Corporate Governance: An Overview

Corporate Governance
Facilitator: Mr. Bijoy S Guha ISBS Workshop

Principal Reference Texts:
1) Corporate Governance & Accountability Solomon & Solomon (John Wiley & Sons/ ISBN 9812-53-234-X) 2) Corporate Governance: Principles, Policies & Practice Fernando (Pearson/ ISBN 978-81-317-5845-8)
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CORPORATE GOVERNANCE: AN OVERVIEW
Corporate Governance: An Overview

The Business Environment
Economic
Environmental
Organization
Political
INDUSTRY
Technological
Legal Social

The Interested People
Investor
Profits/ Growth EPS/ROI Quality of Life
Supplier
Do they prioritize the same?
Society
Value for Money
Customer
Employee
Security/ Esteem
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A company seeks to delight all of them!

The Governance Context
Shareders
Transparency, Disclosures
Market & Competition
Service Satisfaction
Empowerment, Performance Norms

Legal, Regulatory
Depositors, borrowers & customers

Business Ethics
The Board Top Managent
Relationship
Policy, Directions
Expertise, Performance
Compliance, Accountability
Services, Supplies
Employees
Career Job Satisfaction
Fairness Other Transparency Stakeholders

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Social Responsibility
A company seeks to delight all of them!

Evolution
Business
Trade & Commerce Companies Corporations
National International Transnational/Global
Ownership & Interest

Family Owned Shareholder Stakeholder Ownership, Management & accountability
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Evolution
Development of Stock Markets structures has led to the evolution of governance involving the (Top) Management & Shareholders:
Companies, originally owned and run by families/groups, needed a large number of investors (viz. finances) for growth and expansion These investors, in turn, required some assurance (security of their monies) leading to limited liability.
Shareholders are not responsible for debts of the companies in which they invest. They do not jeopardize their wealth!
Thus, stock markets is a means to acquire external finances.

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Evolution: The Modern Corporation
Buyers and sellers of corporation stocks were individual investors, e.g. wealthy business families, who often had a vested, personal interest in the corporations whose shares they owned.
The Board of Directors of corporations were nominated
by the principal shareholders, comprised people who had an emotional as well as monetary investment in the company (e.g. Ford), Thus, the Board diligently kept an eye on the company and its principal executives. The Board, mostly chosen by the President/ CEO, may have been made up primarily of their friends and colleagues.
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Separation (divorce) of ownership from control:
Systems in UK/USA allow owners (principally shareholders) to delegate running of corporations to company managements. With the dispersed public shareholding, other/multiple owners had little influence over company management since they were rendered powerless by the wide dispersion of ownership; Markets have become largely institutionalized: buyers and sellers are largely institutions e.g. pension / mutual /hedge funds, insurance Cos., banks, brokers etc. Now, company shares have power vested in such interest-groups.
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Entry of Stakeholders
IT, and with it, globalization of operations, increased awareness and social consciousness has led to:
Shareholder Activism i.e. mainly manifest in the voice of the minority shareholders which are diverse. Legal, ethical & societal demands for increasing affirmative actions on Corporate Social Responsibility
Environmental and other linked demands, Consequent liabilities arising from non-business legislation
Sustainability issues
Shifting of focus from a narrow Shareholder to a more comprehensive Stakeholder demands.

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The Agenda
A Corporation allows different parties to contribute capital, expertise & labour for mutual benefit:

The investors (shareholders) participate in the profits without taking the responsibility for Operations; The management runs the company without being responsible for personally providing Funds; Therefore, the investors appoint a legally constituted Board of Directors to represent them and protect their interests; The BoD has an obligation to approve all decisions that impact the long-run performance of the Company
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The Agenda
Thus, Corporate governance is most often viewed
as both:
the structure and
the relationships
which determine corporate direction & performance.

The Board of Directors is typically central to
corporate governance.
Its relationship to the other primary participants,
typically shareholders and management, is critical.

