3 Corporate Governance

1. Learning Objectives:

The aim of the module is to make the students understand the concept of corporate governance know the status of corporate governance in India to understand the various dimensions of corporate governance.

Understand the relationship between corporate governance and strategic management.

2. Introduction:

Nothing happens in organizations randomly. The success or the failure of the firms depends on how effectively the plans are prepared and executed. Now the challenges of the managers are very complex and unstructured. There is lot of pressure on the top management to be quick in solving in the strategic problems. To the top of this the increasing allegations on the top management for wrongdoings, economic misbalances and excessive executive compensation, and it is the reason why the firm leaders are under great pressure. When left to its own CEOs sometimes pursue initiatives that are different from the shareholders interest. They do so may be because they lack the wisdom to make decisions in the interest of the shareholders or they do so because of the reasons of pride, ego or greed. International survey indicates that most people think business executives are overpaid. Other research suggests that CEO receive highest pay when corporate governance is weakest. CEOs and the directors are actually the employees of the owners (shareholders). They are the people who actually take the decisions and run the firm. The shareholders cannot do much to check the actions of the managers. There is always a potential risk that the interest of the shareholders will be sacrificed for the interest of the managers.

Corporate Governance is a mechanism used to manage the relationships and conflicting interests among the various stakeholders, aligning the decisions with the values and to determine and control the strategic direction and performance of organizations. Firms’ shareholders are the company’s legal owners. It ensures the long term sustainable value for the firm’s shareholders. At its core it is concerned with identifying the ways to ensure that strategic decisions are made effectively. Effective CG is of interest to nations as it reflects societal standards.

Over the years, numerous corporate scandals have prompted renewed interest in the mechanism and the practices of governance. The regulatory bodies are forced to institute new laws and regulations for increased supervision and auditing of business operations and financial reporting. Strategy is the top management’s plans to develop and sustain competitive advantage, which cannot be duplicated by its competitors so that the organization’s mission is fulfilled. Accordingly an organization has a strategic plan, accordingly its competitive advantage is understood, and its members understand the reason for its existence. Corporate governance is a debatable and upcoming issue that is generating headlines in both corporate and academic circles. The area of concern is the mechanism of governance and the interaction between the Board responsible for governance & corporate strategy. It is also concerned with the integration of governance with business operations. The management of Alibaba delayed possibly the largest IPO in U.S. history, several times due to issues concerning disclosure and governance. Corporate governance has become the latest buzz word in the business management. Owners of businesses of all sizes are realizing the importance of governance. The change has been seen as the companies are now developing their strategies by considering the principles of corporate governance. Systems and procedures are designed strategically to structure authority, balance responsibility and provide accountability to stakeholders. In nutshell, corporate governance is about balancing profitability with sustainability.

3. Corporate Governance:

Corporate governance, a term that was unknown before the 1990, is now the first concern wherever business and finance are discussed. Corporate governance carries such a wide variety of interpretations. An effective system of corporate governance has two requirements: at the organizational level it needs to ensure that the company fulfils its objectives. It follows Anglo-American concept where a company works for the wellbeing of shareholders, and good governance ensures that decisions are taken and implemented to enhance shareholder value. At the economic level as said by the Chairman of Federal Reserve Alan Greenspan, corporate governance is to promote the proper allocation of nation’s savings to its most productive use.

As highlighted by the very well known Cadbury Committee in its report in 1992

“The responsibilities of the board include setting the company’s strategic aims, providing the leadership to put them into effect, supervising the management of the business and reporting to shareholders on their stewardship. The board’s action are subject to laws, regulations and the shareholders in general meeting”.

Organization for Economic Co-operation and Development ( 2004) defined Corporate Governance as

“Set of rules that define the relationship between stakeholders, management, and board of directors of a company and influence how that company is operating. At its most basic level, corporate governance deals with issues that result from the separation of ownership and control. But corporate governance goes beyond simply establishing a clear relationship between shareholders and managers”. “Corporate governance involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined”.

The Kumarmangalam Committee in 1999 said in its report that

“The Committee is of the view that the non-executive directors, i.e. those who are independent and those who are not, help bring an independent judgment to bear on board’s deliberations especially on issues of strategy, performance, management of conflicts and standards of conduct”.

