CORPORATE GOVERNANCE

• Interest in the corporate governance practices of modern corporations, particularly in relation to accountability, increased following the high-profile collapses of a number of large corporations during 2001–2002, most of which involved accounting fraud; and then again after the recent financial crisis in 2008.
• In 1997, the East Asian Financial Crisis severely affected the economies of Thailand, Indonesia, South Korea, Malaysia, and the Philippines through the exit of foreign capital after property assets collapsed. The lack of corporate governance mechanisms in these countries highlighted the weaknesses of the institutions in their economies

What is Corporate Governance:

• Corporate governance broadly refers to the mechanisms, processes and relations by which corporations are controlled and directed. Governance structures identify the distribution of rights and responsibilities among different participants in the corporation (such as the board of directors, managers, shareholders, creditors, auditors, regulators, and other stakeholders) and includes the rules and procedures for making decisions in corporate affairs.
• Corporate Governance may be defined as a set of systems, processes and principles which ensure that a company is governed in the best interest of all stakeholders. It is the system by which companies are directed and controlled. It is about promoting corporate fairness, transparency and accountability. In other words, ‘good corporate governance’ is simply ‘good business’. It ensures:
  • Adequate disclosures and effective decision making to achieve corporate objectives;
  • Transparency in business transactions;
  • Statutory and legal compliances;
  • Protection of shareholder interests;
  • Commitment to values and ethical conduct of business.
• In other words, corporate governance is the acceptance by management of the inalienable rights of shareholders as the true owners of the corporation and of their own role as trustees on behalf of the shareholders. It deals with conducting the affairs of a company such that there is fairness to all stakeholders and that its actions benefit the greatest number of stakeholders. In this regard, the management needs to prevent asymmetry of benefits between various sections of shareholders, especially between the owner-managers and the rest of the shareholders.
• It is about commitment to values, about ethical business conduct and about making a distinction between personal and corporate funds in the management of a company. Ethical dilemmas arise from conflicting interests of the parties involved. In this regard, managers make decisions based on a set of principles influenced by the values, context and culture of the organization. Ethical leadership is good for business as the organization is seen to conduct its business in line with the expectations of all stakeholders.
• Corporate governance includes the processes through which corporations’ objectives are set and pursued in the context of the social, regulatory and market environment. Governance mechanisms include monitoring the actions, policies and decisions of corporations and their agents.
• The Securities and Exchange Board of India Committee on Corporate Governance defines corporate governance as the “acceptance by management of the inalienable rights of shareholders as the true owners of the corporation and of their own role as trustees on behalf of the shareholders. It is about commitment to values, about ethical business conduct and about making a distinction between personal & corporate funds in the management of a company.”
• Corporate governance practices are affected by attempts to align the interests of stakeholders.

Stakeholder interests and principal–agent issue:

• In corporations, the main external stakeholders are shareholders, debt holders, trade creditors and suppliers, customers, and communities affected by the corporation’s activities. Internal stakeholders are the board of directors, executives, and other employees.
• All parties to corporate governance have an interest, whether direct or indirect, in the financial performance of the corporation. Directors, workers and management receive salaries, benefits and reputation, while investors expect to receive financial returns. For lenders, it is specified interest payments, while returns to equity investors arise from dividend distributions or capital gains on their stock. Customers are concerned with the certainty of the provision of goods and services of an appropriate quality; suppliers are concerned with compensation for their goods or services.
• Much of the contemporary interest in corporate governance is concerned with mitigation of the conflicts of interests between stakeholders. In large firms where there is a separation of ownership and management and no controlling shareholder, the principal–agent issue arises between upper-management (the “agent”) which may have very different interests, and by definition considerably more information (information asymmetry), than shareholders (the “principals”). The shareholder forgoes decision rights (control) and entrusts the manager to act in the shareholders’ best (joint) interests.
• The danger arises that, rather than overseeing management on behalf of shareholders, the board of directors may become insulated from shareholders and beholden to management. This aspect is particularly present in contemporary public debates and developments in regulatory policy.
• Partly as a result of this separation between the shareholders and managers, corporate governance mechanisms include a system of controls intended to help align managers’ incentives with those of shareholders.

• Ways of mitigating or preventing these conflicts of interests include the processes, customs, policies, laws, and institutions which have an impact on the way a company is controlled. An important theme of governance is the nature and extent of corporate accountability.
• A key factor in a party’s decision to participate in or engage with a corporation is their confidence that the corporation will deliver the party’s expected outcomes. When categories of parties (stakeholders) do not have sufficient confidence that a corporation is being controlled and directed in a manner consistent with their desired outcomes, they are less likely to engage with the corporation. When this becomes an endemic system feature, the loss of confidence and participation in markets may affect many other stakeholders.

