Management Code 17 Notes Unit 1 (UGC NET Paper 2)

Corporate Governance

Corporate governance is the overall control of activities in a corporation. Corporate governance is the set of processes, customs, policies, laws, and institutions affecting the way a corporation (or company) is directed, administered or controlled. It is concerned with the formulation of long-term objectives and plans and the proper management structure (organisation, systems and people) to achieve them. At the same time, it entails making sure that the structure
functions to maintain the corporation’s integrity and responsibility to its various constituencies. Corporate governance also includes the relationships among the many stakeholders involved and the goals for which the corporation is governed. The principal stakeholders are the shareholders, the board of directors, employees, customers, creditors, suppliers, and the community at large.

Definitions of Corporate governance

According to Adrian Cadbury, Chairman of Cadbury

“Corporate governance is concerned with holding the balance between economic and social goals between individual and communal goals. The corporate framework is there to encourage the efficient use of resources and equally requires accountability for the stewardship of those resources. The aim is to align as nearly as possible the interests of individuals, corporations, and society.”

According to Shleifer and Vishny
“Corporate governance deals with the ways suppliers of finance to corporations assume themselves of getting a return on their investment.”

According to World Bank
“Corporate governance is about promoting fairness, transparency, and accountability.”

According to A Board Culture of Corporate Governance, business author Gabrielle O’Donovan
Corporate governance as ‘an internal system encompassing policies, processes and people, which serves the needs of shareholders and other stakeholders, by directing and controlling management activities with good business savvy, objectivity, accountability and integrity. Sound corporate governance is reliant on external marketplace commitment and legislation, plus a healthy board culture which safeguards policies and processes.

Factors influencing Corporate Governance

(a) The Ownership Structure

The structure of ownership of a company determines, to a considerable extent, how a corporation is managed and controlled. The ownership structure can be either 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 Germany and Japan. But the pattern of shareholding is not as simple as the above statement seeks to convey. The pattern varies across the globe.
Our corporate sector is characterized by the co-existence of state owned, private and multinational enterprises. The shares of these enterprises (except those belonging to the public sector) are held by institutional as well as small investors. Specifically, shares are held by

(i) the term-lending institution

(ii) institutional investors, comprising government owned mutual funds, Unit Trust of India and the government owned insurance corporations

(iii) corporate bodies

(iv) directors and their relatives and

(v) foreign investors.

Large shareholders tend to be active in corporate governance either through their representatives on company boards or through their active participation in annual general body meetings. This has been demonstrated by Reliance Industries. Ltd. which has the highest number of equity shareholders spread across the country.

(b) The Structure of Company Boards

Along with the structure of ownership, the structure of company boards has considerable influence on the way the companies are managed and controlled. The board of directors is responsible for establishing corporate objectives, developing broad policies and selecting top-level executives to carry out those objectives and policies. The board also reviews management’s performance to ensure that the company is run well and shareholder’s interests are protected. Company boards are permitted to vary in size, composition and structure so as to best serve the interests of the corporation and the shareholders. Board membership may include both inside directors and outside directors. Again, boards can be single-tiered or two-tiered.
With regard to the size of board, opinions and practices vary. Some argue that the adequate size is to range from nine to fifteen. Some others put the figure at ten and yet others recommend a minimum of five and a maximum of ten. Company boards in the UK have, on an average, seven directors on their boards. Japanese companies have larger boards, the figure going upto sixty.

(c) 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 company, i.e. proportion between debt and equity, has implications for the quality of governance. Contrary to the Modigliani-Miller hypothesis that the financial structure of the firm has no relationship to the value of a firm, recent research has shown that the financial structure does matter. It is no secret that the lenders exercise significant influence on the way a company is managed and controlled. Banks as creditors, for example, can perform the important function of screening and monitoring companies as they (banks) are better informed than other investors. Further, banks can diminish short-term biases in managerial decision making by favouring investments that would generate higher benefits in the long run. Unlike the regulator, the market is not bound by broad rules and can exercise business judgement. It therefore makes sense for the regulator to pass on as much of the burden of ensuring corporate governance to the markets as possible. The regulator can then concentrate on making the markets more efficient at performing this function.

Development banks hold large blocks of shares in companies. They are equally big debt holders too. Being equity holders, these investors have their nominees in the boards of companies. These nominees can effectively block resolutions which may be detrimental to their interests. Unfortunately, the role of nominee directors has been passive, as has been pointed out by several committees including the Bhagavati Committee on Takeovers and the Omkar Goswami Committee on Corporate Governance.

(d) The Institutional Environment

Corporate governance mechanisms are economic and legal institutions and often the outcome of political decisions. For example, the extent to which shareholders can control the management depends on their voting rights as defined in company law, the extent to which creditors will be able to exercise financial Cairns on a bankrupt unit will depend on bankruptcy laws and procedures and the extent to which the market for corporate control efficiency operates to discipline under performing management will depend on take-over regulations.

Mechanisms Ensuring Corporate Governance

The fundamental institutions of corporate governance in our country have been in existence for a long time. Compared to many developing countries, mechanisms of corporate governance in India are much more institutionalized. In our country, there are six mechanisms to ensure corporate governance.