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The Agenda
The authority structure of a firm lies at the heart of the issue:
who has claim to the cash flow of the firm, who has a say in its strategy and its allocation of resources.
The Corporate Governance framework shapes Effectiveness and compliance, Corporate efficiency, Employee wellbeing stability, retirement security
etc., and Social Responsibility e.g. the endowments of orphanages, hospitals, etc.
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The Agenda
It creates both the temptations for cheating and the rewards for honesty, inside the firm and more generally in the body politic.
Corporate governance influences social standing & mobility, stability and fluidity It is no wonder then, that corporate governance
provokes conflict. Anything so important will be fought over like other decisions about authority
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Sir Adrian Cadburys conceptual definition
Corporate governance is defined as holding the balance between economic and social goals and also between individual and common goals. The governance framework is there to encourage the efficient use of resources and equally to require accountability for the stewardship of those resources. The aim is to align as nearly as possible the interests of individuals, corporations and society. The incentive for corporations is to achieve their corporate aims and to attract investment. The incentive for states is to strengthen their economies and discourage fraud and mismanagement.
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Evolution of Definition
The traditional view of Corporate Governance are based on the three fundamental assumptions for the corporations existence: Primacy of the
Primacy of the Shareholder Shareholder Diversity of the shareholder groups Maximization of shareholders wealth
These are supported in mature capitalistic economies by:

Well functioning market system Highly developed legal institutions
Ensuring checks & balances for good corporate behaviour
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Evolution of Definition
... the process of supervision & control intended to ensure that managements act in accordance with the shareholders interest arising largely from the separation of ownership and control (Parkinson, 1994) Corporate governance is a field in economics that investigates how to ensure 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 i.e., how the corporate owners can secure/motivate that the corporate managers will deliver a competitive rate of return. (Mathiesen, 2002)
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Contemporary Definition
The system of checks and balances, both internal and external, which ensures that the companies discharge their accountability to all stakeholders and act in a socially responsible way in all areas of their business activity (Solomon & Solomon).
Much of the contemporary interest in corporate governance is concerned with mitigation of the conflicts of interests between stakeholders. Ways of mitigating/preventing these conflicts of interests include the processes, customs, policies, laws & institutions which impact the way a company is controlled
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Developments
From late 80s multiple and repeated disasters in failed
business of the world, three reasons cited are:

lack of trust, low levels of transparency unethical trading
practices. E.g.:
BCCI, London &HK, avoided scrutiny and falsified
accounts.; Maxwell (Communication & Newspaper)UK pension fund fraud by abuse of position. The oldest British bank Barrings, made unethical investment decisions without covering the risk. Barrings went bankrupt, shaking up global financial markets. The Enron collapse in 2001 (USA) focused international attention on failed companies
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Developments
In succession, governments world-wide, followed with a series of regulatory mechanisms and legislations, viz.:
UK The Cadbury Committee Report (1992), The Higgs Report & The Smith Report (2003) USA The Sarbanes-Oxley Act, informally termed sarbsox or sox (2002) OECD (Organization for Economic Cooperation & Development) Principles of Corporate Governance (2004) Specifically, there was a decline in the Societys faith in business institutions and institutional investment organizations.
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Developments
Contemporary discussions of corporate governance tend to refer to principles raised in three documents released since 1990:
The Cadbury Report (UK, 92), The Principles of Corporate Governance (OECD, 98 & 04), The Sarbanes-Oxley Act (US, 02). The Cadbury and OECD reports present general principals around which businesses are expected to operate; The Sarbanes-Oxley Act is an attempt by Federal US to legislate several of the principles recommended in above documents.
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Developments
The Cadbury Committee report (1992)
The BCC (British Chamber of Commerce) setting up a committee to prevent recurrences under Sir Adrian Cadbury the Chairman of the Cadbury: is the first known report on Corporate Governance. A set of Mandatory and Non-mandatory Recommendations were issued, resulting in the definition: The system by which companies are directed and controlled. Is a guide to effective board practice. It is based on the underlying principles of all good governance: accountability, transparency, probity and focus on the sustainable success of an entity over the longer term.
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Developments
OECD Principles of Corporate Governance, 2004 (extract from the Preamble)
There is no single model for good corporate governance. However , from the work carried out globally, some common principles that underlie good Corporate Governance are :

