Corporate Governance

What is corporate governance?

• Corporate governance is the set of processes, customs, policies, laws, and institutions affecting the way a corporation (or company) is directed, administered or controlled. Corporate governance also includes the relationships among the many stake holders involved and the goals for which the corporation is governed.

Stakeholders

Stakeholders

• The principal stakeholders are the shareholders/members, management, and the board of directors. Other stakeholders include labor (employees), customers, creditors (e.g., banks, bond holders), suppliers, regulators, and the community at large. For Not-Profit-For Corporations or other membership Organizations the “shareholders” means “members”.

Corporate governance – an academic point of view

It can be seen as one that

addresses “the problems

that result from the

separation of ownership

and control”.

Shareholders

Board

Employees

Management

Separation of ownership & control

Corporate governance focuses on:

• Structures and mechanisms that ensure internal structure and rules of the board of directors

• Disclosure strictures in regard to information for shareholders and creditors

• Transparency of operations and an impeccable process of decision-making

• Control of management

A simple model for corporate governance 1. Shareholders elect directors as their representatives2. Directors vote on key issues and adopt majority

decision3. Directors make transparent decisions for which

shareholders and others can make them accountable4. Companies adopt accounting standards that generate

information required by directors, investors, other stakeholders for decision-making

5. Companies adopt policies and practices compatible with relevant national, state, and local laws

McKinsey & Company Report - 2001

• McKinsey and company report titled “Giving New Life to the Corporate Governance Reform Agenda for Emerging Markets” suggests a two-version governance chain model.

• The “market model” governance chain (model 1) described below is applicable to efficient, well-developed equity markets and dispersed ownership prevalent in the developed industrial nations like US, UK, Canada, and Australia

The “market model” governance chain – Model 1

Shareholder environment Independence & performance

Capital market liquidity Transparency & accountability

Inst

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orporate context

Sophisticated institutional ownership

Active equity markets

Active takeover market

Non-executive majority boards

Aligned Incentives

High disclosure

Shareholder equality

Dispersed ownership

• The “control model” governance chain (model 2) described below is represented by underdeveloped equity markets, concentrated (family) ownership, less shareholder transparency and inadequate protection of minority and foreign shareholders familiar in Asia, Latin America, and some East European countries. In such transitional and developing capital economies, there is need to build, nurture and grow supporting institutions such as strong and efficient capital market regulator and judiciary to enforce contracts or protect property rights

The “control model” governance chain – Model 2

Shareholder environment Independence & performance

Capital market liquidity Transparency & accountability

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nal c

onte

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orporate context

Concentrated ownership

Reliance on family, bank, public finance

Under developed New issue market

Limited takeover market

Insider boards

Incentives aligned with core shareholders

Limited disclosures

Inadequate minority protection

Corporate Misgovernance

• From the early years of the new millennium, a few US companies got mired in a grave crisis of credibility. Business conglomerates like Xerox, WorldCom, and Enron perpetuated frauds to artificially inflate turnovers and profits. Such problems of corporate America and developing economies like India were growing due to the failure of auditing profession to safeguard the interests of shareholders and other stakeholders. Corporate lootings have destroyed the term “business ethics”. The swashbuckling CEOs are suddenly being looked upon as crooks who gamble the retirement savings of hapless workers and unwary investors.

Misgovernance in the US - 2002

• WorldCom improperly booked $3.8 billion in expenses leading to inflation of profits

• Enron created outside partnerships that hid its poor financial position; company executives made millions selling company stocks

• Accounting firm Anderson was accused of shredding Enron documents and got convicted for obstructing justice

• Mismanagement by Dynegy, Waste Management, Adelphia Communications, Imclone Systems, Peregrine Systems

Misgovernance in India

• Only after 1947, industrial growth and corporate culture had started in India. But the Indian scene was dominated by:

• Feudalistic forces• Political system bordering on pseudo-democracy• Business firms practicing unethical methods on the

market place showing little respect to human and organizational values in regard to employees, shareholders, and customers

• Increasing corruption at all levels of government fanned the desires of firms not held accountable for more and more unethical practices

• Various public sector undertakings enjoying monopoly passed on to the hapless customers costs of corporate misgovernance

• Private firms fleeced their customers and denied due to the government; they also resorted to rampant corporate corruption

