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Contents: Nature The context Factors affecting corporate governance Mechanism of corporate governance Introduction: In the previous chapters we have discussed, in detail, business ethics, corporate social responsibility and social audit. The central theme of all this discussion is that a business unit should operate in an ethical and socially responsive manner. Who are the people to ensure such behaviour from a company? What mechanism is there to ensure such behaviour from a company? Are there any ways and means through which it can be assured that people involved in running a business operate in a way that is expected of them? This chapter seeks to answer these questions and other related issues Corporate governance has succeeded in attracting a good deal of public interest because of its apparent importance for the economic health of corporations and society in general. However, the concept of corporate governance is poorly defined because it potentially covers a large number of distinct economic phenomenons. As a result different people have come up with different definitions that basically reflect their special interest in the field. The best way to define the concept is perhaps to list a few of the different definitions rather than just mentioning one definition.
1. "Corporate governance is a field in economics that investigates how to secure/motivate efficient management of corporations by the use of incentive mechanisms, such as contracts, organizational designs and legislation. This is often limited to the question of improving financial performance, for example, how the corporate owners can secure/motivate that the corporate managers will deliver a competitive rate of return", www.encycogov.com, Mathiesen . 2. “Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment”, The Journal of Finance, Shleifer and Vishny [1997, page 737]. 3. "Corporate governance is the system by which business corporations are directed and controlled. The corporate governance structure specifies the distribution of
it also provides the structure through which the company objectives are set. page 15]. shareholders. as quoted by an article in Financial Times.". more broadly. "Corporate governance is about promoting corporate fairness. The structure to ensure corporate governance. and say it (corporate governance) is the fancy term for the way in which directors and auditors handle their responsibilities towards shareholders. Corporate governance is a topic recently conceived. OECD's definition is consistent with the one presented by Cadbury [1992. the board. and the means of attaining those objectives and monitoring performance".which can be defined narrowly as the relationship of a company to its shareholders or. customers. from an article in Financial Times . and consequently blurred at the edges…corporate governance as a subject. page 1]. By doing this. systems and people) to achieve them.rights and responsibilities among different participants in the corporation. and spells out the rules and procedures for making decisions on corporate affairs. bankers and indeed for the reputation and standing of our nation and its economy” Maw et al. as yet ill-defined. Wolfensohn. employees. includes the board of directors. such as. transparency and accountability" J. shareholders and other stakeholders. “Some commentators take too narrow a view. [1994. Before examining the role of each of these groups. which helps to maintain the corporation's reputation and responsibility towards various groups. creditors and others. as its relationship to society -…. 4. The perspective Corporate governance has been an active subject of academic and policy debates for quite a long time in many of the advanced . president of the Word bank. as an objective. it involves making sure that the structure functions in a way. for our understanding. 5. OECD April 1999. June 21. 1999. it is useful to understand the relevance of corporate governance in the present perspective. "Corporate governance . At the same time. or as a regime to be followed for the good of shareholders. top management. Others use the expression as if it were synonymous with shareholder democracy. It is concerned with the formulation of long-term objectives and plans and the proper management structure (organization. Nature of corporate governance Corporate governance is the overall control of activities in a Corporation. 6. The role of each of these stakeholders is crucial in guaranteeing responsible corporate performance. managers.
Germany and Japan. alerted company owners and managers in the developing and changing economies to the fact that effective corporate governance is crucial for competitiveness and success in the long run. particularly the US. UK. The international competitiveness and successful functioning of companies in these countries has of late. build on . In particular. the World Bank has been in the process of formulating a draft code of corporate governance for developing countries that would review the principles of effective governance.countries. In fact the importance of corporate governance has been highlighted by international agencies like OECD and the World Bank.