Note:- The principal–agent problem or agency dilemma occurs when one person or entity (the “agent”) is able to make decisions that impact, or on behalf of, another person or entity: the “principal”. The dilemma exists because sometimes the agent is motivated to act in his own best interests rather than those of the principal.Common examples of this relationship include corporate management (agent) and shareholders (principal), or politicians (agent) and voters (principal)

Objectives of Corporate Governance:

• The aim of “Good Corporate Governance” is to ensure commitment of the board in managing the company in a transparent manner for maximizing long-term value of the company for its shareholders and all other partners. It integrates all the participants involved in a process, which is economic, and at the same time social.
• The fundamental objective of corporate governance is to enhance shareholders’ value and protect the interests of other stakeholders by improving the corporate performance and accountability. Hence it harmonizes the need for a company to strike a balance at all times between the need to enhance shareholders’ wealth whilst not in any way being detrimental to the interests of the other stakeholders in the company.
• Further, its objective is to generate an environment of trust and confidence amongst those having competing and conflicting interests.It is integral to the very existence of a company and strengthens investor’s confidence by ensuring company’s commitment to higher growth and profits.
• Broadly, Corporate Governance seeks to achieve the following objectives:
  • A properly structured board capable of taking independent and objective decisions is in place at the helm of affairs;
  • The board is balance as regards the representation of adequate number of non-executive and independent directors who will take care of their interests and well-being of all the stakeholders;
  • The board adopts transparent procedures and practices and arrives at decisions on the strength of adequate information;
  • The board has an effective machinery to subserve the concerns of stakeholders;
  • The board keeps the shareholders informed of relevant developments impacting the company;
  • The board effectively and regularly monitors the functioning of the management team;
  • The board remains in effective control of the affairs of the company at all times.
• The overall endeavour of the board should be to take the organization forward so as to maximize long term value and shareholders’ wealth.

Prerequisites and Constituents of Corporate Governance:

• Today adoption of good Corporate Governance practices has emerged as an integral element for doing business. It is not only a pre-requisite for facing intense competition for sustainable growth in the emerging global market scenario but is also an embodiment of the parameters of fairness, accountability, disclosures and transparency to maximize value for the stakeholders.
• Corporate governance cannot be regulated by legislation alone. Legislation can only lay down a common framework – the “form” to ensure standards. The “substance” will ultimately determine the credibility and integrity of the process. Substance is inexorably linked to the mindset and ethical standards of management.
• Studies of corporate governance practices across several countries conducted by the Asian Development Bank, International Monetary Fund, Organization for Economic Cooperation and Development and the World Bank reveal that there is no single model of good corporate governance.
• The OECD Code also recognizes that different legal systems, institutional frameworks and traditions across countries have led to the development of a range of different approaches to corporate governance. However, a high degree of priority has been placed on the interests of shareholders.
• Irrespective of the model, there are three different forms of corporate responsibilities which all models do respect:

1. Political Responsibilities: the basic political obligations are abiding by legitimate law; respect for the system of rights and the principles of constitutional state.
2. Social Responsibilities: the corporate ethical responsibilities, which the company understands and promotes either as a community with shared values or as a part of larger community with shared values.
3. Economic Responsibilities: acting in accordance with the logic of competitive markets to earn profits on the basis of innovation and respect for the rights/democracy of the shareholders which can be expressed in terms of managements’ obligation as ‘maximizing shareholders value’.

• In addition, business ethics and corporate awareness of the environmental and societal interest of the communities, within which they operate, can have an impact on the reputation and long-term performance of corporations.
• The three key constituents of corporate governance are the Board of Directors, the Shareholders and the Management.

1. A board of directors or  board of governors is a body of elected or appointed members who jointly oversee the activities of a company or organization. The pivotal role in any system of corporate governance is performed by the board of directors. It is accountable to the stakeholders and directs and controls the management. It stewards the company, sets its strategic aim and financial goals and oversees their implementation, puts in place adequate internal controls and periodically reports the activities and progress of the company in the company in a transparent manner to all the stakeholders.

