Lesson 19 Concept of corporate governance

Contents: Nature The context Factors affecting corporate governance Mechanism of corporate governance Introduction: In the previous chapters we have discussed, in detail, business ethics, corporate social responsibility and social audit. The central theme of all this discussion is that a business unit should operate in an ethical and socially responsive manner. Who are the people to ensure such behaviour from a company? What mechanism is there to ensure such behaviour from a company? Are there any ways and means through which it can be assured that people involved in running a business operate in a way that is expected of them? This chapter seeks to answer these questions and other related issues Corporate governance has succeeded in attracting a good deal of public interest because of its apparent importance for the economic health of corporations and society in general. However, the concept of corporate governance is poorly defined because it potentially covers a large number of distinct economic phenomenons. As a result different people have come up with different definitions that basically reflect their special interest in the field. The best way to define the concept is perhaps to list a few of the different definitions rather than just mentioning one definition.

Definitions
1. "Corporate governance is a field in economics that investigates how to secure/motivate efficient management of corporations by the use of incentive mechanisms, such as contracts, organizational designs and legislation. This is often limited to the question of improving financial performance, for example, how the corporate owners can secure/motivate that the corporate managers will deliver a competitive rate of return", www.encycogov.com, Mathiesen [2002]. 2. Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment, The Journal of Finance, Shleifer and Vishny [1997, page 737]. 3. "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, 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", OECD April 1999. OECD's definition is consistent with the one presented by Cadbury [1992, page 15]. 4. "Corporate governance - which can be defined narrowly as the relationship of a company to its shareholders or, more broadly, as its relationship to society -.", from an article in Financial Times [1997]. 5. "Corporate governance is about promoting corporate fairness, transparency and accountability" J. Wolfensohn, president of the Word bank, as quoted by an article in Financial Times, June 21, 1999. 6. Some commentators take too narrow a view, and say it (corporate governance) is the fancy term for the way in which directors and auditors handle their responsibilities towards shareholders. Others use the expression as if it were synonymous with shareholder democracy. Corporate governance is a topic recently conceived, as yet ill-defined, and consequently blurred at the edgescorporate governance as a subject, as an objective, or as a regime to be followed for the good of shareholders, employees, customers, bankers and indeed for the reputation and standing of our nation and its economy Maw et al. [1994, page 1].

Nature of corporate governance

Corporate governance is the overall control of activities in a Corporation. It is concerned with the formulation of long-term objectives and plans and the proper management structure (organization, systems and people) to achieve them. At the same time, it involves making sure that the structure functions in a way, which helps to maintain the corporation's reputation and responsibility towards various groups. The structure to ensure corporate governance, for our understanding, includes the board of directors, top management, shareholders, creditors and others. The role of each of these stakeholders is crucial in guaranteeing responsible corporate performance. Before examining the role of each of these groups, it is useful to understand the relevance of corporate governance in the present perspective.

The perspective
Corporate governance has been an active subject of academic and policy debates for quite a long time in many of the advanced

countries, particularly the US, UK, Germany and Japan. The international competitiveness and successful functioning of companies in these countries has of late, alerted company owners and managers in the developing and changing economies to the fact that effective corporate governance is crucial for competitiveness and success in the long run. In fact the importance of corporate governance has been highlighted by international agencies like OECD and the World Bank. In particular, the World Bank has been in the process of formulating a draft code of corporate governance for developing countries that would review the principles of effective governance, build on

international guidelines, assess governance practices in emerging markets, and distil the best practices from these and developed countries. In our country, while several mechanisms of governance have formally been in place for much longer time than in most of the developing countries, the issue of proper governance has assumed relevance only recently. In fact, the lack of adequate governance of Indian companies has been highlighted in academic circles and other forums as one of the primary reasons for under performance of industrial establishments. At least three reasons have triggered off concern in corporate governance in our country. First, since 1991, the country has moved into liberalized economy and one of the victims of the market-based economy is transparent fair business practice. In the survival of the fittest scenarios, norms and principles tend to be given least consideration. In fact, a number of company failures have been reported in the recent past. Several instances of mismanagement have been alleged, with some senior and well known executives being hauled up for nonperformance and/ or non-compliance with legal requirements. Some norms of behaviour to ensure responsive behaviour are of great help. Second, both domestic as well as foreign investors are becoming more demanding in their approach towards the companies in which they have invested their funds. They seek information and want to influence decisions. Increasing integration with global markets calls for a correspondingly improving compliance with global practices in all spheres of corporate activity. Third, interest of non-promoter shareholders and those of small investors are increasingly being undermined. Several MNCs for example, have sought to set up hundred percent subsidiaries and transfer their businesses (carried through Indian joint venture partners) to them. In many cases, there was no thought of consultation with non-promoter shareholders whose interests would be affected. Again, well-known Indian companies, in recent years, raised funds in the GDR markets abroad and in India, for specific objectives. But these funds were diverted to investments elsewhere, without consulting the shareholders. Obviously the sufferers are the minority shareholders.