In fact. norms and principles tend to be given least consideration. Increasing integration with global markets calls for a correspondingly improving compliance with global practices in all spheres of corporate activity. Some norms of behaviour to ensure responsive behaviour are of great help. Third. the country has moved into liberalized economy and one of the victims of the market-based economy is transparent fair business practice. Obviously the sufferers are the minority shareholders. have sought to set up hundred percent subsidiaries and transfer their businesses (carried through Indian joint venture partners) to them. Again. while several mechanisms of governance have formally been in place for much longer time than in most of the developing countries. Second. In fact. assess governance practices in emerging markets. in recent years. and distil the best practices from these and developed countries.international guidelines. for specific objectives. In the survival of the fittest scenarios. They seek information and want to influence decisions. how a Corporation is managed and controlled. both domestic as well as foreign investors are becoming more demanding in their approach towards the companies in which they have invested their funds. Factors influencing corporate governance The ownership structure The structure of ownership of a company determines. First. well-known Indian companies. Several MNCs for example. raised funds in the GDR markets abroad and in India. At least three reasons have triggered off concern in corporate governance in our country. In many cases. since 1991. a number of company failures have been reported in the recent past. The ownership structure can be dispersed among individual and institutional shareholders as in the US and UK or can be concentrated in the hands of a few large shareholders as in . In our country. to a considerable extent. with some senior and well known executives being hauled up for nonperformance and/ or non-compliance with legal requirements. Several instances of mismanagement have been alleged. But these funds were diverted to investments elsewhere. without consulting the shareholders. the issue of proper governance has assumed relevance only recently. the lack of adequate governance of Indian companies has been highlighted in academic circles and other forums as one of the primary reasons for under performance of industrial establishments. interest of non-promoter shareholders and those of small investors are increasingly being undermined. there was no thought of consultation with non-promoter shareholders whose interests would be affected.
.Germany and Japan. According to a study on corporate ownership conducted in 1998. The pattern varies the across the globe. 36 percent of the firms in the world are widely held. But the pattern of shareholding is not as simple as the above statement seeks to convey.
Which patterns of share holding. The structure of company boards Along with the structure of ownership. Unit Trust of India and the government owned insurance corporations (3) corporate bodies (4) directors and their relatives and (5) foreign investors. an average. This has been demonstrated by reliance Industries Limited. the shares are held by (1) the term-lending institutions (2) institutional investors. Dominant shareholders are better informed than the dispersed shareholders. and the roles that they assume which are more important than mere numbers or composition. Which has the highest number of equity shareholders spread across the country. the interest they take. Some argue that the adequate size is to range from 9-15. Japanese companies have larger boards. 18 percent are state-controlled and the remaining 15 percent are in miscellaneous category. The shares of these enterprises (except those belonging to a public sector) are held by institutional as well as small investors. The block holding too has not proved to be a failure either. developing broad policies and selecting top-level executives to carry out those objectives and policies. Our corporate sector is characterized by the co-existence of state owned. Some others put the figure at 10 and yet others recommend a minimum of five and a maximum of 10. Company boards are permitted to vary in size. there is a sizable equity holding by small investors. The board also reviews managements performance to ensure that the company is run well and shareholders’ interests are protected. the structure of company boards has considerable influence on the way the companies are managed and controlled. Specifically. Company boards in the UK have. The financial structure Along with the notion that the structure of ownership matters in corporate governance is the notion that the financial structure of . The board of directors is responsible for establishing corporate objectives. as has been demonstrated through the Bajaj group. corporate performance tends to be better. Board membership may include both inside director and outside directors. Under the concentrated ownership structure. private and multinational Enterprises. is ideal for good corporate performance? Large shareholders tend to be active in corporate governance either through their representative's on the company boards or through a their active participation in annual general body meetings. opinions and practices vary.30 percent are family controlled. seven directors on their boards. With regard to the size of board. comprising government-owned mutual funds. composition and structure so as to best serve the interest of the Corporation and the shareholders. It should be noted that it is the quality of the directors. dispersed or concentrated. Apart from these block holdings. the figure going up to 60.