   The OECD Principles of Corporate Governance (2004) describe the responsibilities of the board; some of these are summarized below:

   • Board members should be informed and act ethically and in good faith, with due diligence and care, in the best interest of the company and the shareholders.
   • Review and guide corporate strategy, objective setting, major plans of action, risk policy, capital plans, and annual budgets.
   • Oversee major acquisitions and divestitures.
   • Select, compensate, monitor and replace key executives and oversee succession planning.
   • Align key executive and board remuneration pay with the longer-term interests of the company and its shareholders.
   • Ensure a formal and transparent board member nomination and election process.
   • Ensure the integrity of the corporations accounting and financial reporting systems, including their independent audit.
   • Ensure appropriate systems of internal control are established.
   • Oversee the process of disclosure and communications.
   • Where committees of the board are established, their mandate, composition and working procedures should be well-defined and disclosed
2. The shareholders‘ role in corporate governance is to appoint the directors and the auditors and to hold the board accountable for the proper governance of the company by requiring the board to provide them periodically with the requisite information in a transparent fashion, of the activities and progress of the company.
3. The management’s responsibility is to undertake the management of the company in terms of the direction provided by the board, to put in place adequate control systems and to ensure their operation and to provide information to the board on a timely basis and in a transparent manner to enable the board to monitor the accountability of management to it.

• The underlying principles of corporate governance revolve around three basic inter-related segments. These are:

1. Integrity and Fairness
2. Transparency and Disclosures
3. Accountability and Responsibility

• Main Constituents of Good Corporate Governance are:

1. Role and powers of Board: the foremost requirement of good corporate governance is the clear identification of powers, roles, responsibilities and accountability of the Board, CEO and the Chairman of the board.
2. Legislation: a clear and unambiguous legislative and regulatory framework is fundamental to effective corporate governance.
3. Code of Conduct: it is essential that an organization’s explicitly prescribed code of conduct are communicated to all stakeholders and are clearly understood by them. There should be some system in place to periodically measure and evaluate the adherence to such code of conduct by each member of the organization.
4. Board Independence: an independent board is essential for sound corporate governance. It means that the board is capable of assessing the performance of managers with an objective perspective. Hence, the majority of board members should be independent of both the management team and any commercial dealings with the company. Such independence ensures the effectiveness of the board in supervising the activities of management as well as make sure that there are no actual or perceived conflicts of interests.
5. Board Skills: in order to be able to undertake its functions effectively, the board must possess the necessary blend of qualities, skills, knowledge and experience so as to make quality contribution. It includes operational or technical expertise, financial skills, legal skills as well as knowledge of government and regulatory requirements.
6. Management Environment: includes setting up of clear objectives and appropriate ethical framework, establishing due processes, providing for transparency and clear enunciation of responsibility and accountability, implementing sound business planning, encouraging business risk assessment, having right people and right skill for jobs, establishing clear boundaries for acceptable behaviour, establishing performance evaluation measures and evaluating performance and sufficiently recognizing individual and group contribution.
7. Board Appointments: to ensure that the most competent people are appointed in the board, the board positions must be filled through the process of extensive search. A well defined and open procedure must be in place for reappointments as well as for appointment of new directors.
8. Board Induction and Training: is essential to ensure that directors remain abreast of all development, which are or may impact corporate governance and other related issues.
9. Board Meetings: are the forums for board decision making. These meetings enable directors to discharge their responsibilities. The effectiveness of board meetings is dependent on carefully planned agendas and providing relevant papers and materials to directors sufficiently prior to board meetings.
10. Strategy Setting: the objective of the company must be clearly documented in a long term corporate strategy including an annual business plan together with achievable and measurable performance targets and milestones.
11. Business and Community Obligations: though the basic activity of a business entity is inherently commercial yet it must also take care of community’s obligations. The stakeholders must be informed about the approval by the proposed and on going initiatives taken to meet the community obligations.
12. Financial and Operational Reporting: the board requires comprehensive, regular, reliable, timely, correct and relevant information in a form and of a quality that is appropriate to discharge its function of monitoring corporate performance.
13. Monitoring the Board Performance: the board must monitor and evaluate its combined performance and also that of individual directors at periodic intervals.
14. Audit Committee: is inter alia responsible for liaison with management, internal and statutory auditors, reviewing the adequacy of internal control and compliance with significant policies and procedures, reporting to the board on the key issues.
15. Risk Management: risk is an important element of corporate functioning and governance. There should be a clearly established process of identifying, analysing and treating risks, which could prevent the company from effectively achieving its objectives. The board has the ultimate responsibility for identifying major risks to the organization, setting acceptable levels of risks and ensuring that senior management takes steps to detect, monitor and control these risks.