3.1 Corporate Governance in India:

Corporate Governance is a concept which was unknown to the Indian corporate until 1990’s. Indian public companies were required to comply with the provisions of Companies Act which has limited disclosure and governance provisions. After the financial crisis of 1990 the Indian Government was forced to take the initiatives and reformative actions. Security and Exchange Board of India was formed in the year 1992 as the regulator of the market. The first major initiative was taken by Confederation of Indian Industries (CII) in 1998. It came up with the voluntary code of Corporate Governance. The code proposed by CII was on the lines of Cadbury Committee which was intended to be followed by all the companies. Scams like Harshad Mehta, Ketan Parikh Scam, UTI Scam, Bhansali Scam and many more highlighted the importance of more standardized code. India needed mandatory and statutory code and therefore, SEBI came up with the setting up of Kumar Mangalam Birla Committee. The committees recommendations were mainly in respect of independent directors and the role & composition of audit committees. These recommendations were accepted and incorporated by SEBI as Clause 49 of the Listing Agreement. Another committee was formed by the Ministry of Corporate Affairs in 2002 under the Chairmanship of Naresh Chandra. SEBI also constituted a committee headed by Narayana Murthy which also gave its report in 2002. On the basis of the recommendations of the Murthy Committee Clause 49 was revised and present Clause 49 is applicable to all the companies which have paid up capital of 5 crores or more or the companies which have net worth of 25 crore or more anytime in the history of the company. Clause 49 has mandatory and non mandatory disclosure norms. Companies have to show separate corporate governance report in the annual reports of the company.

4. Objectives of Corporate Governance

Corporate Governance is integral to the very existence of a company. It strengthens the confidence and inspires the investor’s by ensuring company’s commitment to higher growth and profits. It seeks to achieve following objectives:

A blend different category of directors including non executive and independent directors enhances the capability of the board for making right decisions.

The Board is balanced to take care of the interests of all the stakeholders.

Transparent procedures and practices are adopted for taking decisions. These decisions are based on the strength of adequate information.

The Board has an effective machinery to sub serve the concerns of stakeholders. Keeping the stakeholders informed of material developments in the company.

The Board gets the mechanism for effective and regular monitoring of the management.

The Board remains in effective control of the affairs. The objective of the Board should be to take the organization forward, maximizing long-term values and shareholders’ wealth.

5. Elements of good Corporate Governance

The Board responsible for all the major functions of the company is also responsible to ensure value creation for its stakeholders. Corporate governance defines the powers, responsibilities, roles, and accountability. It requires every detail should be documented and communicated to all. The essential elements of good corporate governance:

Board should be transparent in policies, processes and should be independent.

The Board should be effective and should be committed for achieving sustained prosperity for all.

Accountability to stakeholders should be ensured through a proper communication channel. They should be properly communicated for actions taken.

Fairness to all stakeholders should be at the priority.

The organization should be socially and environmentally responsible and should be concerned for regulations. Clear and unambiguous legislation and regulations are foundation to effective corporate governance.

Clear objectives, appropriate ethical framework, and unambiguous processes, clear demarcation of responsibility and accountability, establishing clear boundaries for acceptable behavior, sound business planning and establishing performance evaluation measures ensures good governance.

Explicitly prescribed codes of ethical practices and conduct should be communicated and clearly understood and followed by each member of the organization.

Long-term corporate strategy should also document the objectives of the company along with the achievable and measurable performance targets and milestones.

Audit Committee should coordinate with the management, internal and statutory auditors. It should review the adequacy of internal control and compliance with significant policies.

Risk being an important part of corporate governance should be clearly identified and analyzed by taking measures. A proper mechanism should be developed and reviewed at regular intervals.

A Vigil mechanism and Whistle Blower Policy should be formulated helps the employees in reporting about unethical behavior, any actual or suspected frauds or violation of company’s code of conduct.

6. Separation of Ownership and Control

A small business is often governed by individuals well known to everyone in the organization. Ownership may rest with a one person, with in a family, or between a few business partners. As the firm grew larger, now shareholders—the owners of the firm—are represented by a board of directors elected by them who have the authority and responsibility to monitor firm. These changes created the modern public corporations. The primary legal mechanism that is designed to align CEOs action with that of the shareholders interest is a company’s board of directors. Elected by the shareholders they are responsible to ensure that CEO behaves in a way that promotes shareholders interest. The Satyam scam in India focused major flaws in corporate governance practices by the board. Unethical conduct of the directors, fraudulent accounting and disclosure practices, dubious role of auditors, inefficiency of the board, failure of board especially independent directors.

6.1 Why directors neglect shareholders interest:

With such powers at their command why does board have frequently failed to stand up to CEOs who neglect shareholders interest? The reasons may be:-

Time constraints: – Generally the directors are outsiders holding higher executive positions with the other firms. Many times directors serve several boards. The number of board meetings is very less. The directors spend very less time for other committee meetings and informal meetings.

CEO Factor:- The CEO is present at all the formal meetings of the board. Any criticism of the CEO should be face-to-face. Many directors are reluctant to confront CEO in this way. The problem is aggravated when the CEO also holds the position of Chairman of the board.

Weak shareholder power:-It is expected that the shareholders of the poor performing companies would quickly expel the directors and replace them with good performing ones. But until recently shareholders have rarely taken such initiative. An election of the director is more of a ratification of the candidates proposed by the incumbent board.