Contrary to the Modigliani . has implications for the quality of governance. that is proportion between debt and equity.the company.miller hypothesis that the financial structure of the firm .
because of the close financial relationship with the companies to which they lend. seeks to translate into action articles 38 and 39 in part IV of the constitution. It is no secret that the lenders exercise significant influence on the way a company is managed and controlled. Compared to many developing countries. the mechanisms of corporate governance in India are more institutionalized. For example. Mechanisms of corporate governance The fundamental institutions of corporate governance in our country have been in existence for a long time. by which the state was directed that the ownership and control of the material resources of the community are so distributed as to conform to the common good and the operation of the economic system does not result in concentration of wealth and means of production to the common detriment. Since then. the Act aims at not only ensuring that the interest of all stakeholders are adequately protected but tries to go beyond.has no relationship to the value of the firm. as amended up to date. in spite of such institutions. recent research has shown that the financial structure does matter. are expected to play a more favourable role than other investors in reducing the costs of financial distress. In our country. and political environment within which a company operates determines in large measure the quality of corporate governance. Further banks can diminish short-term biases in managerial decision making by favouring investments that would generate higher benefits in the long run. Banks as creditors. corporate governance mechanisms are economic and legal institutions and often the outcome of political decisions. corporate governance has assumed greater relevance for reasons stated earlier. to some extent. However. for example. Also. Through the consolidation of many successive amendments and a large number of statutory rules and regulations. can perform the important function of screening and monitoring companies as they (banks). Banks. The Act. The arms of the Act are quite . regulatory. their are six mechanisms to ensure corporate governance: (1) Companies Act Companies in our country are regulated by the companies Act. corporate governance has not been a major issue until the announcement of the new economic policy in 1991. are better informed than other investors. the extent to which shareholders can control the management depends on their voting right as defined in the Company Law. In fact. The companies Act is one of the biggest legislations with 658 sections and 14 schedules. and in some cases of because of their nominees on company boards. 1956. The institutional environment The legal. the extent to which creditors will be able to exercise financial claims on a bankrupt unit will depend on bankruptcy laws and procedures etc.
But to ensure corporate governance. the Act confers legal rights to shareholders to (1) vote on every resolution placed before an annual general meeting. (2) to elect .long and touch every aspect of a company's insistence.
the board constituted a committee under the chairmanship of. but those companies which have accessed the capital market in the recent past. The companies Bill. Finally. One such initiative is to mandate information disclosure both in prospectus and in annual accounts. 2000. the board has taken a number of initiatives towards investor protection. to the listing agreement. Another aspect of the SEBI regulations is that in most public issues. the promoters (typically the dominant shareholders) are required to take a minimum stake of about 20 percent in the capital of the company and to retain these shares for a minimum lock-in period of three years. Securities law The primary securities law in our country is the SEBI Act. The area in which SEBI has laid down guidelines. One of the most valuable is the information relating to the performance of other companies in the same group. considered the recommendations of the committee and decided to make amendments to the listing agreement by adding a new Clause. SEBI intervenes in corporate takeovers in order to protect the interests of minority shareholders. in its meeting held on 25th January. (4) removal of directors and (5) take active part in the annual general meetings.directors who are responsible for specifying objectives and laying down policies. relate to prohibiting preferential allotments to dominant shareholders at a price lower than the average market price during the preceding six months. While the companies Act it self mandates certain standards of information disclosure. Also. the acquirer of a controlling block of shares must take an open offer to the public for at least 20 percent of the issued share capital of the target company at a price not below that was paid for the control block. Among these. has amended several provisions of the Act and introduced new provisions incorporating some internationally accepted corporate governance practices and aimed at strengthening corporate democracy. The board. namely Clause 49. Since its setting up in 1992. of protecting interests of minority shareholders of and providing maximum flexibility to the companies in responding to the market needs. 1997 and recently moved ordinance on companies (amendment). SEBI Act has added substantially to these requirements in an attempt to make these documents more meaningful. . the amendments that have made headlines are permitting companies to buy back shares and the liberalization of inter-corporate investments. 1997. As per the Securities law. (3) determine remuneration of directors and the CEO. Kumaramangalam Birla to suggest ways to promote and raise the standards of corporate governance in listed companies.