Factors influencing corporate governance

The ownership structure The structure of ownership of a company determines, to a considerable extent, how a Corporation is managed and controlled. The ownership structure can be dispersed among individual and institutional shareholders as in the US and UK or can be concentrated in the hands of a few large shareholders as in

Germany and Japan. But the pattern of shareholding is not as simple as the above statement seeks to convey. The pattern varies the across the globe. According to a study on corporate ownership conducted in 1998, 36 percent of the firms in the world are widely held,

30 percent are family controlled, 18 percent are state-controlled and the remaining 15 percent are in miscellaneous category. Our corporate sector is characterized by the co-existence of state owned, private and multinational Enterprises. The shares of these enterprises (except those belonging to a public sector) are held by institutional as well as small investors. Specifically, the shares are held by (1) the term-lending institutions (2) institutional investors, comprising government-owned mutual funds, Unit Trust of India and the government owned insurance corporations (3) corporate bodies (4) directors and their relatives and (5) foreign investors. Apart from these block holdings, there is a sizable equity holding by small investors. Which patterns of share holding, dispersed or concentrated, is ideal for good corporate performance? Large shareholders tend to be active in corporate governance either through their representative's on the company boards or through a their active participation in annual general body meetings. This has been demonstrated by reliance Industries Limited. Which has the highest number of equity shareholders spread across the country. The block holding too has not proved to be a failure either. Dominant shareholders are better informed than the dispersed shareholders. Under the concentrated ownership structure, as has been demonstrated through the Bajaj group, corporate performance tends to be better. The structure of company boards Along with the structure of ownership, the structure of company boards has considerable influence on the way the companies are managed and controlled. The board of directors is responsible for establishing corporate objectives, developing broad policies and selecting top-level executives to carry out those objectives and policies. The board also reviews managements performance to ensure that the company is run well and shareholders interests are protected. Company boards are permitted to vary in size; composition and structure so as to best serve the interest of the Corporation and the shareholders. Board membership may include both inside director and outside directors. With regard to the size of board, opinions and practices vary. Some argue that the adequate size is to range from 9-15. Some others put the figure at 10 and yet others recommend a minimum of five and a maximum of 10. Company boards in the UK have, an average, seven directors on their boards. Japanese companies have larger boards, the figure going up to 60. It should be noted that it is the quality of the directors, the interest they take, and the roles that they assume which are more important than mere numbers or composition. The financial structure Along with the notion that the structure of ownership matters in corporate governance is the notion that the financial structure of

the company, that is proportion between debt and equity, has implications for the quality of governance. Contrary to the Modigliani - miller hypothesis that the financial structure of the firm

has no relationship to the value of the firm; recent research has shown that the financial structure does matter. It is no secret that the lenders exercise significant influence on the way a company is managed and controlled. Banks as creditors, for example, can perform the important function of screening and monitoring companies as they (banks), are better informed than other investors. Further banks can diminish short-term biases in managerial decision making by favouring investments that would generate higher benefits in the long run. Also, Banks, because of the close financial relationship with the companies to which they lend, and in some cases of because of their nominees on company boards, are expected to play a more favourable role than other investors in reducing the costs of financial distress. The institutional environment The legal, regulatory, and political environment within which a company operates determines in large measure the quality of corporate governance. In fact, corporate governance mechanisms are economic and legal institutions and often the outcome of political decisions. For example, the extent to which shareholders can control the management depends on their voting right as defined in the Company Law, the extent to which creditors will be able to exercise financial claims on a bankrupt unit will depend on bankruptcy laws and procedures etc.

Mechanisms of corporate governance

The fundamental institutions of corporate governance in our country have been in existence for a long time. Compared to many developing countries, the mechanisms of corporate governance in India are more institutionalized. However, in spite of such institutions, corporate governance has not been a major issue until the announcement of the new economic policy in 1991. Since then, corporate governance has assumed greater relevance for reasons stated earlier. In our country, their are six mechanisms to ensure corporate governance: (1) Companies Act Companies in our country are regulated by the companies Act, 1956, as amended up to date. The companies Act is one of the biggest legislations with 658 sections and 14 schedules. Through the consolidation of many successive amendments and a large number of statutory rules and regulations, the Act aims at not only ensuring that the interest of all stakeholders are adequately protected but tries to go beyond. The Act, to some extent, seeks to translate into action articles 38 and 39 in part IV of the constitution, by which the state was directed that the ownership and control of the material resources of the community are so distributed as to conform to the common good and the operation of the economic system does not result in concentration of wealth and means of production to the common detriment. The arms of the Act are quite

