4.

Corporate Governance Framework and Codes

• Corporate governance framework

• Internal corporate governance mechanisms

• External corporate governance mechanisms

• Key Principles of corporate governance

• Evolution of corporate governance codes

• Corporate Governance Code - Pathways

 Corporate Governance Framework

Corporate governance framework in a country is determined by:

Interaction between Internal Mechanisms and External Forces

 Internal Mechanisms –

 define the relationship among the key players in the corporation

 External forces-

 forces notably policy, legal, regulatory, and market forces that together
govern the behavior and performance of the firm
Corporate Governance Framework

World Bank, 2000

 Internal Corporate Governance

Internal corporate governance mechanisms

 define the relationship among the key players in the corporation

 operate within the firm boundary that

 determines the decision making in the firm affecting its performance

and sustainability.
 Internal Corporate Governance

 Internal corporate governance mechanisms:

 ownership structure

 the Board of directors,

 executive remuneration and incentives,

 capital structure (debt)

Internal Corporate Governance

 Internal corporate governance mechanisms

 offer greater flexibility to the corporations, and

 vary according to their requirements.

 Based on the characteristics of its operating environment, and

 relationship between shareholders, stakeholders and management.

Internal Corporate Governance

 Board of directors and its committees

 central to the internal monitoring and control mechanism

 pivotal role in maintaining a sound relationship between

constituents of the firm.

 Disclosure of information

 on how the firm is managed and governed is an important determinant

 of the internal relationship between the management, board,

shareholder and stakeholders.
 Internal Corporate Governance

 The governance issue and monitoring mechanism

 in different countries is based on the ownership structure of

corporations.

 Corporate governance codes,

 both national (e.g. UK and German Corporate governance code),

and

 international (OECD Principles of Corporate Governance,

2004,2015) are based on the internal corporate governance
 Internal Corporate Governance

 New practices and norms focusing on internal corporate governance,

 particularly on the board of directors, emerge for greater

monitoring of management after the scandals.

 In the aftermath of the international financial crisis,

 several changes have taken place in internal corporate governance

 both in national and international codes affecting functioning of the

corporations.
External Corporate Governance

 External corporate governance, located outside the boundary of

the corporation situated in

 either in laws/regulations (regulatory institutions), markets or

 in societal conditions (culture, politics and community)

 External corporate governance is framework

 outside firm’s purview in which it has to operate,

 cannot alter them.

External Corporate Governance

 Markets are external corporate environment in which the firms

operate.

 Firms are monitored and disciplined by competitive markets

 Markets include

 capital market,

 market for corporate control,

 labor market ,and

 product markets.
External Corporate Governance

 Institutional investors play a very active role in monitoring the

management.

 Market for corporate control is an important external corporate

governance mechanism

 This mechanism quite prevalent in the Anglo-American countries

External Corporate Governance

 Product markets are another feature of external monitoring in the

competitive markets.

 The product market provides effective competition among firms to

survive over the long term or otherwise fail and face bankruptcy.

 Managerial labor market also helps in disciplining poor performing

managers

 An inefficient or non-performing manager is likely to be replaced by

efficient and well performing manager
 External Corporate Governance

 Market for external agents such as

 accounting and auditing professionals,

 lawyers,

 investment bankers,

 credit rating agencies, and

 media

 External agents have a close watch on the functioning of the

corporations, and

 significantly influence corporate behavior through their actions.

 External Corporate Governance
 The laws/regulations are important external corporate governance,
which significantly influence conditions in which the firm operates.

 laws of self-regulatory organizations (stock exchanges), and

 state or federal laws that contain rules for protection of

shareholders,

 Laws provide the framework under which different constituents of the

firm have a relationship with each other.

 “External laws, rules, and institutions that provide

 a level, competitive playing-field, and

 discipline the behavior of insiders, whether managers or

shareholders”
External Corporate Governance

 External corporate governance through laws and regulations are

mandatory for corporations to abide.

 Companies face fine, penalties and other form sanctions, in case

they fail to comply with them.

 Laws/ regulations are enforced through

 a compliance mechanism by the regulatory (courts, securities

regulator), and

 self-regulatory bodies (stock exchanges) and provide the

external monitoring mechanism for corporations.
Four core values of the OECD CG framework

Accountability

Transparency

Responsibility

Fairness
Core values of the OECD CG framework

Fairness

• The corporate governance framework should protect shareholder

rights, and

• ensure the equitable treatment of all shareholders, including minority

and foreign shareholders.