the market is not bound by broad rules and can exercise business judgment. Most debt contracts involve covenants that make it less easy for the dominant shareholders to indulge in gross abuses. Nominees on company boards . The regulator can then concentrate on making the markets more efficient at performing this function. They have sought to cultivate an image of being honest with the investors and about being concerned about shareholder value maximization. a separate section on corporate governance in the annual reports of the company (see box). remuneration of directors. management discussion and analysis report to form part of annual report to the shareholders. setting up of a qualified and independent audit committee.The Clause 49 provides for the optimum composition of executive and non-executive directors. for information to be furnished in the report on corporate governance. Unlike the regulator. The ability of debt holders to monitor the company is quite high because typically. What makes capital market discipline so much more attractive than regulatory intervention is that unlike the regulator. Here in lies the role the minority shareholders can play effectively. we have seen Indian companies voluntarily accepting international accounting standards though they are not legally binding. and this enables him to monitor the actions of the management. In the last few years. they can sell their shares. thus depressing the share prices. these are large institutions with High stakes. They have voluntarily gone for greater disclosure and more transparent governance practices than are mandated by law. It therefore makes sense for the regulator to pass on as much of the burden of ensuring corporate governance to the markets as possible. In a well functioning capital market. there is a strong reason for corporates themselves to voluntarily adopt transparent processes and subject themselves to external monitoring to reassure potential investors. the creditor has contractual rights to reclaim his interest and principal. the market is taking micro decisions all the time. and auditors compliance certificate to the effect that all the conditions of corporate governance have been complied with. the market is very good at micro-level judgments and decisions. They can refuse to subscribe to the capital of a company in the primary market and in the secondary market. Unlike the shareholder who is a residual claimant. A depressed share price makes the company an attractive takeover target. A debt holder too has a role to play in disciplining a company's management. Discipline of the capital market Capital market itself has considerable impact on corporate governance. In fact. It is its success in doing so that makes it much an efficient allocator of capital.
the role of nominee directors has been passive. the directors are required to report on their steward ship by means of annual report and financial statements sent to the shareholders. the mandatory provisions. Other lacunae include problems concerning audit quality. which may be detrimental to their interests. Users of auditors’ Services are often dissatisfied with the performance of auditors and seldom believe auditors live up to the solemn image presented by the Cadbury Committee. The auditing process ensures that financial statements are accurate and complete." In practice. The audit provides an external and objective check on the way in which the financial statements have been prepared and presented. Shareholders. Credible financial statements are essential for a business enterprise to raise capital and for society to have trust in Limited companies. So what is wrong with auditing? Auditors' independence or the perceived lack of it is a major issue. thereby enhancing their reliability and usefulness for making investment decisions. But legal rules alone cannot ensure good corporate governance. . Given the separation of ownership from management. or the financials being “dressed up”. good corporate governance depends.Development banks hold large blocks of shares in companies. Unfortunately. As the Cadbury committee observed. Codes of conduct The mechanisms discussed till now are regulatory in approach. as has been pointed out by several committees including the Bhagwati Committee on takeovers and the Omkar Goswami committee on corporate governance. besides of course. The are mandated by law and violation of any provision invite penal action. on good auditing. Auditors are the conscious-keepers of shareholders. the role of auditors in detecting frauds and reviewing internal controls and the record of the accounting profession establishing accounting and auditing standards. lenders and others who have financial stakes in companies. it is not always true. in part. What is needed is self-regulation on the part of directors. employees and tax officers often voice caustic comments such as auditors being “hand in glove” with the management. Obviously. and it is an essential part of the checks and balances required. Being equity holders. These are equally big debt holders too. Audit is often considered to be just an annual ritual. Statutory audit Statutory audit is yet another mechanism directed to ensure good corporate governance. These nominees can effectively block resolutions. Auditing enhances the credibility of financial reports prepared by any enterprise. these investors have their nominees in the boards of companies. "the annual audit is one of the cornerstones of corporate governance.
