CORPORATE GOVERNANCE Ever wondered about the role car brakes play in giving confidence to the person in the

drivers seat? If it is not for this confidence, the driver would never put his foot on the gas pedal to speed up the car. If it is not for this confidence, he may not drive at all. Think of the car as a corporate entity and the brakes as corporate governance. Corporate Governance provides similar confidence to investors. Without this confidence companies cannot flourish. If it is not for this confidence, the investors (shareholders) will not buy shares in companies. The aim of corporate governance principles is to ensure that company is governed and run in the interest of shareholders (the investors). This assurance is important due to the separation of ownership of a company from its control; the company is owned by the shareholders, but run and controlled by the management (directors). Without corporate governance principles there is a risk that the directors may run the company in their own interest instead of shareholders, for instance by paying themselves high salaries, or by manipulating financial performance and paying themselves high bonuses, by hiring Yes-men who act as rubber stamps to their decisions.

Before we move on to corporate governance principles, let us first understand the composition of the board of directors of a company. What does the board of directors look like? This is how the composition of board looks like:

In the eyes of law, a person is a director if he attends board meetings and joins the decision making process of the board. The articles of association of a company give the board the power to appoint one of them as the Chairman of the board. The chairman is the leader of the board and takes charge of board meetings and general meetings such as the AGM. The articles of a company also give power to the board to appoint one or more people from the board as Managing Director (also called CEO). The managing director assigns specific responsibilities to the members of the board, for instance the responsibility of looking after the finances, IT, operations, etc. The directors assigned with specific responsibilities look after the day-to-day running of the business in relation to those responsibilities and are called executive directors. Although the executive directors report to the managing director in their role as executive director, as members of the board, they all work together and take decisions collectively at board meetings, such as approving accounts and proposing dividend. This is how the structure looks like at board meetings when decisions are taken collectively:

What is the difference between Executive and Non-Executive directors? Executive directors are those directors who have management responsibilities in the company for instance the finance director. Managing director is also an executive director. A non-executive director is a director without the responsibility of any management function, i.e. without an executive role. Although they do not take part in executive functions, they have the same powers and responsibilities as directors. They are appointed for various reasons. The first reason is that they have experience and knowledge which should help the board make better decisions collectively. The second reason is that they can act as a check on the powers of the executive directors and make sure they are not running the company in their own interest. The third reason they are appointed is to carry out certain tasks that the executive directors should not. Examples include acting as members of remuneration committee and audit committee. Acting as members of remuneration committee they can decide the salaries of executive directors. This will make sure the executive directors do not misuse their powers and pay themselves high salaries. Being a part of the audit committee they will make sure that the auditors are independent and do not yield to management pressure to give a clean audit report. This will ensure that the directors do not manipulate the financial information for their own interest. Example The directors may keep the books open at the end of an accounting period. This means that January sales are recorded as December sales. When this happens, the financial statements include inflated revenues and assets (receivables/cash). If the auditor is not independent, he may collude with the management and give a clean audit report. The non-executive director will make sure that the auditor is independent. The presence of a non-executive director in the audit committee will deter such a thing from happening. This is what the picture might look like for an organization without an audit committee:

Remember: Appointing non-executive directors is not a requirement of law but represents best practices. Are corporate governance principles voluntary or compulsory? In UK, although some of the principles of good corporate governance are a requirement of law most of them are voluntary. Combined Code The combined code is a voluntary code of best practices in corporate governance. Although the code is intended for listed companies, other companies are encouraged to adopt it. Listed companies must comply with the provisions of combined code. If they do not comply, they should state a reason for non-compliance. All listed companies are required to do this. Following are the broad principles of combined code: The board The principle states that every company should have a board that should be responsible for setting the strategic direction of the company and that each board should have Non-Executive Directors who should be responsible for the following: 1. Checking the integrity of financial statements. 2. Deciding the remuneration of executive directors. 3. Hiring and firing executive directors. Chairman and Chief Executive The chairman is responsible for running the board and the chief executive is responsible for

running the company. There should be a clear division of these responsibilities. These roles should not be exercised by the same person since this would give unquestioned powers in the hand of one man. Also, the CEO should not after retirement become the chairman of the company. Board Balance Atleast half of the board should be comprised of independent non-executive directors. Appointments The appointment of non-executive directors should be the responsibility of nomination committee which should be comprised of independent non-executive directors. Information The board should have access to information to make timely decisions. Performance evaluation There should be an evaluation of the board and the individual directors each year. Remuneration Remuneration of directors should be high enough to attract directors of sufficient caliber, but not excessive. A significant proportion of the remuneration should be linked to company performance. Financial Reporting The board should state in the annual report its responsibility for preparing accounts and the fact that the business is a going concern. Audit Committee The audit committee should consist entirely of independent Non-executive Directors. The committee should be responsible for the following: 1. 2. 3. 4. Monitoring the integrity of financial statements. Keeping an eye on auditors independence. Making recommendations for appointment, removal and remuneration of auditors. Deciding whether non-audit work should be given to auditors.

Relations with shareholders Since the contact of the shareholders will be mainly with the Chairman or Managing Director, the chairman should ensure that the views of the shareholders are communicated to the board.