long and touch every aspect of a company's insistence. But to ensure corporate governance, the Act confers legal rights to shareholders to (1) vote on every resolution placed before an annual general meeting; (2) to elect

directors who are responsible for specifying objectives and laying down policies; (3) determine remuneration of directors and the CEO; (4) removal of directors and (5) take active part in the annual general meetings. The companies Bill, 1997 and recently moved ordinance on companies (amendment), 1997, has amended several provisions of the Act and introduced new provisions incorporating some internationally accepted corporate governance practices and aimed at strengthening corporate democracy, of protecting interests of minority shareholders of and providing maximum flexibility to the companies in responding to the market needs. Among these, the amendments that have made headlines are permitting companies to buy back shares and the liberalization of inter-corporate investments. Securities law The primary securities law in our country is the SEBI Act. Since its setting up in 1992, the board has taken a number of initiatives towards investor protection. One such initiative is to mandate information disclosure both in prospectus and in annual accounts. While the companies Act it self mandates certain standards of information disclosure, SEBI Act has added substantially to these requirements in an attempt to make these documents more meaningful. One of the most valuable is the information relating to the performance of other companies in the same group, but those companies which have accessed the capital market in the recent past. Another aspect of the SEBI regulations is that in most public issues, the promoters (typically the dominant shareholders) are required to take a minimum stake of about 20 percent in the capital of the company and to retain these shares for a minimum lock-in period of three years. The area in which SEBI has laid down guidelines, relate to prohibiting preferential allotments to dominant shareholders at a price lower than the average market price during the preceding six months. Also, SEBI intervenes in corporate takeovers in order to protect the interests of minority shareholders. As per the Securities law, the acquirer of a controlling block of shares must take an open offer to the public for at least 20 percent of the issued share capital of the target company at a price not below that was paid for the control block. Finally, the board constituted a committee under the chairmanship of, Kumaramangalam Birla to suggest ways to promote and raise the standards of corporate governance in listed companies. The board, in its meeting held on 25th January, 2000, considered the recommendations of the committee and decided to make amendments to the listing agreement by adding a new Clause, namely Clause 49, to the listing agreement.

The Clause 49 provides for the optimum composition of executive and non-executive directors; setting up of a qualified and independent audit committee; remuneration of directors; management discussion and analysis report to form part of annual report to the shareholders; a separate section on corporate governance in the annual reports of the company (see box); for information to be furnished in the report on corporate governance; and auditors compliance certificate to the effect that all the conditions of corporate governance have been complied with. Discipline of the capital market Capital market itself has considerable impact on corporate governance. Here in lies the role the minority shareholders can play effectively. They can refuse to subscribe to the capital of a company in the primary market and in the secondary market; they can sell their shares, thus depressing the share prices. A depressed share price makes the company an attractive takeover target. A debt holder too has a role to play in disciplining a company's management. Unlike the shareholder who is a residual claimant, the creditor has contractual rights to reclaim his interest and principal; and this enables him to monitor the actions of the management. Most debt contracts involve covenants that make it less easy for the dominant shareholders to indulge in gross abuses. The ability of debt holders to monitor the company is quite high because typically, these are large institutions with High stakes. In a well functioning capital market, there is a strong reason for corporates themselves to voluntarily adopt transparent processes and subject themselves to external monitoring to reassure potential investors. In the last few years, we have seen Indian companies voluntarily accepting international accounting standards though they are not legally binding. They have voluntarily gone for greater disclosure and more transparent governance practices than are mandated by law. They have sought to cultivate an image of being honest with the investors and about being concerned about shareholder value maximization. What makes capital market discipline so much more attractive than regulatory intervention is that unlike the regulator, the market is very good at micro-level judgments and decisions. In fact, the market is taking micro decisions all the time. It is its success in doing so that makes it much an efficient allocator of capital. Unlike the regulator, the market is not bound by broad rules and can exercise business judgment. It therefore makes sense for the regulator to pass on as much of the burden of ensuring corporate governance to the markets as possible. The regulator can then concentrate on making the markets more efficient at performing this function. Nominees on company boards