• Employees at all levels of government and at the top levels of private sector firms indulged in or contributed to corporate misgovernance

Scams in India that rocked the investor confidence

• “Big Bull” Harshad Mehta’s security scam uncovered in April, 1992

• During 1993-94, stock market index shot up by 120% - during this boom 3911 companies that raked in Rs. 25,000 crore had vanished or failed to set up projects

• 1995-96 witnessed the plantation companies scam worth Rs. 50.000 crore raised from gullible investors looking for huge returns

• 1995-1997 saw the scam worth Rs. 50,000 crore in the so-called non-banking finance sector when the firms performed the vanishing act

• 1995-98 also produced the mutual fund scam worth Rs. 15,000 crore borne out of the huge returns promised by public sector banks

• In 2001, Ketan Parek resorted to price rigging in association with a bear cartel

Companies adopted different illegal tactics • Cornering of industrial licenses to pre-empt

competitors and put up entry barriers • Using Import licenses• Illegally holding money abroad• Bribing officialdom to generate unaccounted

money to be used for “business” expenses and political donations

• Tax evasions through compensation packages to senior level managers and using funds and facilities for personal uses such as travel, furniture home improvements etc.

Winds of change

Prior to reforms in 1991, Indian companies were insulated by closed economy, a sheltered market, limited access to global business, lack of competitive spirit and regulatory framework – all these changed on account of:

• Market-driven performs• Economic liberalization• Dismantling of control and quota regime • Delicensing and deregulation of industries• Changes in import/export policies• Globalization of the economy within and outside the

ambit of the WTO

Corporate governance movement in India The movement took of:• The Confederation of Indian Industry (CII)

framed a code in 1997 and 30 large listed companies voluntarily adopted this code

• In 1999, the Securities and exchange Board of India (SEBI, set up in 1988 and was made a statutory body in 1992) appointed a committee headed by Kumar Mangalam Birla to mandate international standards of corporate governance for listed companies

• By 2003 every listed company joined the SEBI code

Historical perspective of corporate

governance: from a narrow to broader vision • Traditionally, the problem of the separation of

ownership by shareholders and the control by management

• Historical developments of corporate misdemeanor and growing visions of society followed

• Governance should stand up to the expectations of all stakeholders namely employees, consumers, large institutional investors, government, and the society as a whole

• More additions to the ambit of corporate governance included business ethics, social responsibility, management discipline, corporate strategy, life-cycle development, stakeholder participation in decision making processes, and promotion of sustainable economic development

All these had gone far beyond the original prescription of Milton Friedman that the companies should conduct the business purely in accordance with the desires of the shareholders

Growth of modern ideas of corporate governance

Watergate scandal which brought about the end of Nixon Presidency led to the disclosure that many companies made illegal political contributions by bribing governmental officials – out came the legislation of the Foreign and Corrupt Practices Act of 1977. In the same year Securities Exchange Commission (SEC) proposed mandatory reporting on financial controls.

The Cadbury Committee• UK was rocked by a

series of scams and business collapses during the 1980s early 1990s. In 1991, London Stock Exchange appointed Sir Adrian Cadbury committee to draft a code of practices in English corporations to define and apply internal controls to limit their exposure to financial losses. The committee submitted the “Code of Best Practices” in 1992. It included guidelines to board of directors, non-executive directors, and those on reporting and control.

The Sarbanes –Oxley Act (SOA) 2002• In the US, stock market began

declining in early 2000. Well- known companies like Enron, WorldCom Adelphia, Global Crossing, Dynegy and a few others steeped in corruption, fraud, deception collapsed damaging investor confidence. Stock prices plummeted and investors lost billions of dollars. Investigations by the US Congress and the Securities and Exchange Commission (SEC) brought about a comprehensive Act, the Sarbanes-Oxley Act was enacted into law on July 30, 2002.

Sen. Paul Sarbanes Michael Oxley

The Sarbanes – Oxley Act was formulated to protect investors by improving the accuracy and reliability of corporate disclosures. The act contained a number of provisions that dramatically change the reporting and corporate director’s governance obligations of public companies, the directors, and officers.

