Module 3

Corporate Governance

Definition• CG refers to the distribution of rights &

responsibilities among different participants in a corporate entity such as shareholders, management & other stakeholders & spells out rules & procedures for making decisions on corporate affairs

• CG is generally perceived as a set of codes & guidelines to be followed by the companies. But governance is more than just board processes & procedures. It involves relationship b/w company’s mgmt, its board, shareholders & stakeholders

• From this point of CG focus on a simple model:

1.Shareholders elect directors who represent them

2.Directors- vote on key matters- majority decision

3.Decisions- made in transparent manner- so that directors can be held responsible

4.Company- adopts- accounting stds- generate information necessary for directors, investors & other stakeholders

5.Company policies & practices- adhere to applicable national, state & local laws

Mckinsey suggested 2 version of Governance Model

• Market model:• Efficient, well

developed equity markets & dispersed ownership- US,UK, Canada, Australia

• Model depicts- CG- well understood & highly appreciated by global investors

• Control model:• Depicts governance

chain- underdeveloped equity markets, concentrated (family) ownership, less shareholder transparency, inadequate protection of minority & foreign stakeholders

• In such developing economies- need to build & nurture supporting institutions- market regulator & judiciary

Organisation of Economic Co-operation & Development

• Defines CG as the system by which business corporations are directed & controlled

• CG is a structure- specifies distribution of rights & responsibilities among diff participants in the corporation, such as the Board, managers, shareholders & other stakeholders- spells out the rules & procedures for making decisions on corporate affairs

• By CG- provides structure through which the company objective is set, means to attain & monitoring the performance

•

• Most worldwide organizations- strongly promote CG- means of enhancing economic growth of a member nations such as world bank, OECD, APEC (Asia Pacific Economic Cooperation)- insist inalienable rights of shareholders, equitable treatment, role of stakeholders in realizing CG through disclosure, transparency & boards’ responsible in ensuring all these

• OECD- emphasised following requirements of corporate Governance:

1. Rights of shareholders: includes secure ownership of their shares, voting rights, the right to full disclosure of information, participation in decision or sale of any corporate assets including mergers, acquisitions, right to know the capital structure, transparent transactions, should know the cost & benefits of exercising their voting rights

2. Equitable treatment of shareholders: i. All shareholders- including minority

foreign shareholders- equitable treatment- all share

ii. Equal opportunity for redressal of their grievances & violation of their rights

iii. Should not have any difficulties in exercising their voting rights

iv. Should avoid situations- conflict of interest- decision making

3. Role of stakeholders in CG:i. CG framework- apart from recognizing-

rights of shareholders, allows employees representation on BOD, profit sharing

ii. For active stakeholder- ensure that they have access to relevant information

4. Disclosure & transparency:i. OECD- no of provisions- laid for the

disclosure & dissemination- key info about the company- to the entitled

ii. Ranges form company’s objective to financial details, operating results, governance structure & policies, remuneration, foreseeable risk factors etc

iii. OECD- spells out guidelines for annual audits- to be performed

5. Responsibilities of the board:i. Primary function- protecting the company,

its shareholders & stakeholders ii. Functions include concerns about

corporate stgy, risk, executive compensation & performance, accounting, monitoring effectiveness

Historical Perspective of Corporate Governance• From narrow to broader vision:

• CG has focused traditionally on the problems of separation of ownership by shareholders & control by management

• It is now accepted that firms should respond to the expectations of more categories of stakeholders

• Wide range of CG practices include business ethics, social responsibility, mgmt discipline, corporate strategy, stakeholder participation in DM & promotion of sustainable dvlpment

Growth of Modern Ideas of CG from USA• The seeds of modern ideas of CG-

Watergate scandal- US- investigations- revealed- regulators & legislative bodies failure- control & stop several major corporations- making illegal politics contribution- bribing govt officials-paved way for stiffer legislations

Cadbury Committee• In England, Sir Adrian Cadbury was entrusted

in 1991- by London Stock Exchange- drafting a code of practices- to assist corporations- defining & applying internal controls-limit their exposure to financial loss

• CC invested extensively- accountability of BOD- to shareholders & to the society

