Corporate Governance

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

Stakeholders

Corporate governance – an academic
point of view
Separation of ownership & control

It can be seen as one that addresses “the problems that result from the separation of ownership and control”.

Shareholders

Board

Management

Employees

A simple model for corporate governance
1. 2. 3. Shareholders elect directors as their representatives Directors vote on key issues and adopt majority decision Directors make transparent decisions for which shareholders and others can make them accountable Companies adopt accounting standards that generate information required by directors, investors, other stakeholders for decision-making Companies adopt policies and practices compatible with relevant national, state, and local laws

4.

5.

McKinsey & Company Report 2001
• McKinsey and company report titled “Giving New Life to the Corporate Governance Reform Agenda for Emerging Markets” suggests a twoversion governance chain model. • The “market model” governance chain (model 1) described below is applicable to efficient, welldeveloped equity markets and dispersed ownership prevalent in the developed industrial nations like US, UK, Canada, and Australia

The “market model” governance chain
Model 1
Shareholder environment Non-executive majority boards

Independence & performance

Dispersed ownership Institutional context

Corporate context

Sophisticated institutional ownership

Aligned Incentives

Active equity markets Active takeover market

High disclosure

Shareholder equality Transparency & accountability

Capital market liquidity

The “control model” governance chain
Model 2
Shareholder environment

Independence & performance

Concentrated ownership Institutional context

Insider boards

Reliance on family, bank, public finance Under developed New issue market Limited takeover market

Incentives aligned with core shareholders

Corporate context

Limited disclosures Inadequate minority protection Transparency & accountability

Capital market liquidity

Corporate Misgovernance
• Misgovernance in the US • Misgovernance in India • Scams in India

Winds of change
Prior to reforms in 1991, Indian companies were insulated by closed economy, a sheltered market, limited access to global business, lack of competitive spirit and regulatory framework – all these changed on account of: Market-driven performs Economic liberalization Dismantling of control and quota regime Delicensing and deregulation of industries Changes in import/export policies Globalization of the economy within and outside the ambit of the WTO

• • • • • •

Corporate governance movement in India
The movement took of: • The Confederation of Indian Industry (CII) framed a code in 1997 and 30 large listed companies voluntarily adopted this code • In 1999, the Securities and exchange Board of India (SEBI, set up in 1988 and was made a statutory body in 1992) appointed a committee headed by Kumar Mangalam Birla to mandate international standards of corporate governance for listed companies • By 2003 every listed company joined the SEBI code

Historical perspective of corporate governance: from a narrow to broader vision
• Traditionally, the problem of the separation of ownership by shareholders and the control by management • Historical developments of corporate misdemeanor and growing visions of society followed • Governance should stand up to the expectations of all stakeholders namely employees, consumers, large institutional investors, government, and the society as a whole

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

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

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

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

Sen. Paul Sarbanes

Michael Oxley

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

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

Distinguishing the roles of board and management
• Business is to be managed “by or under the direction’” of the board. The responsibility of managing the business is delegated to the CEO, who in turn delegates to other senior managers. The board is positioned between the shareholders (owners) and the company’s management. The board holds important functions:

1. Appoint and remove CEO 2. Indirectly oversee the conduct of the business 3. Review and approve company’s financial objectives, corporate plans and objectives 4. Advice and counsel top management 5. Identify and recommend candidates to shareholders for electing directors 6. Review systems to comply with laws and regulations

Composition of board and other related issues
• Committee elected by the shareholders of a limited company for the policies of the company – sometimes full-time functional directors are also appointed. • The SEBI appointed Kumar Mangalam Birla’s report defined the composition of the board as:

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

Board of Directors

Executive Directors

Non-Executive Directors

Independent Directors

Affiliated Directors
(Nominee Directors)

Types of Directors

• Executive director – an executive of the company and also a member of the board • Non-Executive director – no employment relationship • Independent non-executive directors – free from any business or other relationship which may interfere with the exercise of independent judgment • Affiliated director – who has some kind of independence, yet may have links with suppliers, customers, etc.

Roles of CEO and Chairperson
• The composition of the board is a major issue • Professionalizing of family companies should start with the composition of the board. • Combining the roles of CEO and Chairperson prevalent in US and India result in conflicting interests and decision making. In UK and Australia the CEO can not be the chairperson of the board. • CEO is to lead the senior management and the chairperson is to lead the board and more over it may be too heavy to handle both jobs by one person.

Disclosure and Audit
• The Cadbury Report termed audit as “one of the corner stones of corporate governance”. Audit provides a basis for reassurance to the share holders and everyone else who has a financial stake in the company. Audits raise a host of issues: 1. Should boards establish audit committees? How should it be composed? 2. How to ensure the independence of the auditor? 3. What about the non-audit services rendered by the auditors?

Recent corporate scandals involving auditors

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

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

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