Issues in Corporate Governance

• Corporate governance means different things to different people. But to all, corporate governance is a means to an end, the end being long term shareholder , and importantly, stakeholder value. Good corporate governance practices involve some critical and crucial issues. These are:

Distinguishing the roles of board and management• Business is to be managed “by or under

the direction’” of the board. The responsibility of managing the business is delegated to the CEO, who in turn delegates to other senior managers. The board is positioned between the shareholders (owners) and the company’s management. The board holds important functions:

1. Appoint and remove CEO

2. Indirectly oversee the conduct of the business

3. Review and approve company’s financial objectives, corporate plans and objectives

4. Advice and counsel top management

5. Identify and recommend candidates to shareholders for electing directors

6. Review systems to comply with laws and regulations

Composition of board and other related issues• Committee elected by the shareholders of a limited company for the

policies of the company – sometimes full-time functional directors are also appointed.

• The SEBI appointed Kumar Mangalam Birla’s report defined the composition of the board as:

“The board of directors of a company shall have an optimum

combination of executive and non-executive directors with not less than 50 per cent of the board of directors to be non-executive directors. The number of independent directors would depend whether the chairman is executive or non-executive. In case of a non-executive chairman, at least one –third of the board should comprise independent directors and in case of executive chairman, at least half of the board should be independent directors.”

Board of Directors

Executive Directors Non-Executive Directors

Independent Directors Affiliated Directors (Nominee Directors)

Types of Directors

• Executive director – an executive of the company and also a member of the board

• Non-Executive director – no employment relationship

• Independent non-executive directors – free from any business or other relationship which may interfere with the exercise of independent judgment

• Affiliated director – who has some kind of independence, yet may have links with suppliers, customers, etc.

Roles of CEO and Chairperson

• The composition of the board is a major issue• Professionalizing of family companies should start with

the composition of the board.• Combining the roles of CEO and Chairperson prevalent

in US and India result in conflicting interests and decision making. In UK and Australia the CEO can not be the chairperson of the board.

• CEO is to lead the senior management and the chairperson is to lead the board and more over it may be too heavy to handle both jobs by one person.

Should board have committees?

• Many committees on corporate governance have recommended appointment of special committees for:

1. Nomination2. Remuneration3. Auditing4. When the above committees are composed of

independent directors selected due to their competence, professional expertise in their own fields, and proven experience, they are likely to take objective decisions and serve the long term interests of the company.

Appointments and reelection of directors

• As per the Indian Company Law, shareholders elect directors; but when there are so many shareholders and they are scattered all over the country, specially constituted committees go into these issues and elect persons as directors who will be confirmed in the ensuing General Body meetings of the company. Same way re-election of the directors too takes place.

Directors’ and executives’ remuneration

• This is one of the mixed and vexed issues of corporate governance. In recent years the remuneration payable has become most visible and politically sensitive issue. Essentially the shareholders should get a full disclosure about how much benefits the directors are entitled and paid for. Committees (Cadbury) on corporate governance have laid emphasis on issues such as transparency, “pay-for-performance”, severance payments, pension for non-executive directors, and appointment of remuneration committees.

Disclosure and Audit

• The Cadbury Report termed audit as “one of the corner stones of corporate governance”. Audit provides a basis for reassurance to the share holders and everyone else who has a financial stake in the company. Audits raise a host of issues:

1. Should boards establish audit committees? How should it be composed?

2. How to ensure the independence of the auditor?

3. What about the non-audit services rendered by the auditors?

Recent corporate scandals involving auditors

Arthur Andersen Accountancy firm Arthur

Andersen was declared guilty of obstructing justice by shredding documents relating to the failed energy giant Enron. The verdict could be the death knell for the 89-year old company, once one of the world's top five accountants.

• Andersen has already lost much of its business, and two-thirds of its once 28,000 strong US workforce. Following the conviction, multi-million dollar lawsuits brought by Enron investors and shareholders demanding compensation are likely to follow, and could bankrupt the firm.

Satyam

• Price Waterhouse resigned as statutory auditor of Satyam Computer Services Ltd with effect from February 12, 2009, while stating that it would co-operate with the ongoing investigations into the Rs 7,800 crore fraud at the IT major.

• Protection of shareholder rights and their expectations

• Dialogue with Institutional investors

• Should investors have a say in making company “socially responsible corporate citizen”?