Basis for effective Corporate Governance The Rights of Shareholders and Key Ownership functions Equitable treatment of Shareholders The Role of Stakeholders in Corporate Governance Disclosure and Transparency
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Developments
Sarbanes-Oxley Act (2002)
The bill was enacted as a reaction to a number of major corporate and accounting scandals including those affecting Enron, Tyco International, Adelphia, Peregrine Systems and WorldCom. The act contains 11 sections, ranging from additional corporate board responsibilities to criminal penalties, and requires the Securities and Exchange Commission (SEC) to implement rulings on requirements to comply with the law.
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Developments
Some of the critical sections of SOX are:
Section 302: It requires quarterly certification of financial reports, disclosure of all known control deficiencies and discloses acts of fraud.CEO and CFO are responsible for this section. Section 404: Management of annually certify internal controls; Independent accountant must attest report ; deals with quarterly change reviews. Management and Independent auditor should be responsible for this act. Section 409: Monitors operational risks, material event reporting. Management and independent auditor should be responsible for this act.
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Developments
SOX the impact in India
During 2002-03 SEBI (to evaluate the adequacy of the existing practices and to further improve the existing practices) set up a committee under the Chairmanship of Mr Narayana Murthy It considered the governance practices and provisions prevalent globally including the provisions of the US SarbanesOxley Act, 2002 In 2004, SEBI revised Clause 49 of the Listing Agreement mandating compliance to corporate governance which included the inclusion of CEO/CFO Certification - a new requirement and is based on the SOX. The revised Clause requires CEO and CFO to certify to the Board the annual financial statements.
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The Issue
Corporate Governance needs to stimulate both business prosperity and accountability to multiple stakeholders what is the balance? Is regulation really the answer? Rules and regulations in essence are reactionary they lag the need, but do they deter for the future? Is the more voluntary approach, substituting regulations by proposals/ guidelines in Board room practices more pragmatic? Is it not more worrisome for shareholders to feel that the directors (of the companies they own) are so untrustworthy that they have to be tied down?
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CORPORATE GOVERNANCE: FRAMEWORK
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Corporate Governance: Framework

Agency Theory
Given the divorce of management and ownership, this theory define shareholder as principals who delegate day to day decision-making to the directors who are agents. This is the most common structure today.
Top managers are in effect hired hands who may be more interested in their own rather than the shareholders welfare/interests! Problems highlighted by the theory: Objectives are in conflict and may be too difficult/ expensive for owners ascertain what the agent is actually doing e.g. padding remuneration.
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Agency Theory
Risk-taking/sharing problem which arises
with different
attitude towards risk. Tendency for maximising short-term gains rather than creation of long-term wealth for shareholders. More widespread the holding, the more the probability of the problems particularly with strong voice of institutional investors
As a remedy, Agency theory suggests that top management take a significant ownership of the firm and have a stake in the long-term performance.
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Stewardship
In contrast, this theory suggests that managers are motivated to act in for the welfare of the corporation than in their self-interest. Thus, top managers focus on fulfilling higher-order needs (Maslow) and see the corporation as an extension of themselves:
The
Top Manager thus is a steward rather than a hired hand for the Board Top management care more for the company than that shown by short-term investors and shareholders. Promote involvement and empowerment of employees.
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Stewardship
For Top
executive, mobility is not so high particularly in difficult times. Their interest for long-term performance is therefore high.
Agency Theory Stewardship Theory Focus: Sociological, Performance & long-term Convergence of interest of Managers & Principals Relationship Basis: risk taking & trust Behaviour: collectivistic, societal, mutuality
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Focus: Materialistic, (Cost) Control & short-term

Differing Interests of Managers & Principals Relationship Basis: risk avoidance & control Behaviour: individualistic, opportunistic & self-serving