7. Agency Relationship

The relationship between the owners and managers create an agency relationship. It is a relationship between owners (principals) of the business and decision-makers (agents) who are hired to manage principals’ operations and maximize returns on investment. The separation of ownership and managerial control can be problematic because the principal and the agents have different objectives. Managerial Opportunism can be defined as seeking of self-interest with knowing. It is an attitude and set of behaviors. It is difficult for the principals to know beforehand which agent will act opportunistically. Therefore, governance and control mechanisms to prevent agents from acting opportunistically. Scam of Ranbaxy in the year 2004 is a case of systematic fraud as the company was exposed to risk by manipulating the data submitted to the regulators. The shareholding pattern in 2004 was promoters’ 32.04%, foreign shareholding 32.98% and Indian institutions’ shareholding 15.16% which included the FII’s shareholding of 22.68%. The corporate governance failures manifested in the Board’s failure to detect fraud, absence of adequate risk management system, and unethical culture.

8. Agency Cost and Governance Mechanism

The firm incurs costs when it uses one or more governance mechanism. Agency cost are the sum of the incentives, monitoring, enforcement and individual financial losses incurred by the principal because the governance mechanism cannot guarantee total compliance by the agent. In general the managerial interest may prevail when the governance mechanism are weak, as is exemplified by allowing the managers a significant amount of autonomy to make strategic decisions. If strong governance mechanisms are used, the firms strategy should better reflect the interest of the shareholders.

9. Ownership Concentration

Both the number of large block shareholders and their percentage of shares define ownership concentration. Ownership concentration as a governance mechanism has received considerable interest because large shareholders demanding to adopt effective governance mechanisms to control managerial decisions. In general a large number of shareholders with small holdings and few large block holders produce weak monitoring of managerial decisions and make it difficult for the owners to control their actions. Such concentration has an influence on strategies and firm value. One of the biggest challenges and issue of corporate governance in India is the concentration of ownership in the hands of the few founding family members. There is actually a gap between the majority and the other shareholders.

10. Executive Compensation

Executive compensation is a governance mechanism that seeks to align the interest of the managers and owners through salaries, bonuses and long term incentive compensation, such as stock, awards and options. The use of longer term pay helps the firms to cope with or avoid potential agency problem by linking managerial wealth to the wealth of the shareholders. Effectively using executive compensation as governance mechanism is challenging to firms.

11. Market for corporate control

It is an external governance mechanism that becomes active when a firm’s internal control fails. The market for corporate control is made of individuals and firms that buy ownership positions in or takeover potentially undervalued corporations. Because the undervalued firm’s executives are assumed to be responsible for formulating and implementing that led to poor performance, they are usually replaced. Thus, when the market for corporate control ensures that managers who are ineffective or act opportunistically are disciplined.

12. Corporate Governance and Strategic Management

Since, last twenty years Strategic management is developing and changing styles based on thinking “My business is thinking –T.A. Edison”. This change is based on the thought that the managers should be very creative, aware of company’s atmosphere and the changes of business world. The relationship between organizations, environment, economy and society, economy is changing fast. Managers should be creative in achieving companies’ objectives. Financial scandals around the world compelled to develop strategic management by adopting new terms and styles matching with the reality. Management must take care of the interests of stakeholders, and from this objective, the financial society becomes strict. Corporate governance was taken as a solution and key to earn back the lost trust. Many acts and codes have been enacted such as Sarbanes – Oxley, Cadbury report, Hample Report, etc.

Strategic management enhances accountability and social responsibility as part of their strategy where the shareholder’ interests are highlighted. This can be interrupted by employee’s interests or even environment regulations and responsibilities creating interest conflict. Corporate governance is align the interest of top-level managers with the interests of shareholder. Overall corporate governance is structure that has managerial role. It uses different tools like corporate governance legislation, corporate governance ethics and corporate governance responsibilities which can help to attain strategic objectives. Agency relation is between shareholders and manager, and also between managers and employees. They should keep stakeholders’ interests with companies’ objectives at top. Agency relationship can leads to “managerial opportunism”. If there is weak controlling system this interest will be maximized, and therefore ethic codes are created to check. Corporate governance is related to the way how the company is controlled and administered, it is an important part of strategic management that can improve company’s performance. Value creation and competitive advantage are common objectives on long-term basis for corporate governance and strategic management.

Summary: Much of the responsibility for ensuring corporate governance falls on the company’s board of directors. There is dynamic relationship between corporate governance and strategic management. The management is responsible for the planning and execution of the strategies in the best interest of the shareholders. But taking the decisions for the personal interest of the board has resulted in many scams all over the world. Many Acts, Codes and legislations have need enacted all over the world to check the managerial actions. There are many reasons why corporate governance is a must for the organizations to regain the lost trust of the market. Internal and external both the mechanisms are required for effective governance and decision making.