The Cadbury Committee in the UK advocated the famous “code of best practice”. following the . The London Stock Exchange constituted the committee in 1992.
transparency in short focusing on the subject of. that non-executive directors should be appointed only for specific term and that they should be a formal process for their appointment involving the board as a whole. to be judged by the company's financial results and the resultant growth in shareholder value. The code is thus based on checks and balances. and that pay should be set by a remuneration Committee. good governance issues were seen as relating to both the effectiveness and the accountability of the board of directors: • Effectiveness was seen as a measure of the quality of the leadership of the directors. The cause of anxiety then.just prior to the failure . Subsequent scandals relating to "excessive" remuneration paid to directors. was not so much that the companies had failed. • Executive directors: the main concern was with their remuneration . • Accountability were seen as largely a matter of disclosure of all relevant information . created a climate for business to establish more effective norms of corporate behaviour. consisting mainly of non-executive directors. while not mandating compliance with any element of the code. in order to exercise their rights. asked all listed companies to append to their annual reports. • The role of non-executive directors: it was emphasized that the majority of the board should be "independent" (in the sense of being free of any business relation which could materially interfere with the exercise of independent judgment). In due course. adequate disclosure to enable those entitled to have the information they need. a declaration of the extent of their compliance with the code.gave no fore warning of the true state of the financial affairs. and.collapse of several British companies. in response to the finance Ministry's veiled threats that soften . as that their annual reports and financial statements . to whom a company is answerable. the London Stock Exchange. Shareholders were left to draw their own conclusions about the quality of governance in their companies. especially at the level of the board of directors and the chief executive. The Confederation of Indian Industry (CII) issued a draft code of "desirable corporate governance" for the Indian industry in April 1997. with the posts of the board. chairman and chief executive being separated. to guard against undue concentration of power. It comprises four sections: • The role of board of directors: it was proposed that the (inside) executive directors be balanced by adequate number of (out side) non-executive directors. How did the Cadbury Committee address the situation? Basically.that there should be a full and cleared disclosure of directors’ emoluments.
.the self-regulatory regime. greater the likelihood of harsher government regulations.
financial sector reforms have made it very important for firms to rely on capital markets to a greater degree for their needs of additional capital. The future As we go into the future. which will necessarily maximize corporate value and. corporate governance will become more relevant and a more acceptable practice. but they have also made markets more competitive. More and more progressive companies are drawing and enforcing codes of conduct. This makes the worst forms of misgovernance less attractive than in the past. employees and the state. Globalization: globalization of the financial markets has exposed issuers. Seeds are already sown towards honest business practices. These tendencies would be further strengthened by a variety of forces that are acting today and would become stronger in years to come. leaning heavily on British model. thereby. investors and intermediaries to the higher standards of disclosure and corporate governance that prevail in more developed markets. only time will tell. satisfy the claims of creditors.The CII code. Tax reforms: tax reforms coupled with the deregulation and competition have tilted the balance a away from black money transactions. This means that in order to survive. companies will need to invest continuously on a large scale. In order to understand the problem we shall try to understand the problem by understanding this live case of the Enron Debacle: • • • • Live Case . Disintermediation: meanwhile. are accepting tougher accounting standards and are following more stringent disclosure norms than are mandated by law. Such forces are: Deregulation: economic reforms have not only increased growth prospects. is based on the explicit assumption that "good governance helps to maximize the share holder value." Whether the code will stimulate a change in corporate governance.