• Committee submitted report- “Code Of Best Practices”- elaborated mtds of CG- to achieve balance b/w essential powers of the board & accountability

Corporate Governance in Banking Sector

• Some bank failures- in west- underlined the necessity of close monitoring- banking system of a country- can threaten financial stability- within country & globally

• Central Bank Governors of the group of ten countries, Bank for International Settlements, International Monetary Funds & world bank- ways & means- strengthen financial stability

Issues in Corporate Governance• CG means- to an end- being long term

shareholder value. Some governance issues being crucial & critical to achieve these objectives are:

1.Distinguishing the roles of board & management:

• Constitutions of more & more stress & underline- business to be managed “by or under the direction if the board”

• Such practice-responsibility for managing-

• Business- delegated- by the board to CEO- delegates responsibilities- senior executives

• Board occupies- key position b/w company’s shareholders (owners) & the company’s management.

• The following are the functions of the board:1.Select, decide the remuneration- evaluate on

regular basis- whenever necessary- change the CEO

2.Oversee indirectly the conduct of the company’s business- evaluate- company’s properly managed or not

3. Review & approve the financial objectives (wherever necessary)-company- & major corporate plans

4. Render advice & counsel- top management

5. Identify & recommend candidates- to shareholders- for electing them to BOD

6. Review the adequacy of systems- to comply with applicable laws & regulations

2. Composition of the board & related issues:

3. BOD- committee elected by the shareholders- responsible for the policy of the company

4. Full time functional directors- responsible for each branch

5. Composition- no of directors- different expertise

6. SEBI- appointed- Kumar Mangalam Birla committee report- composition of board- BOD- company- optimum combination of

• Executives & non executives directors- with not less than 50% of board directors to be non executive directors.

5.The no of independent directors- depends chairman- executive or non executive

6.Non executive chairman- one third of the board- independent directors

7.Executive chairman- half of the board- independent directors

• Executive director- executive of the company- also member of BOD

• Non executive directors- not employee of the company- does not engage in day to day management- but involved in policy making & planning, strategy formulation- hold shares of the company

BOD

Non- exec.Directors

Exec. Directors

Affiliated directors

(Nominee)Independent

directors

• Independent non executive directors- outsiders- process of DM- watchful monitors of promoters & management-on behalf of public shareholders

• Affiliated or nominee directors- impairing relationship- company- eg: director- links major supplier or customer of company

3.Separation of roles of the CEO & chairperson:

4.Composition of board- major issue- link b/w shareholders & management

2. In India, US- combining CEO & chairman-conflicts in DM- concentration of the power

3. Role of CEO- lead senior management- manage the enterprise; role of chairperson- lead the board- board has to evaluate the performance of the senior management including CEO

4. Should the board have committees?: recommends special committees: nomination, remuneration, auditing-clear procedures- reporting back to the board- lessens the burden on board

5. Appointments to the board & directors re-election: as per Indian Company Law- elect directors- expensive, time consuming. Actual practice-board- constitutes committee-selects & appoints- prospective director-formally elected- by shareholders- annual general body meeting.

• In India- endorse- rarest of Rare opposing6.Directors & non executives compensation:

key issues are: pay for performance, severance payments (compensation- laid off, mutual agreement to leave the company- employee may receive- month pay for each year), transparency, pensions

7.Disclosure & audit: OECD- no of provisions for disclosure- for auditing- questions are- should board form committee? If so- composition, how to ensure independence of auditor, precautions etc

8. Protection of shareholders rights & their expectations: vital factor for the company- no of questions- company adhere to one to one voting?, voting through poll or by hand?, should shareholders approval for all major transactions

9. Dialogue with institutional stakeholders: CC- recommends- investors- regular & systematic contact- companies- apart from participation in meeting, voting, positive interest in composition of the board, rather than just buying & selling of shares

10.Should investors have say in making a company socially responsible corporate citizen?