Development banks hold large blocks of shares in companies. These are equally big debt holders too. Being equity holders, these investors have their nominees in the boards of companies. These nominees can effectively block resolutions, which may be detrimental to their interests. Unfortunately, the role of nominee directors has been passive, as has been pointed out by several committees including the Bhagwati Committee on takeovers and the Omkar Goswami committee on corporate governance. Statutory audit Statutory audit is yet another mechanism directed to ensure good corporate governance. Auditors are the conscious-keepers of shareholders, lenders and others who have financial stakes in companies. Auditing enhances the credibility of financial reports prepared by any enterprise. The auditing process ensures that financial statements are accurate and complete, thereby enhancing their reliability and usefulness for making investment decisions. Credible financial statements are essential for a business enterprise to raise capital and for society to have trust in Limited companies. Obviously, good corporate governance depends, in part, on good auditing. As the Cadbury committee observed, "the annual audit is one of the cornerstones of corporate governance. Given the separation of ownership from management, the directors are required to report on their steward ship by means of annual report and financial statements sent to the shareholders. The audit provides an external and objective check on the way in which the financial statements have been prepared and presented, and it is an essential part of the checks and balances required." In practice, it is not always true. Users of auditors Services are often dissatisfied with the performance of auditors and seldom believe auditors live up to the solemn image presented by the Cadbury Committee. Audit is often considered to be just an annual ritual. Shareholders, employees and tax officers often voice caustic comments such as auditors being hand in glove with the management, or the financials being dressed up. So what is wrong with auditing? Auditors' independence or the perceived lack of it is a major issue. Other lacunae include problems concerning audit quality, the role of auditors in detecting frauds and reviewing internal controls and the record of the accounting profession establishing accounting and auditing standards. Codes of conduct The mechanisms discussed till now are regulatory in approach. The are mandated by law and violation of any provision invite penal action. But legal rules alone cannot ensure good corporate governance. What is needed is self-regulation on the part of directors, besides of course, the mandatory provisions.

The Cadbury Committee in the UK advocated the famous code of best practice. The London Stock Exchange constituted the committee in 1992, following the

collapse of several British companies. The cause of anxiety then, was not so much that the companies had failed, as that their annual reports and financial statements - just prior to the failure - gave no fore warning of the true state of the financial affairs. Subsequent scandals relating to "excessive" remuneration paid to directors, created a climate for business to establish more effective norms of corporate behaviour. How did the Cadbury Committee address the situation? Basically, good governance issues were seen as relating to both the effectiveness and the accountability of the board of directors: Effectiveness was seen as a measure of the quality of the leadership of the directors, to be judged by the company's financial results and the resultant growth in shareholder value. Accountability were seen as largely a matter of disclosure of all relevant information - transparency in short focusing on the subject of, to whom a company is answerable. The code is thus based on checks and balances, especially at the level of the board of directors and the chief executive, to guard against undue concentration of power, and, adequate disclosure to enable those entitled to have the information they need, in order to exercise their rights. It comprises four sections: The role of board of directors: it was proposed that the (inside) executive directors be balanced by adequate number of (out side) non-executive directors, with the posts of the board, chairman and chief executive being separated. The role of non-executive directors: it was emphasized that the majority of the board should be "independent" (in the sense of being free of any business relation which could materially interfere with the exercise of independent judgment), that non-executive directors should be appointed only for specific term and that they should be a formal process for their appointment involving the board as a whole. Executive directors: the main concern was with their remuneration - that there should be a full and cleared disclosure of directors emoluments, and that pay should be set by a remuneration Committee, consisting mainly of non-executive directors. In due course, the London Stock Exchange, while not mandating compliance with any element of the code, asked all listed companies to append to their annual reports, a declaration of the extent of their compliance with the code. Shareholders were left to draw their own conclusions about the quality of governance in their companies. The Confederation of Indian Industry (CII) issued a draft code of "desirable corporate governance" for the Indian industry in April 1997, in response to the finance Ministry's veiled threats that soften

the self-regulatory regime, greater the likelihood of harsher government regulations.

The CII code, leaning heavily on British model, is based on the explicit assumption that "good governance helps to maximize the share holder value, which will necessarily maximize corporate value and, thereby, satisfy the claims of creditors, employees and the state." Whether the code will stimulate a change in corporate governance, only time will tell.

The future
As we go into the future, corporate governance will become more relevant and a more acceptable practice. Seeds are already sown towards honest business practices. More and more progressive companies are drawing and enforcing codes of conduct, are accepting tougher accounting standards and are following more stringent disclosure norms than are mandated by law. These tendencies would be further strengthened by a variety of forces that are acting today and would become stronger in years to come. Such forces are: Deregulation: economic reforms have not only increased growth prospects, but they have also made markets more competitive. This means that in order to survive, companies will need to invest continuously on a large scale. Disintermediation: meanwhile, financial sector reforms have made it very important for firms to rely on capital markets to a greater degree for their needs of additional capital. Globalization: globalization of the financial markets has exposed issuers, investors and intermediaries to the higher standards of disclosure and corporate governance that prevail in more developed markets. Tax reforms: tax reforms coupled with the deregulation and competition have tilted the balance a away from black money transactions. This makes the worst forms of misgovernance less attractive than in the past. In order to understand the problem we shall try to understand the problem by understanding this live case of the Enron Debacle:

Live Case