Core values of the OECD CG framework

Responsibility:

• The corporate governance framework should recognize the rights of

stakeholders as established by law, and

• encourage active co-operation between corporations and

stakeholders in creating wealth, jobs, and the sustainability of
financially sound enterprises.
Core values of the OECD CG framework

Transparency:

• The corporate governance framework should ensure that timely and

accurate disclosure is made,

• on all material matters regarding the company, including its financial

situation, performance, ownership, and governance structure.
Core values of the OECD CG framework

Transparency:

• The corporate governance framework should ensure that timely and

accurate disclosure is made,

• on all material matters regarding the company, including its financial

situation, performance, ownership, and governance structure.
Core values of the OECD CG framework

Accountability:
• The corporate governance framework should ensure

• the strategic guidance of the company,

• the effective monitoring of management by the board, and

• the board’s accountability to the company and shareholders.

Evolution &Development of Corporate Governance Codes

• The antecedents to corporate governance regulation suggest that crisis

and subsequent reforms are universal phenomena.

• Waves of CG reforms and regulation occur during the periods of

recession, corporate collapse and re-examination of the viability of
regulatory systems”

• With the occurrence of corporate frauds and collapses at regular

intervals,

• antecedents to failure change and new best practices of corporate

governance emerge with the aim of long term sustainability of business.
Early Developments in Corporate Governance

• The stock market crash of the US in 1930s, often referred as the “Great
Depression”,

• exposed the pitfalls in the accountability and management in many

of the US corporations.

• This ultimately resulted in the promulgation of the US Securities

Act, 1934.

• Corporate governance as a vital issue emerged only in the late 1980s

and 1990s

• due to the significant rise of unacceptable and unethical practices in

the corporations, particularly in the US and the UK.
 Evolution of Corporate Governance Codes in the World
• Collapse of some major corporations in the UK in 1990s was central to
rise in concern about corporate governance there, and around the
world.

• The collapse of Bank of Credit and Commerce International (BCCI) and

pension fraud in the Maxwell Group and scandal at Polly Peck implied
serious weakness in the governance framework,

• related to internal controls and financial reporting, within which

companies were operating.

• Scandals significantly influenced subsequent events that led to the

emergence and development of CG codes in the UK, the US and
around the world

• Culminated in setting up the Treadway Committee in the US in 1987 and

the Cadbury Committee in the UK in 1991.
Evolution of Corporate Governance Codes in the World

• The Cadbury Report of 1992, first published report on corporate

governance, significantly influenced debate on corporate governance,
and placed it on the top international agenda.

• The Cadbury Report of 1992, was followed by a publication of number

of corporate codes in different industrialized countries.

• Some of corporate codes after Cadbury report are :

 Bosch Report (1995) - Australia,

 Cardon Report (1998) - Belgium,
 Dey Report (1994) - Canada,
 the Vienot Report (1999) – France,
 the Peters Report (1997) - Netherlands,
 Swedish Academy Report (1994),
 King Report (1994) – South Africa etc.
Evolution of Corporate Governance Codes in the World
Corporate Governance Development : Year of First Code by Country
Year Country
1992 United Kingdom
1994 South Africa, Canada
1995 Australia, France, Pan-Europe
1996 Spain
1997 USA, Japan, The Netherlands
1998 India, Belgium, Germany, Italy, Thailand
1999 Brazil, Greece, Hong Kong, Ireland, Mexico, Portugal, South Korea, OECD, Commonwealth
2000 Denmark, Indonesia, Kenya, Malaysia, Romania, Philippines
2001 Brazil, China, Czech Republic, Malta, Peru, Singapore, Sweden
2002 Austria, Cyprus, Hungary, Kenya, Pakistan, Poland, Russia, Slovakia, Switzerland, Taiwan

2003 Finland, Lithuania, Macedonia, New Zealand, Nigeria, Turkey, Ukraine, Latin America

2004 Argentina, Bangladesh, Iceland, Norway, Slovenia

2005 Jamaica, ICGN, Latvia, Lithuania, Malta
2006 Egypt, Estonia, Lebanon, Luxemburg, , Sri Lanka, Trinidad and Tobago
2007 Bulgaria, Colombia, Kazakhstan, Moldova, United Arab Emirates
2008 Morocco, Serbia, Tunisia
2009 Algeria, Croatia, Georgia, Georgia
Asian Financial Crises - Exponential Rise of Corporate
Governance Codes
• The economic crisis of Southeast Asian countries in 1997 (Malaysia,
Thailand, Indonesia, Philippines) and that of Russia and Brazil signified
the importance of corporate governance in transition and emerging
countries.

• International organizations like the Organization for Economic

Cooperation and Development (OECD) and the Commonwealth
Association of Corporate Governance (CACG), both issued a separate
report on the principles of effective corporate governance in 1999.

• The OECD with the help of the World Bank and other international
financial institutions (like Asian Development Bank) actively engaged in
reforming CG in developing and other countries based on these
principles.
Asian Financial Crises - Exponential Rise of Corporate
Governance Codes

New Corporate Governance Codes Issue (1992- 2010)

New Code
New CG Codes
cummulative New codes

90
N u m b er o f C o d es

80
70
60
50
40
30
20
10
0

Year
Early 21st Century Crises - Consolidation of the
Corporate Governance Codes
• In the beginning of the 21st century, managers were engaged in illicit
activities under pretext of shareholder wealth maximization that resulted
in several corporate collapses

• The high profile corporate frauds of Enron, WorldCom, Adelphia, Tyco

and Global Crossing in the US; Parmalat, Marconi, Royal Ahold and
Vivendi Universal in the Europe, and HIH and One-Tel in Australia
refocused issue of corporate mismanagement in the developed
countries.