• One school of thought- socially responsible company-enhance cost- reducing profits- but another school of thoughts- Environment friendliness & economic gains- not contradictory- benefits corporations for a long run

Relevance of Corporate Governance

• Different economies have systems of CG- differ in relative strength exercised by the stakeholders & how they influence the management

• Good corporate governance means governing the corporation in such a way- interest of the shareholders are protected- while ensuring the stakeholders requirements are fulfilled

Need for & importance of Corporate Governance

• Corporate Governance- needed to create a corporate culture of consciousness, transparency & openness

• Refers to combination of laws, rules, regulations, procedures & voluntary practices- enable companies to maximise shareholders long term value

• Should lead to increasing customer satisfaction, shareholder value & wealth

Benefits of Good Corporate Governance

• Good corporate governance secures- effective & efficient operation of a company in interest of all stakeholders

• Provides assurance that management- acting best interest of the corporation- contributing to the business prosperity- through openness in disclosures & accountability

• Key contributions of good corporate governance include:

1. Creation & enhancement of corporation’s competitive advantage:

• Competitive advantage- grows naturally- corporation or its service- creation of value for its buyers.

• Creating competitive advantage- vision to innovate & strategy to manage process of delivering value.

• Strategies that creates value to corporations

• are sales, marketing, customer base & branding. Eg: Himalayas- Ayurveda, Sony- Quality etc

2.Enabling a corporation perform efficiently by preventing fraud & malpractices:

• The Code of Best Conduct policies & procedures- governing the behavior of individuals of a corporation-form part of CG

• Prevents fraud & malpractices- destroys business from inside (internal trading)

3. Providing protection to shareholders interest:

• CG- set of rules- focuses on transparency of info & management

• Imposes fiduciary duty on management- act in bets interest of all shareholders & properly disclose the operations of the corporations

• Particularly important when ownership & management enterprise of an enterprise are in different hands

4. Enhancing value of an enterprise:• Improved management accountability &

operational transparency- fulfill investors expectations & confidence on management & corporations

• In turn increases the value of the corporations

• Companies- adopted CG stds- enhanced market valuations

5. Ensuring compliance of laws & regulations:• Jurisdictions- protect investors- compliance-

key agenda in establishing good CG

Concept of Corporate• Term business corporation- instrument

through which capital is assembled for activities of producing & distributing goods & services & making investments

• Company- an association of many persons, who contributes money or moneys’ worth to a common stock- invest in some trade or business- share profit & loss arising. Persons who contribute it, or whom it belongs are “Members”. The proportion of capital- entitled as his shares, shares are transferable

• Corporation- association of persons- perpetual succession- corporations- distinct from its members- has a common seal.

• Characteristics of a corporate are:1. Incorporated association: legally registered

under Companies Act2. Artificial legal existence: Supreme court of

India defines legal status of the company as “The Corporation in law is equal to a natural person- has its own entity- bears its own name & seal, assets are separate distinct from its members, it can sue & it can be sued, the liability of the investors & shareholders is limited to the capital invested by them”

3. Perpetual existence: life of the corporation- not like life of the members. Corporate life does not end with exit, retirement, insolvency or death of any or all directors. A company’s existence- depends on law & it can only dissolve it

4. Common seal: company- legal entity- documents- seal & signed by the CEO. Under the Companies Act- any document- seal of the company- witnessed by 2 directors of the company

5. Extensive membership: joint stock company- public limited- min no is 7 no limit in issuance of shares

6. Separation of management from ownership: practical- shareholders- scattered- not feasible- take part in administration. BOD- oversees management- daily administration- salaried managers- misgovernance

7. Limited liability: Liability of the each shareholder is limited to proportion of shares he holds so joint stock company is also called as “limited company”

• If company is unable to repay the loan or interest- creditors can claim only on the assets of the company but not on the personal belongings of the shareholder

• This limitation of liability eliminates- “risk” of investments- stimulated investments- large industries

8. Transferability of shareholders: public limited company- free transferring of shares- without the consent of the company- imparts liquidity

Concept of Governance• Governance- process of decision making & the

process by which it is implemented. Analysis of governance focuses on the formal & informal players involved in decision making & implementing the decisions made

• Government- one of the players in governance- others involved are for example rural areas- influential landlords, NGOs, religious leaders, political parties etc

• Urban areas small scale entrepreneurs, media• National level- media, MNCs etc

Theoretical basis of Corporate Governance

Agency theory Conflicts of interest between owners & the

managers of a firm is the “Agent Problem” & the cost inflicted- dissonance- “Agency Cost”