Codes and guidelines:

• Corporate governance principles and codes have been developed in different countries and issued from stock exchanges, corporations, institutional investors, or associations (institutes) of directors and managers with the support of governments and international organizations. As a rule, compliance with these governance recommendations is not mandated by law, although the codes linked to stock exchange listing requirements may have a coercive effect.
• One of the most influential guidelines has been the Organisation for Economic Co-operation and Development (OECD) Principles of Corporate Governance. The OECD guidelines are often referenced by countries developing local codes or guidelines.
• Building on the work of the OECD, other international organizations, private sector associations and more than 20 national corporate governance codes formed the UN Intergovernmental Working Group of Experts on International Standards of Accounting and Reporting (ISAR) to produce their Guidance on Good Practices in Corporate Governance Disclosure. This internationally agreed benchmark consists of more than fifty distinct disclosure items across five broad categories:
  • Auditing
  • Board and management structure and process
  • Corporate responsibility and compliance in organization
  • Financial transparency and information disclosure
  • Ownership structure and exercise of control rights

Internal corporate governance controls:

• Monitoring by the board of directors
• Internal control procedures and internal auditors: Internal control procedures are policies implemented by an entity’s board of directors, audit committee, management, and other personnel to provide reasonable assurance of the entity achieving its objectives related to reliable financial reporting, operating efficiency, and compliance with laws and regulations. Internal auditors are personnel within an organization who test the design and implementation of the entity’s internal control procedures and the reliability of its financial reporting.
• Balance of power: The simplest balance of power is very common; require that the President be a different person from the Treasurer. This application of separation of power is further developed in companies where separate divisions check and balance each other’s actions. One group may propose company-wide administrative changes, another group review and can veto the changes, and a third group check that the interests of people (customers, shareholders, employees).
• Remuneration: Performance-based remuneration. It may be in the form of cash or non-cash payments such as shares and share options, superannuation or other benefits.
• Monitoring by large shareholders and/or monitoring by banks and other large creditors

External corporate governance controls:

• External corporate governance controls encompass the controls external stakeholders exercise over the organization. Examples include:

1. competition
2. debt covenants
3. demand for and assessment of performance information (especially financial statements)
4. government regulations
5. managerial labour market
6. media pressure
7. takeovers

Benefits of Corporate Governance:

Benefits:

• The concept of corporate governance has been attracting public attention for quite some time. It has been finding wide acceptance for its relevance and importance to the industry and economy. It contributes not only to the efficiency of a business enterprise, but also, to the growth and progress of a country’s economy.
• Progressively, firms have voluntarily put in place systems of good corporate governance for the following reasons:
  • Several studies in India and abroad have indicated that markets and investors take notice of well managed companies and respond positively to them. Such companies have a system of good corporate governance in place, which allows sufficient freedom to the board and management to take decisions towards the progress of their companies and to innovate, while remaining within the framework of effective accountability.
  • In today’s globalised world, corporations need to access global pools of capital as well as attract and retain the best human capital from various parts of the world. Under such a scenario, unless a corporation embraces and demonstrates ethical conduct, it will not be able to succeed.
  • The credibility offered by good corporate governance procedures also helps maintain the confidence of investors – both foreign and domestic – to attract more long-term capital. This will ultimately induce more stable sources of financing.
  • A corporation is a congregation of various stakeholders, like customers, employees, investors, vendor partners, government and society. Its growth requires the cooperation of all the stakeholders. Hence it imperative for a corporation to be fair and transparent to all its stakeholders in all its transactions by adhering to the best corporate governance practices.
  • Good Corporate Governance standards add considerable value to the operational performance of a company by:
    1. improving strategic thinking at the top through induction of independent directors who bring in experience and new ideas;
    2. rationalizing the management and constant monitoring of risk that a firm faces globally;
    3. limiting the liability of top management and directors by carefully articulating the decision making process;
    4. assuring the integrity of financial reports, etc.

    It also has a long term reputational effects among key stakeholders, both internally and externally.

  • Also, the instances of financial crisis have brought the subject of corporate governance to the surface. They have shifted the emphasis on compliance with substance, rather than form, and brought to sharper focus the need for intellectual honesty and integrity. This is because financial and non-financial disclosures made by any firm are only as good and honest as the people behind them.
  • Good governance system, demonstrated by adoption of good corporate governance practices, builds confidence amongst stakeholders as well as prospective stakeholders. Investors are willing to pay higher prices to the corporates demonstrating strict adherence to internally accepted norms of corporate governance.
  • Effective governance reduces perceived risks, consequently reduces cost of capital and enables board of directors to take quick and better decisions which ultimately improves bottom line of the corporates.
  • Adoption of good corporate governance practices provides long term sustenance and strengthens stakeholders’ relationship.
  • A good corporate citizen becomes an icon and enjoy a position of respects.
  • Potential stakeholders aspire to enter into relationships with enterprises whose governance credentials are exemplary.
  • Adoption of good corporate governance practices provides stability and growth to the enterprise.