• These scandals led to stringent CG reforms in the US, resulting in the

enactment of Sarbanes Oxley (SOX) Act in 2002

• OECD Principles of Corporate Governance were revised in 2004 and

CG codes of most of the countries also went underwent major revisions
and issuance of revised codes.
Early 21st Century Crises - Consolidation of the
Corporate Governance Codes
Growth of Corporate Governance Codes (1992-2010)

total codes year

Total codes cummulative total coes
num ber of codes

300
250
200
150
100
50
0

year
 CG : Rule based vs Principle based Approach

• CG norms and codes in different countries have been instigated broadly

either through mandatory or voluntary approaches.

• Pathways to corporate governance decided by the regulators based on

the gravity of governance problem and evaluation of risk of failures.

• Two distinct approaches towards corporate governance are voluntary

based “comply or explain” approach of the UK CG Code, and legislative
approach encapsulated in the US Sarbanes-Oxley Act of 2002.

Approaches to Corporate Governance Implementation

Voluntary Approach: Principle Alternative

based Combination of
both Voluntary and
Mandatory
Mandatory Approach: Legislation Approaches
based
Principle based Approach

• A “soft law” implementation of corporate governance, where companies

are not necessarily bound to comply with norms.

• The UK Corporate Governance code is based on the “comply or

explain” principle,

• listed companies have to disclose that they have complied with the
provisions of the code, and

• if they have taken a different stance, it need to be accompanied with the

reasons for non-compliance.

• Many countries (Australia, Canada, Germany, Netherlands and other

European Countries) emulated same approach towards corporate
governance
Principle based Approach

• Approach allows companies flexibility in adopting their own corporate

governance structure depending upon their size and requirements.

• “investors make an informed assessment of whether non-compliance is

justified in the particular circumstances” (p. 488-489).

• Comply or explain is a partly enabling approach that does not

necessitate full compliance the code, but disclosure of compliance with
the code is obligatory
Principle based Approach

• It relies on effective market based mechanism for enforcement and

compliance with the governance code.

• In the absence of any credible market forces, however, companies can

easily get away with the non-compliance.

• There is possibility companies may engage in

 following routine check the box approach, and

 may use standard explanations for any deviations from the code.
Rule based Approach

• Rule based legislative approach is prescriptive and rigid way of

implementing corporate governance norms for the companies.

• The US has adopted a rule based approach of implementing corporate

governance through Sarbanes Oxely Act(2002)/ Dodd Frank Act (2010).

• The SOX Act and subsequent amendments to the listing requirement in

the US mandate companies to adopt the norms enshrined in the SOX
Act with no excuse and alternative for non-compliance
Rule based Approach

• The rule based approach is based “one-size-fits-all” principle, with

necessity for companies to comply with all the CG provisions.

• Ensures higher compliance with CG norms and practices.

• Compliance cost to companies is much higher as compared to the self-

regulatory way, particularly for smaller companies.

• SOX Act has put on the companies for mandatory compliance, and even
forced companies to go private to get exempted from its mandatory
compliance
 Rule and Principle Based Approach : Which is Better ?

• No prior clarity of establishment whether the voluntary approach

dominates over the legislative way or vice versa. Both have own
benefits and cost.

• The “comply and explain” approach grants companies greater flexibility

in choosing their governance structure based upon their size and nature
of economic activity. Compliance of governance code can vary among
companies.

• There are some concerns on weak monitoring and enforcement

mechanism of this approach, with the market not playing its envisaged
role. So, enforcement remains a critical issue in the voluntary approach.

• Mandatory regime ensures higher compliance with corporate

governance norms and practices. But compliance cost to companies is
much higher as compared to the self-regulatory way, particularly for
smaller companies.
New Directions to Corporate Governance Codes

• Adoption of regulation or voluntary approach decided

• by the country regulators

• based on the corporate governance problem and evaluation of risk

of failures (Wong, 2008).

• With advent of high of cost of failures, voluntary norms become

prescriptive and even attain legislative status.

• The “comply or explain” principle, based on the self-regulation has

changed over the time and has become more prescriptive in nature.

• Sequel to recent crisis, many norms related to board of directors and

executive remuneration have become part of the legislation.
New Directions to Corporate Governance Codes

• Both approaches have their own drawbacks,

• Ideal solution may be a combination of both mandatory rule and

voluntary code.

• Mandatory rule set minimum basic ground and voluntary amply

supporting them as desirable structure.