In organizational set up owners (principal) & managers (agents), owners hire employees to carry out specified activity

CG- designing- putting disclosure in places- monitoring & oversight &corrective systems- align both objectives- minimise agency costs

Problems with Agency Theory1. Fair and accurate financial disclosure:• Financial & non financial disclosure-

relate to role of independent auditors- appointed for the audit of the company- present a “true & fair” view of the financial health of the corporation

• Responsibility of the auditors- raise queries & objections, arrive at a true & fair view of financial position

2. Efficient & independent board of directors:

• Joint stock company- owned by shareholders- appoints directors to supervise management- ensure that it does all ethical & legal means to make business grow & maximise long term corporate value

Stewardship theory • The stewardship theory assumes- managers

are trustworthy- motives are aligned with objectives,

• Managers are stewards-behavior- will not depart from organisation

• Control undermines the org. behavior of the steward- lowering his motivation

• Stewardship- oversee day to day operations- trusteeship- better understanding of the roles & responsibilities of the employees

Behavioral difference betweenAgency theory1. Managers acts as

agents2. Governance

approach- materialistic

3. Behavior pattern is individualistic, opportunistic, self serving

4. Mgrs- motivated by their own objectives

Stewardship theory1. Managers acts as

stewards2. Governance

approach- non-materialistic

3. Behavior pattern is collectivistic, pro-organisational, trustworthy

4. Mgrs- motivated by their principals objectives

Agency theory

5. Interest of managers & principals differ

6. Role of the management is to monitor & control

7. Owners attitude- avoid risks

8. Principal manager relationship- based on control

Stewardship theory

5. Interest of managers & principals converge

6. Role of the management is to facilitate & empower

7. Owners attitude- take risks

8. Principal manager relationship- based on trust

Psychological MechanismsAgency Theory1. Motivation revolves

around lower order needs & extrinsic needs

2. Social Comparison is between Compatriot (fellow citizen)

3. Little attachment to the company

4. Power rests with the institution

Stewardship Theory

1. Motivation revolves around higher order needs & intrinsic needs

2. Social Comparison is between principal

3. Great attachment to the company

4. Power rests with the personnel

Situational MechanismsAgency Theory1. Management

philosophy- control oriented

2. To deal with increasing uncertainty & risks- theory suggests- greater controls & more supervisions

Stewardship Theory1. Management

philosophy- involvement oriented

2. To deal with increasing uncertainty & risks- theory suggests- training & empowering ppl & making jobs challenging & motivating

Agency Theory

3. Risk orientation- system of control

4. Cultural differences revolve around individualism

5. Objective is cost control

Stewardship Theory

3. Risk orientation- trust

4. Cultural differences revolve around collectivism

5. Objective is improving performance

Stakeholder Theory• This theory- emphasis on ethics of care,

ethics of professional relationship, social contract theory, theory of property rights

• Criticism of stakeholder theory:• Definition of genuine stakeholders-

stakeholder model• Few opine- employees, customers, suppliers,

government, community etc

Sociological Theory• More focused on broad composition & wealth

distribution• Financial reporting, disclosure & auditing- to

realise socio economic objectives of the corporations

Obligation to the Society• Corporation- association of persons- part of

the society. Activities- bound to impact society as the society’s values- impact on corporation

• Mutual rights & obligations: national interest, legal compliance, honest & ethical conduct

1. National interest: company- committed in all its actions- benefit the economic development- not to involve- any activity- mitigate against the objectives

2. Political non-alignment: company should support democratic constitution- not to sponsor for any political party for the campaign or as donations

3. Legal compliances: company- should comply with applicable government laws, rules & regulations. All levels of management- aware of these laws- violating- criminal or civil liability or disciplinary action

4. Rule of law: no favoritism- protection of shareholders especially minority shareholders

5. Honest & ethical conduct: every officer in the company- CEO,CFO, MD etc- deal with professionalism, honesty, commitment& sincerity- with high moral & ethical standards

6. Corporate citizenship: corporation- good corporate citizenship- not only by abiding laws- but also by assisting the improvement of QWL

7. Ethical behavior: set examples- moral responsibility of BOD

8. Social concerns: corporate exist beyond time & space- equitable treatment of shareholders

9. CSR: responsiveness towards the society10.Environment friendliness: Environmental

sense- eco friendly products11.Healthy & safe working environment:

company should provide- Healthy & safe working environment- prevents wasteful use of resource & avoids hazardous impact

12.Competition: open to competition- no unethical advertisements- company- market its products & services- own merit

13.Trusteeship: corporations- social & economic purpose- coalition of interest- shareholders, employees & others- enhance the value of the shareholder

14.Accountability: answerable to public & stakeholders- cannot be enforced through law

15.Effectiveness & efficiency: context of good governance- sustainable use of resources to protect the environment

16.Timely responsiveness: towards stakeholders & employees

17.Corporations should uphold fair name of the country: companies- export their product/ service- quality

Obligation to the Investors• Company has to ideally follow obligations to the

investors by promoting transparency & informed shareholders participation

• In context of enhanced awareness of better governance corporate should address these issues:

1. Towards shareholders: company- committed to enhance shareholders value- comply by govt laws- fair & transparency in all means to the shareholders & stakeholders

2. Measures promoting transparency & informed shareholder participation: addressing the issues of the shareholders & provides meaningful participation of shareholders- without the interference of the management & accounting it

3. Transparency: decision taking & enforcement- follows rules & regulations- directly accessible- to those who are affected by the decisions & enforcement

4. Financial reporting & records: prepare & maintain accounts- biz affairs (transaction & affairs)- according to the standards- accessible to the auditors, non executive, independent directors, government agencies. Any misrepresentation & or/ misinformation on financial accounts- violation of the firm

Obligation to Employees1. Fair employment practices: performance & quality

based compensation, promotion, privacy, punishment etc

2. Equal opportunities employer: no illegal discrimination (race, caste, religion, gender, colour, marital status, nationality, disability etc)

3. Encouraging whistle blowing: ideal corporate- proactively deal with whistle blowers- comfortable reporting channels- no unfair termination of the whistle blowers

4. Humane treatment: companies- treat employees- customers- cater basic needs

5. Participation: freedom of association & expression

6. Empowerment: it unleashes the creativity & innovation in the organization- decision making power- vested in the appropriate levels in the hierarchy

7. Equity & inclusiveness: employees- should not feel excluded from the mainstream, equal opportunities

8. Participative & collaborative environment: collaborative environment- brings peace & harmony- improves productivity, higher profits & market share

Obligations to Customers • Company’s existence- cannot be justified-

without catering to the needs of the customer.

1. Quality of products & services: Committed to supply goods & services of high quality set by the quality stds @ national level

2. Products @ affordable price: normal profits- but not by exploiting the consumers

3. Unwavering commitment to customer satisfaction: earn goodwill & should deliver what they promise (quality, after sales service, warranties & guarantees)

Managerial Obligation1. Protecting company’s assets: should not be

misused or dissipated for the purpose of conducting business- includes tangible assets like machineries, system, facilities, as well as intangible assets

2. Behavior towards government agencies: company employee- should not give any firm’s fund or donation- govt agency or intermediaries- favoring official duties

3. Control: principle of governance- management- exercise- freedom & appropriate checks- ensure biz risk- managed pre-emptively & effectively

4. Consensus oriented: good governance- mediation of different interest in society- broad interest- whole community to be achieved.

5. Gifts & donations: company’s employees- should not- receive any gifts, illegal payments, remuneration, donations etc- to obtain biz or uncompetitive favors for the conduct of the biz

6. Roles & responsibilities of corporate board & directors: role of corporate BOD as stewards- stakeholders- gained importance, successive scams & company’s failure- demands more transparency & accountability.

• Good board more of non executive directors & independent directors

7. Direction & management must be distinguished: necessary to distinguish 2 main components- in terms of policy making & oversight responsibilities. Executives who are also on board- can be a part of board & as well as part of management.

• Directors derive authority- only when acting collectively- managers sense the responsibilities- execute the policies- under the supervision of the board

8. Managing & whole time directors: whole time directors- devote whole time- company affairs- rather than serving non executive board