Trusteeship
An extension of the trust theme is the trusteeship model, wherein the Directors hold the investors money in trust for creation of assets and are legally liable to the shareholders.
Concurrently, they had fiduciary (ethical, moral, in-trust) responsibility to the public and the Society at large.
Managers balance the various interest for and in the interest of the Corporation.
Indian governance mode draws from Gandhi-jis similar thinking, particularly in respect of employee relations. Oriental cultures also imply that an entrepreneur is ordained by God to act as his chosen one for society.
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Transaction Cost
Initiators of this theory (Cyert & March, 1996), suggest that a firm is not just an impersonal economic unit in a world of perfect markets (and equilibrium), but an organization of people with differing views and objectives.
This theory is based on the fact that firms have become so large that they effectively substitute for the market in determining allocation of resources.
Thus, the way in which a company is organized determines its control over transactions e.g. extent of vertical integration; Kiretsus in Japan, Cartels etc,
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Transaction Cost
Managements,
in order to reduce risk, internalize transactions as far as possible, insuring against uncertainties of future product & prices In classical economics , Profit maximization occurs with all players equally rational; in practice, this is governed by bounded rationality. Transaction cost economics suggests the behavioural slant for profit generation. Since there is space for opportunism, the perils outlined in agency theory also visit this practice.
The principal difference from the Agency Theory, lies in the shift of emphasis from individuals (and ambition) to transactions (opportunism).
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Accountability
The Cadbury Report, (UK: 1992) was the first to set out a code which companies, though not bound to, were expected to comply with, state that in their Annual Reports and justify areas of non-compliance.
The three general areas covered were: The Board of Directors, auditing & shareholding focussing attention on The Board as the principal mechanism of corporate governance, requiring monitoring and assessment. Auditing (and accounting) were deemed to provide the transparency and communication with shareholders and stakeholders.
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Accountability
Lastly, the report highlighted the importance of institutional shareholders as the largest and most influential group.
This led, more than other reforms, to the shift of Directors dialogue towards greater accountability and engagement - which in turn has led to The more significant shift to corporate responsibility towards a range of stakeholders encouraging greater (corporate) social responsibility.
Another area of concern, addressed by the Greenbury Report, (UK:1995) addressed the balance between Directors remuneration and company performance.
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Control/Ownership: parties
Government Agencies & Authorities Stock Exchanges The Management
The Board including its Chair The Chief Executive Officer Other Senior & Line Managers Shareholders Auditors
May include influential stakeholder e.g. Creditors, Customers & (local) Community
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Government Agencies & Authorities and Stock Exchanges principally influence the ownership and control structures.
Control and ownership structure refers to the types and composition of shareholders in a corporation. Ownership is typically defined as the ownership of cash flow rights whereas control refers to ownership of control or voting rights
Ownership is not control due to the existence of : dualclass shares, voting coalitions, proxy votes, clauses in the articles of association that confer additional voting rights to certain shareholders.
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Family interests dominate ownership and control structures of many (Indian) corporations
It has been suggested the oversight of family controlled corporation is superior to that of corporations "controlled" by institutional investors!
A study by Credit Suisse found that companies in which "founding families retain a stake of more than 10% of the company's capital enjoyed a superior performance over their respective sectoral peers. "Look beyond Six Sigma and the latest technology fad. One of the biggest strategic advantages a company can have is blood ties," Forget in Business Week.
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The significance of institutional investors varies substantially across countries:
In Anglo-American countries (Australia, Canada, New Zealand, U.K., U.S.) and Europe, institutional investors dominate the market for stocks in larger corporations the majority of the shares in the Japanese market are held by financial companies and industrial corporations, these are not institutional investors if their holdings are largely within the group.
However, the agenda of these institutional investors is primarily securitization of their interests.
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Roles
A boards role as derived from Agency Theory: Shareholders give up their (control) decision rights and entrusts the managers(agents) act in the shareholder best (joint) interest. Agency concern (i.e. Risks) is lowest for the dominant/controlling shareholder(s). A Board of Directors is expected to play the pivotal role in corporate governance and is responsible for Organizations strategy & directional policy; hiring & remunerating top executives and Accountability to authorities & investors
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Roles
Setting corporate strategy, overall direction, mission and vision Hiring and firing the CEO and top management Controlling, monitoring and supervising top management Board of Directors Reviewing and approving the use of (critical) resources
Caring for shareholder interests

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Roles
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Roles
Trends today (particularly in US & UK):

Boards are smaller and getting more involved in shaping rather than supervising; Institutional investors are getting larger share of voice in Boards, thus pressure on corporate performance. More outside Directors are being inducted (loosening of the grip of CEOs); taking on members with specialized knowledge/expertise thus take more control of functions; Globalization and Societal demands are making Boards more international (expertise) and focusing more on broader aspects of business e.g. CSR.
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Mechanisms and controls
Corporate governance mechanisms and controls are designed to reduce the inefficiencies that arise from moral hazard and adverse selection.
E.g., to monitor managers' behavior, an independent third party (the external auditor) attests the accuracy of information provided by management to investors.
An ideal control system should regulate both motivation and ability. Internal corporate governance controls monitor activities and then take corrective action to accomplish organizational goals. They include:
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Monitoring by the board of directors: Regular board meetings allow potential problems to be identified, discussed and avoided