• Effectiveness of corporate governance system cannot merely be legislated by law neither can any system of corporate governance be static. As competition increases, the environment in which firms operate also changes and in such a dynamic environment the systems of corporate governance also need to evolve. Failure to implement good governance procedures has a cost in terms of a significant risk premium when competing for scarce capital in today’s public markets.

Limitations and Future Prospects of Corporate Governance:

• The issues of governance, accountability and transparency in the affairs of the company, as well as about the rights of shareholders and role of Board of Directors have never been so prominent as it is today.
• India has become one of the fastest emerging nations to have aligned itself with the international trends in Corporate Governance. As a result, Indian companies have increasingly been able to access to newer and larger markets around the world; as well as able to acquire more businesses. The response of the Government and regulators have also been admirably quick to meet the challenges of corporate delinquency. But, as the global environment changing continuously, there is a greater need of adopting and sustaining good corporate governance practices for value creation and building corporations of the future.
• It is true that the ‘corporate governance’ has no unique structure or design and is largely considered ambiguous. There is still lack of awareness about its various issues, like, quality and frequency of financial and managerial disclosure, compliance with the code of best practice, roles and responsibilities of Board of Directories, shareholders rights, etc. There have been many instances of failure and scams in the corporate sector, like collusion between companies and their accounting firms, presence of weak or ineffective internal audits, lack of required skills by managers, lack of proper disclosures, non-compliance with standards, etc. As a result, both management and auditors have come under greater scrutiny.
• But, with the integration of Indian economy with global markets, industrialists and corporates in the country are being increasingly asked to adopt better and transparent corporate practices. The degree to which corporations observe basic principles of good corporate governance is an increasingly important factor for taking key investment decisions. If companies are to reap the full benefits of the global capital market, capture efficiency gains, benefit by economies of scale and attract long term capital, adoption of corporate governance standards must be credible, consistent, coherent and inspiring.
• Quality of corporate governance primarily depends on following factors, namely:- integrity of the management; ability of the Board; adequacy of the processes; commitment level of individual Board members; quality of corporate reporting; participation of stakeholders in the management; etc. Since this is an important element affecting the long-term financial health of companies, good governance framework also calls for effective legal and institutional environment, business ethics and awareness of the environmental and societal interests.
• Hence, in the years to come, corporate governance will become more relevant and a more acceptable practice worldwide. This is easily evident from the various activities undertaken by many companies in framing and enforcing codes of conduct and honest business practices; following more stringent norms for financial and non-financial disclosures, as mandated by law; accepting higher and appropriate accounting standards; enforcing tax reforms coupled with deregulation and competition; etc.
• However, inapt application of corporate governance requirements can adversely affect the relationship amongst participants of the governance system. As owners of equity, institutional investors are increasingly demanding a decisive role in corporate governance. Individual shareholders, who usually do not exercise governance rights, are highly concerned about getting fair treatment from controlling shareholders and management. Creditors, especially banks, play a key role in governance systems, and serve as external monitors over corporate performance. Employees and other stakeholders also play an important role in contributing to the long term success and performance of the corporation. Thus, it is necessary to apply governance practices in a right manner for better growth of a company.
• There is a greater need to increase awareness among entrepreneurs about the various aspects of corporate governance. There are some of the areas that need special attention, namely:-
  • Quality of audit, which is at the root of effective corporate governance;
  • Role of Board of Directors as well as accountability of the CEOs and CFOs;
  • Quality and effectiveness of the legal, administrative and regulatory framework; etc.

Legal Framework for Corporate Governance:

• In rapidly changing national and global business environment, it has become necessary that regulation of corporate entities is in tune with the emerging economic trends, encourage good corporate governance and enable protection of the interests of the investors and other stakeholders.
• Further, due to continuous increase in the complexities of business operation, the forms of corporate organizations are constantly changing. As a result, there is a need for the law to take into account the requirements of different kinds of companies that may exist and seek to provide common principles to which all kinds of companies may refer while devising their corporate governance structure.
• The important legislations for regulating the entire corporate structure and for dealing with various aspects of governance in companies are Companies Act, 1956(Now Companies Act 2013). These laws have been introduced and amended, from time to time, to bring more transparency and accountability in the provisions of corporate governance. That is, corporate laws have been simplified so that they are amenable to clear interpretation and provide a framework that would facilitate faster economic growth.
• Secondly, the Securities Contracts (Regulation) Act, 1956, Securities and Exchange Board of India Act, 1992 and Depositories Act, 1996 and Securities and Exchange Board of India (SEBI), are to protect the interests of investors in the securities markets as well as to maintain the standards of corporate governance in the country.

Companies Act 2013: