Unit-5 An Overview of Corporate Governance

According to Institute of Company Secretaries of India- Corporate Governance is the application of

`best Management Practices, Compliance of Laws in true letter and spirit and adherence to ethical
standards for effective management and distribution of wealth and discharge of social responsibility
for sustainable development of all stakeholders.”

Corporate governance is the system by which companies are directed and controlled. Boards of
directors are responsible for the governance of their companies. The shareholders' role in
governance is to appoint the directors and the auditors and to satisfy themselves that an
appropriate governance structure is in place.

The Oxford University Press Business English Dictionary defines corporate governance as the “way in
which directors and managers control a company and make decisions, especially decisions that have
an important effect on the shareholders.” The concept of corporate governance is becoming
increasingly important for companies.

Employing good corporate governance helps the company regulate risk and reduce the opportunity
for corruption. Often, scandals and fraud within a company become more likely where directors and
senior management do not have to comply with a formal governance code. The board should meet
regularly, retain control over the business and monitor those in management to enable it to see how
the company is functioning. Furthermore, a good corporate governance scheme will make clear to
every officer of the company his or her duties and will encourage them to keep these duties in mind
when making decisions.

Issues affecting corporate governance practices in India.

1. Getting the Board Right

To this end, the law requires a healthy mix of executive and non-executive directors and
appointment of at least one-woman director for diversity. There is no doubt that a capable, diverse
and active board would, to large extent, improve governance standards of a company. The challenge
lies in ingraining governance in corporate cultures so that there is improving compliance "in spirit".
Most companies' in India tend to only comply on paper; board appointments are still by way of
"word of mouth" or fellow board member recommendations. It is common for friends and family of
promoters (a uniquely Indian term for founders and controlling shareholders) and management to
be appointed as board members. Innovative solutions are the need of the hour - for instance, rating
board diversity and governance practices and publishing such results or using performance
evaluation as a minimum benchmark for director appointment.

2. Performance Evaluation of Directors

Although performance evaluation of directors has been part of the existing legal framework in India,
it caught the regulator's attention recently. In January 2017, SEBI which is the India's capital markets
regulator, released a 'Guidance Note on Board Evaluation'. This note elaborated on different aspects
of performance evaluation by laying down the means to identify objectives, different criteria and
method of evaluation. For performance evaluation to achieve the desired results on governance
practices, there is often a call for results of such evaluation are made public. Having said that,
evaluation is always a sensitive subject and public disclosures may run counter-productive. In a peer
review situation, to avoid public scrutiny, negative feedback may not be shared. To negate this
behaviour, the role of independent directors in performance evaluation is key.

3. True Independence of Directors

Independent directors' appointment was supposed to be the biggest corporate governance reform.
However, 15 years down the line, independent directors have hardly been able to make the desired
impact. The regulator on its part has, time and again, made the norms tighter: introduced
comprehensive definition of independent directors, defined a role of the audit committee, etc.
However, most Indian promoters design a tick-the-box way out of the regulatory requirements. The
independence of such promoter appointed independent directors is questionable as it is unlikely
that they will stand-up for minority interests against the promoter. Despite all the governance
reforms, the regulator is still found wanting. Perhaps, the focus needs to shift to limiting promoter's
powers in matters relating to in independent directors.

4. Removal of Independent Directors

While independent directors have been generally criticised for playing a passive role on the board,
instances of independent directors not siding with promoter decisions have not been taken well -
they were removed from their position by promoters. Under law, an independent director can be
easily removed by promoters or majority shareholders. This inherent conflict has a direct impact on
independence. In fact, even SEBI's International Advisory Board proposed an increase in
transparency with regard to appointment and removal of directors. To protect independent
directors from vendetta action and confer upon them greater freedom of action, it is imperative to
provide for additional checks in the process of their removal - for instance, requiring approval of
majority of public shareholders.

5. Accountability to Stakeholders, employees & external stakeholders.

Empowerment of independent directors has to be supplemented with greater duties for, and
accountability of directors. In this regard, Indian company law, revamped in 2013, mandates that
directors owe duties not only towards the company and shareholders but also towards the
employees, community and for the protection of environment. Although these general duties have
been imposed on all directors, directors including independent directors have been complacent due
to lack of enforcement action. To increase accountability, it may be a good idea to require the entire
board to be present at general meetings to give stakeholders an opportunity to interact with the
board and pose questions.
6. Executive Compensation

Executive compensation is a contentious issue especially when subject to shareholder accountability.

Companies have to offer competitive compensation to attract talent. However, such executive
compensation needs to stand the test of stakeholders' scrutiny. Presently, under Indian law, the
nomination and remuneration committee (a committee of the board comprising of a majority of
independent directors) is required to frame a policy on remuneration of key employees. Also, the
annual remuneration paid to key executives is required to be made public. Is this enough? To retain
and nurture a trustworthy relationship between the shareholders and the executive, companies may
consider framing remuneration policies which are transparent and require shareholders' approval.

7. Founders' Control and Succession Planning

In India, founders' ability to control the affairs of the company has the potential of derailing the
entire corporate governance system. Unlike developed economies, in India, identity of the founder
and the company is often merged. The founders, irrespective of their legal position, continue to
exercise significant influence over the key business decisions of companies and fail to acknowledge
the need for succession planning. From a governance and business continuity perspective, it is best if
founders chalk out a succession plan and implement it. Family-owned Indian companies suffer an
inherent inhibition to let go of control. The best way to tackle with this is widen the shareholder
base – as other institutional investors pump in capital, founders are forced to think about a
succession plan and step away with dignity.

8. Risk Management

Today, large businesses are exposed to real-time monitoring by business media and national media
houses. Given that the board is only playing an oversight role on the affairs of a company, framing
and implementing a risk management policy is necessary. In this context, Indian company law
requires the board to include a statement in its report to the shareholders indicating development
and implementation of risk management policy for the company. The independent directors are
mandated to assess the risk management systems of the company. For a governance model to be
effective, a robust risk management policy which spells out key guiding principles and practices for
mitigating risks in day-to-day activities is imperative.

9. Privacy and Data Protection

As a key aspect of risk management, privacy and data protection is an important governance issue.
In this era of digitization, a sound understanding of the fundamentals of cyber security must be
expected from every director. The board must assess the potential risk of handling data and take
steps to ensure such data is protected from potential misuse. The board must invest a reasonable
amount of time and money in order ensure the goal of data protection is achieved.

10. Board's Approach to Corporate Social Responsibility (CSR)

India is one of the few countries which has legislated on CSR. In Company’s meeting specified
thresholds are required to constitute a CSR committee from within the board. This committee then
frames a CSR policy and recommends spending on CSR activities based on such policy. Companies
are required to spend at least 2% of the average net profits of last three financial years. For
companies who fail to meet the CSR spend, the boards of such companies are required to disclose
reasons for such failure in the board's report. Companies which have failed to comply received
notices from the ministry of corporate affairs asking for reasons why they did not incur CSR spend
and in some cases questioning the reasons disclosed for not spending. In these circumstances,
increased effort and seriousness by the board towards CSR is necessary. CSR projects should be
managed by board with as much interest and vigour as any other business project of the company.

The following activities can be performed by a company to accomplish its CSR obligations:

Eradicating extreme hunger and poverty

Promotion of education

Promoting gender equality and empowering women

Reducing child mortality

Improving maternal health

Combating human immunodeficiency virus, acquired, immune deficiency syndrome, malaria and
other diseases

Ensuring environmental sustainability,

Employment enhancing vocational skills, social business projects

Contribution to the Prime Minister’s National Relief Fund or any other fund set up by the Central
Government or the State Governments for socio-economic development, and

Relief and funds for the welfare of the Scheduled Castes, the Scheduled Tribes, other backward
classes, minorities and women and such other matters as may be prescribed.

Theories of Corporate Governance:

Agency Theory

Agency theory defines the relationship between the principals (such as shareholders of company)
and agents (such as directors of company). According to this theory, the principals of the company
hire the agents to perform work. The principals delegate the work of running the business to the
directors or managers, who are agents of shareholders. The shareholders expect the agents to act
and make decisions in the best interest of principal. On the contrary, it is not necessary that agent
make decisions in the best interests of the principals. The agent may be succumbed to self-interest,
opportunistic behaviour and fall short of expectations of the principal. The key feature of agency
theory is separation of ownership and control. The theory prescribes that people or employees are
held accountable in their tasks and responsibilities. Rewards and Punishments can be used to correct
the priorities of agents.

The following are the main aspect of agency theory:

 Agency theory attempts to explain and resolve disputes over the respective priorities
between principals and their agents.

 Principals rely on agents to execute certain transactions, which results in a difference in

agreement on priorities and methods.

 The difference in priorities and interests between agents and principals is known as the
principal-agent problem.

 Resolving the differences in expectations is called "reducing agency loss."

 Performance-based compensation is one way that is used to achieve a balance between

principal and agent.

 Common principal-agent relationships include shareholders and management, financial

planners and their clients, and lessees and lessors.

Stewardship Theory of Corporate Governance

Stewardship theory was introduced by Donaldson and Davis (1989) as a normative alternative to the
agency theory. The executive manager, under stewardship theory, far from being an opportunistic
shirker, essentially wants to do a good job, to be a good steward of the corporate assets. While
profit drives any business, some companies may consider themselves part of something bigger.
Stewardship theory holds that ownership doesn’t really own a company; it’s merely holding it in
trust.

The steward theory states that a steward protects and maximizes shareholders wealth through firm
Performance. Stewards are company executives and managers working for the shareholders,
protects and make profits for the shareholders. The stewards are satisfied and motivated when
organizational success is attained. It stresses on the position of employees or executives to act more
autonomously so that the shareholders’ returns are maximized. The employees take ownership of
their jobs and work at them diligently.
The stewardship theory holds that managers inherently seek to do a good job, maximize company
profits and bring good returns to stockholders. They do not necessarily do this for their own financial
interest, but because they feel a strong duty to the firm.

Stewardship theory is a theory that managers, left on their own, will act as responsible stewards of
the assets they control. Stewardship theorists assume that given a choice between self-serving
behavior and pro-organizational behavior, a steward will place higher value on cooperation than
defection.The assumptions of stewardship theory are that long-term contractual relations are
developed based on trust, reputation, collective goals, and involvement where alignment is an
outcome that results from relational reciprocity

According to the stewardship theory, managers and employees are trustworthy individuals, and as
long as they are compensated according to their needs, there is little to no risk of them abusing their
positions and causing harm to shareholders’ interests. Thus, stewardship theory advocates
management empowerment and the active role of shareholders in their own companies.

Stakeholder Theory

The aim of stakeholder theory is to find what are the best interests based on different stakeholder
groups. Stakeholder theory promotes a practical, efficient, effective, and ethical way to manage
organizations in a highly complex and turbulent environment. It means Stakeholder theory plays an
important role in corporate governance and can serve the company to balance various groups’
benefits. There are three key features of stakeholder theory. Firstly, managers are supposed to
recognize and monitor all legitimate stakeholders, when making a decision and operating they
should fair consider the interests of all stakeholders. Secondly, managers should avoid potential
conflicts between different groups and address problems through open communication and
dialogue. Thirdly, managers need to maintain Friendly Corporation with other entities, both public
and private, to avoid risks from an unstable environment. These principles illustrate the role of
stakeholders play in a company and how to apply stakeholder theory in practice. Stakeholder theory
usually including internal and external stakeholders. Managers, employees, and owners are included
in internal stakeholders, and customers, suppliers; competitors are included in external
stakeholders. Additionally, governments and local communities are considered as a legal or rule
responsibility. Specifically, these stakeholders have the following characteristics in the theory.

Shareholder: According to the act and the constitution of corporations, shareholders could exercise
a serious of power such as voting and transfer ownership. When shareholders received better
dividends from a company, they will buy more shares and help the company maintain stability
through their rights. In general, shareholders only passively react company’s operation rather than
actively participate in corporate governance.

Employees: Company gives employees more attention such as good training and generous welfare,
they will work more effectively to bring better profit to the company. Moreover, employees could
own a part of the shares in the company. As long as the company’s stock price rises, employees can
benefit from it.

Bank and financial institution: When a company provided a confident financial report with them,
these financial institutions will not recall funds and would lend the company more money in the
future. In addition, the company is able to borrow funds at a low rate.

Government: The government collects a large amount of fiscal revenue through tax collection, while
at the same time providing a convenient trading environment for enterprises. Even the government
will give allowance to support company improvement.

Community: Local residents will provide the company with a large number of labor resources, and
the company can rely on them for efficient production. Local residences will also prefer to purchase
the company’s products or services when the company supports community building through charity
activities such as help the community develops local traditional culture.

Environment: A number of environmental lobby groups considered as one part of the stakeholders
and these lobby groups requested all companies to meet environmental standards during
production. If the company is outstanding in the field of environmental protection, the
environmental protection organization actually has a propaganda role for the company. These
stakeholders can affect the company in many ways and become a significant role in corporate
governance. Companies have the responsibility to treat these stakeholders equally and consider
their interests. Because these companies need stakeholders to support their operations so that
profit from it. Thus, stakeholder theory is significant in the practical application of corporate
governance.

Cadbury Committee Recommendations on Corporate Governance:

The London Stock Exchange and the Bank of England set up a committee in 1991 under the
Chairmanship of Sir Adrian Cadbury to look into the financial aspects of corporate governance. The
very focus of the committee was on control and reporting functions of the Board of Directors. It
developed a Code of Corporate Governance which is known as ‘Code of Best Practice’.

The recommendations are in the nature of guidelines relating to Board of Directors, Non-executive
Directors, Executive Directors and those on Reporting and Control.

Relating to the Board of Directors, the recommendations are:

a. The Board should meet regularly retain full and effective control over the company

and monitor the executive management

b. There should be a clearly accepted division of responsibilities at the head of a

company, which will ensure balance of power and authority, such that no

individual has unfettered powers of decision. In companies where the Chairman is

also the Chief Executive, it is essential that there should be a strong and

independent element on the Board, with a recognized senior member.

c. The Board should include non-executive Directors of sufficient calibre and number

for their views to carry significant weight in the Board’s decisions.

d. The Board should have a formal schedule of matters specifically reserved to it for

decisions to ensure that the direction and control of the company is firmly in its

hands.

e. There should be an agreed procedure for Directors in the furtherance of their

duties to take independent professional advice if necessary, at the company’s

expense.

f. All directors should have access to the advice and services of the Company

Secretary, who is responsible to the Board for ensuring that Board procedures are

followed and those applicable rules and regulations are complied with. Any

question of the removal of Company Secretary should be a matter for the Board as

a whole.

Relating to the Non-Executive Directors, the recommendations are:

a. Non-executive Directors should bring an independent judgement to bear on issues

of strategy, performance, resources, including key appointments, and standards of

conduct.

b. The majority should be independent of the management and free from any

business or other relationship, which could materially interfere with the exercise

of their independent judgment, apart from their fees and shareholding. Their fees
should reflect the time, which they commit to the company.

d. Non-executive Directors should be appointed for specified terms and

reappointment should not be automatic.

e. Non-executive Directors should be selected through a formal process and both,

this process and their appointment, should be a matter for the Board as a whole.

For the Executive Directors the recommendations in the Cadbury Code of Best Practices are:

a. Director’s service contracts should not exceed three years without

shareholders’ approval

b. There should be full and clear disclosure of their total emoluments and those of

the Chairman and the highest-paid UK Directors, including pension contributions

and stock options. Separate figures should be given for salary and performance related

elements and the basis on which performance is measured should be explained.

c. Executive Directors’ pay should be subject to the recommendations of a

Remuneration Committee made up wholly or mainly of Non- executive Directors

The Naresh Chandra Committee:

The Naresh Chandra committee is the third major corporate governance initiative launched in India
since the mid-1990s, after the first voluntary code of corporate governance by the Confederation of
Indian Industry (CII) in 1998, followed by Clause 49 of the Listing Agreement by SEBI in 2000. The
committee presented its report on Corporate Governance and Audit in November 2002.