the ability of the board to monitor the firm's executives is a function of its access to information. Executive directors possess superior knowledge of the decision-making process and therefore evaluate top management on the basis of the quality of its decisions that lead to financial performance outcomes Executive directors often look beyond the financial criteria
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Internal control procedures and internal auditors: Internal control procedures are policies implemented by an entity's board of directors, audit committee, management, and other personnel to provide reasonable assurance of the entity achieving its objectives
related to reliable financial reporting, operating efficiency, and compliance with laws and regulations.
Balance of power: The simplest balance of power require that the President be a different person from the Treasurer.
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In the UK, a balance of power between board members was recommended in the Cadbury Committee and confirmed in the Higgs report (2003) The roles of chairman & chief executive should not be exercised by the same individual The US code (Sarbanes-Oxley rules), while prescribing a host of checks, stop short of this.
A CEO generally does not serve as Chairman of the Board in the UK, whereas in the US having the dual role is the norm, despite major misgivings.
In Germany and the Netherlands, a two-tiered Board of Directors is a means of improving corporate governance.
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Remuneration: Performance-based remuneration is designed to relate some proportion of salary to individual performance.
Such incentive schemes, however, are reactive in the sense that they provide no mechanism for preventing mistakes or opportunistic, myopic behavior.
Monitoring by large shareholders, monitoring by banks and other large creditors: Given their large investment in the firm, these stakeholders have the incentives, combined with the right degree of control and power, to monitor the management
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In Anglo-American countries (Australia, Canada, New Zealand, U.K., U.S.), institutional investors dominate the market for stocks in larger corporations The large pools of invested money are designed to maximize the benefits of diversified investments in a very large number of different corporations with sufficient liquidity. This strategy aims to eliminate individual firms risks. Thus, institutional investors have relatively little interest in the governance of a particular corporation, since
Control is expensive (golden handshake) or time & effort required causing investors loose interest and divest.
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Transparency & Disclosure
Transparency is operating in such a way that it is easy for others to see what actions are performed.
Corporate Transparency is the set of information, privacy, and business policies to improve corporate decisionmaking and operations openness to employees, stakeholders, shareholders and the general public.
Within the organization, terms (depicting styles) like fishbowl and glass wall are gaining popularity; Applied to the business society interface, increasing use of information communications technology has accelerated the radical increase in the openness of organizational process and data e.g. Wiki-leaks
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In traditional PR management, damage control involved the suppression of public information.
The reputation economy, however, creates an incentive to be more open, not less. Since (Internet ) commentary is inescapable, the only way to influence it is to be part of it! Mark Zuckerberg : ..more transparency should make for a more tolerant society in which people eventually accept that everybody sometimes does bad or embarrassing things.
Disclosure implies The submission of facts and details concerning assets, situations, or operations
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Companies that are publicly owned are subject to detailed disclosure laws about their financial condition, operating results, management compensation, and other areas of their business. Disclosure laws are designed to protect investors through the disclosure of business and financial information that could be considered relevant to making an investment decision.
GAAP and specific rules of the accounting profession require that certain types of information be disclosed in a business's audited financial statements.
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Court rulings on disclosure laws indicate a movement away from the traditional "Let the buyer beware" (caveat emptor) concept toward one of good faith and fair dealing. To avoid court challenges in areas where disclosure laws are subject to interpretation, businesses tend to err on the side of disclosing information rather than concealing it.
Voluntary disclosure is the provision of information by a companys management beyond statutory requirements e.g. GAAP in accounting and is carried out extensively by many companies.
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Voluntary disclosure benefits investors, companies and the economy; e.g., it helps investors make better capital allocation decisions and lowers firms' cost of capital Firms balance the benefits of voluntary disclosure against the costs, which include the cost of procuring the information to be disclosed, and decreased competitive advantage. The extent and type of voluntary disclosure differs by geographic region, industry, and company size. Other research has found that the extent of voluntary disclosure is affected by the firm's corporate governance & ownership structures.
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Corporate Governance

Facilitator: Mr. Bijoy S Guha ISBS Workshop