1. Companies Act, 1956
Companies Act is one of the biggest legislations with 658 sections and 14 schedules. Through the consolidation of many successive amendments, and a large number of statutory rules and regulations, the Act aims at not only ensuring that the interests of all stakeholders are adequately protected but purports to go beyond. The Act seeks to translate into action Articles 38 and 39 in Part IV of the Constitution, by which the State was directed that the ownership and control of the material resources of the community are so distributed as to subserve the common good and the operation of the economic system does not result in the concentration of wealth and means of production to the common detriment.
To ensure corporate governance, the Act confers legal rights to shareholders to (a) vote on every resolution placed before an annual general meeting; (b) to elect directors who are responsible for specifying objectives and laying down policies; (c) determine remuneration of directors and the CEO; (d) removal of directors and (e) take active part in the annual general meetings.
The Companies Bill, 1997 and the recently promulgated Ordinance on Companies (Amendment) Bill, 1997, have amended several provisions of the Act and introduced new provisions incorporating some internationally accepted corporate governance practices aimed at strengthening corporate democracy, protecting the interests of minority shareholders and providing maximum flexibility to the companies in responding to the market needs.

2. Securities Law
The primary securities law in our country is the SEBI, Act Since its inception in 1992, the Board has taken a number of initiatives towards investor protection. One such initiative is to mandate information disclosure both in prospectus and in annual accounts. SEBI Act has added substantially in an attempt to make these documents more meaningful. One of the most valuable is the information relating to the performance of other companies in the same group, particularly those companies which have accessed the capital market in the recent past.

The Board constituted a Committee under the chairmanship of Kumaramangalam Birla to suggest ways to promote and raise the standards of corporate governance in listed companies. The Board, in its meeting held on January 25; 2000, considered the recommendations of the Committee and decided to make amendments to the listing agreements by adding a new clause, namely clause 49, to the listing agreement.

The clause 49 provides for the optimum composition of executive and non-executive directors; setting up of a qualified and independent audit committee; remuneration of directors; Management Discussion and Analysis Report to form part of annual report to the shareholders; a separate section on Corporate Governance in the annual reports of the company; for information to be furnished in the report on corporate governance; and auditor’s compliance certificate to the effect that all the conditions of corporate governance have been complied with.

3. Discipline of the Capital Market
Capital market has considerable impact on corporate governance. Herein lies the role the minority shareholders can play effectively. They can refuse to subscribe to the capital of a company in the primary market and in the secondary market, they can sell their shares, thus depressing the share prices. A depressed share price makes the company an attractive take-over target.
In a well functioning capital market, there is a strong incentive for corporate managements themselves to voluntarily adopt transparent processes and subject themselves to external monitoring to reassure potential investors. What makes capital market discipline so much more attractive than regulatory intervention is that unlike the regulator, the market is very good at micro level judgements and decisions. Infact, the market is taking micro-decisions all the time. Unlike the regulator, the market is not bound by broad rules and can exercise business judgement. It therefore makes sense for the regulator to pass on as much of the burden of ensuring corporate governance to the markets as possible. The regulator can then concentrate on making the markets more efficient at performing this function.

4. Nominees on Company Boards
Development banks hold large blocks of shares in companies. They are equally big debtholders too. Being equity holders, these investors have their nominees in the boards of companies. These nominees can effectively block resolutions which may be detrimental to their interests. FIS have been asked to take full responsibility for corporate governance in companies where they have substantial stakes. The objective is to boost investor confidence and pop up the capital market. The government has issued a four point directive to FIS asking them to insist on :

(a) making adequate disclosures

(b) moving towards internationally accepted accounting standards

(c) maintaining distance between the CEO and chairman where applicable

(d) holding regular board meeting with proper recording and dissemination of proceedings.

FIs are in the process of revising guidelines for nominee directors. The IDBI is coordinating the process, and the norms will be drawn up in consultation with the Ministry of Finance and the RBI. Among the norms under consideration is one making it mandatory for FI nominee directors on boards of companies to attend specific board meetings, especially those related to finalization of accounts.

FIs are insisting on setting up of audit sub-committees comprising ‘adequate’ number of non-executive independent directors of the company board in each and every large and medium corporate to strengthen internal control structures and safeguard shareholder interests. Constitution of an audit sub-committee, according to the FIs, would help bring in substantial financial discipline on the part of management and check against executive malpractice.

5. Statutory Audit
Statutory audit is yet another mechanism directed to ensure good corporate governance. Auditors are the conscience-keepers of shareholders, lenders and others who have financial stakes in companies.
Auditing enhances the credibility of financial reports prepared by an enterprise. The auditing process ensures that financial statements are accurate and complete, thereby enhancing their reliability and usefulness for making investment decisions. Credible financial statements are essential for business enterprises to raise capital and for society to have trust in limited companies. Obviously, good corporate governance depends, in part, on good auditing.

6. Codes of Conduct
The code is based on checks and balances, especially at the level of the board of directors and the chief executive, to guard against undue concentration of power, and, adequate disclosure to enable those entitled to have the information they need, in order to exercise their rights. It comprises four sections:

• Role of the Board of Directors. It was proposed that the (‘inside’) executive directors be balanced by adequate number of (‘outside’) non-executive directors, with the posts of the board, chairman and chief executive being separated.
• 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 judgement), that non-executive directors should be appointed only for a specific term and there should be a formal process for their appointment involving the board as a whole.

• Executive Directors. The main concern was with their remuneration that there should be a full and clear disclosure of directors’ emoluments, and that pay should be set by a Remuneration Committee, consisting mainly of non-executive directors.

• Financial Reporting and Controls. It was recommended that properly constituted Audit Committees of the Board be appointed, and that non-executive directors report regularly on the effectiveness of systems and internal financial control.

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