Corporate governance becomes necessary because of the incomplete contracts between shareholders and managers. The discussion on corporate governance has been limited by its focus on substantive rationality. A comprehensive assessment of the incomplete contracts between shareholders and managers and an analysis of opportunism shows that procedural rationality, and not substantive rationality is appropriate for the design of corporate governance. Governance structures not incorporating a procedural learning mechanism will exacerbate the agency problem in shareholder management relations. This analysis is significant in the context of the present disillusionment with corporate governance structures.

Why do we need corporate governance structures? A critical rethink is necessary to make sense of the present disillusionment with corporate governance structures in the aftermath of a spate of corporate scandals in the United States. Stock exchange regulators around the world have undertaken a number of measures to restore confidence in corporate boards. The thrust of these measures has been to introduce requirements in the corporate governance structure and disclosure that can be observed by outsiders as indicators of good or bad corporate governance. In these measures there is a significant downplaying of the value of communication from a corporate board regarding its corporate governance practices. Such an approach to corporate governance is described as a rules-based approach to corporate governance. New measures on corporate governance in the US were signed into law on July 30, 2002. The Sarbanes-Oxley Act, passed by the US Congress earlier, incorporates several measures aimed at public accounting reform and investor protection. It will serve as a check list of all things that the top management is expected to do as a signal of good corporate governance practice. For example, it prohibits loans to directors and executive officers and places more rigorous reporting obligations on the corporate board and the CEOs1.

The pressure for a rules-based corporate governance system has increased in most developed countries as shares of some of the larger companies are listed and traded in a number of countries. This has led to demands for harmonization of corporate governance standards. In this era of globalization large companies with listings in a number of countries would prefer to deal with a uniform set of standards rather than have to cope with a variety of corporate governance regimes. Given the preeminence of the US capital markets there is a natural preference for the harmonization of corporate governance requirements in different countries with the corporate governance listing requirements of the New York Stock exchange2. There is also a strong belief held by large investors that a rules-based approach will lead to effective corporate governance3.