
the following trends during the period:

1. The number of companies with the minimum requirement of two independent directors
more than doubled although two companies still had no independent directors by 2007.
2. The percentage of companies disclosing the names of their independent directors in their
annual reports rose from 55% to 96%.
3. Most of the companies did not report the frequency of board meetings in their annual
reports. By 2007, only 27 companies disclosed this information.
4. The number of companies disclosing information about executive compensation
increased from 35 to 100. None of the companies, however, gave a breakdown of such
compensation per executive but only reported the aggregate amount.
5. By 2007, most companies had adopted a corporate governance manual and were
disclosing their corporate governance practices in their annual reports. However, as of
2007, only 60 of the Top 100 Companies reported having implemented a performance
evaluation system for directors and top officers.

The trends reported above for the largest publicly listed companies are encouraging from the
point of view of ensuring greater transparency and accountability. However, there is much room
for improvement since regularity of meetings and performance evaluation systems are essential
elements of competent corporate governance.

Corporate Governance | Teehankee 12

For its part, the Philippine Stock Exchange (PSE) issued Memo for Brokers (MFB) No.392 in
2007 requiring listed companies to (1) report to the PSE any deviation from their Manual of
Corporate Governance, with detailed explanations for any deviation; (2) devote a portion of their
annual reports on compliance with corporate governance standards; and (3) maintain an active
web site reporting disclosures made to the SEC and the PSE, as well as their corporate
governance reports.

In March 2008, PSE verified the number of listed companies maintaining the required web site.
While 168 listed companies reported that they maintained web sites, only 149 of these were
found by PSE to be active or operational. Another 79 listed firms did not have web sites at all.
With respect to compliance with their corporate governance manuals, 110 listed firms certified
that they had no deviations from their manuals, while 84 others certified compliance with
deviations. At least 53 other listed companies did not submit any certification on their compliance
with their manuals.

The PSE also expanded the functions of the Risk Management Office by creating the Corporate
Governance Office. Likewise, the PSE expanded the functions of the board-level Compensation
and Remunerations Committee and renamed it the Corporate Governance Committee, with the
mandate to take charge of corporate governance issues (Philippine Stock Exchange, 2007).

In the area of disclosure, companies have adopted the Philippine Financial Reporting Standards/
Philippine Accounting Standards (PFRS/PAS) in preparing their financial statements. After
PFRS/PAS became mandatory on December 31, 2005, some listed companies encountered
difficulties in submitting compliant annual reports, despite being given a grace period. PSE
intensified its enforcement of disclosure requirements leading, at one time, to the suspension of
trading of the stocks of seven non-compliant companies. Moreover, the fines and penalties
imposed by the PSE on erring companies have been substantial, peaking at Php 9.16 million in
2006 or 215.2% more than the amount of fines and penalties collected in 2005 for the same
violation. Non-compliance levels have gone down somewhat since then (Philippine Stock
Exchange, 2006; 2007).

Understandably, companies need time to adjust their governance processes to come up to the
new levels mandated by government. More a cause of concern is the result of a survey
conducted by the Asian Institute of Management and the Social Weather Station on top
management perceptions and attitudes towards corporate misconduct. The study revealed that
while the majority of the 96 CEOs and top management officials surveyed considered it wrong to
tamper with company records and financial results, about one-fourth of the respondents did not
consider this practice as “always wrong” (Arceo-Dumlao, 2004). This indicates that the level of
commitment to the integrity of financial statements among top management can still be improved
and the misrepresentation of their true economic status by companies to the detriment of various
stakeholders is a very possible scenario.

In 2008 and 2009, such a scenario seemed to unfold as revelations of major financial problems
faced by several rural banks broke out in the local business press (Inquirer.net, 2009). The banks
were alleged by BSP examiners to have been undercapitalized and faced potential bankruptcy. It
came to light that all the banks were part of the Legacy Group of Companies led by Celso de los
Angeles, mayor of Sto. Domingo, Albay. The Philippine Deposit Insurance Corporation (PDIC)
eventually took over several of the banks after their closure. To date, many depositors have yet to
receive their money from the PDIC. The SEC has since filed related charges against other
companies in the Legacy Group for questionable business practices. All the above charges are
still under investigation but, should they turn out be true, the case may be among the largest
corporate governance failures in recent Philippine business history 4.

Conclusion

The focus on corporate governance remains strong as government and the public recognize the
value to their interests of ensuring that corporations are properly run. The cost of bad corporate

Corporate Governance | Teehankee 13

governance has been seen to extend way beyond national boundaries but, in fact, spills over to
the global economy. The public would do well to pay close attention to the ethical outlook of
corporations as led by their boards. As Byrne’s (2002) admonition remains relevant today:

… the first task of the post-Enron corporation is to acknowledge that a company's viability
now depends less on making the numbers at any cost and more on the integrity and
trustworthiness of its practices. In the future, leadership that preaches this new ethos and
reinforces it through value-driven cultures will be far more likely to reap the rewards of the
changing marketplace (p. 19).

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1 Interestingly, beginning with Pennsylvania in 1983, at least thirty States in the US have now adopted various
stakeholder-oriented statutes which allow directors to consider interests beyond those of stockholders and
managers (McDonnell, 2004). The General Corporation Law of Ohio, for example, states that “a director, in
determining what the director reasonably believes to be in the best interests of the corporation, shall consider the
interests of the corporation’s shareholders and, in the director’s discretion, may consider any of the following: (1)
The interests of the corporation’s employees, suppliers, creditors, and customers; (2) The economy of the state
and nation; (3) Community and societal considerations; (4) The long-term as well as short-term interests of the
corporation and its shareholders, including the possibility that these interests may be best served by the
continued independence of the corporation” (Ohio State Government, 2009).
2 The author is grateful to Angela Reyes of the RVR-Starr Center for Corporate Governance of the Asian
Institute of Management for calling attention to this article.
3 In the spirit of a comprehensive stakeholder approach to corporate governance, the Global Reporting Initiative
(2009) is a network-based organization that has developed a framework for companies to measure and report
their economic, environmental, and social performance.
4 Meanwhile, de los Angeles undergoes treatment for cancer in a hospital while a warrant for his arrest has been
served (Cinco, 2009).