Shri

Corporate Governance – Introduction

Corporate governance is a central and dynamic aspect of business. The term
‘governance’ is derived from the Latin word gubernare, meaning ‘to steer’, usually
applying to the steering of a ship, which implies that corporate governance involves the
function of direction rather than control. In fact, the significance of corporate
governance for corporate success as well as for social welfare cannot be overstated.
Recent examples of massive corporate collapse resulting from weak systems of
corporate governance have highlighted the need to improve and reform corporate
governance at international level. In the wake of Enron and other similar cases,
countries around the world have reacted quickly by pre-empting similar events
dramatically.

"Capitalism with integrity outside the government is the only way forward to create
jobs and solve the problem of poverty. We, the business leaders are the evangelists of
capitalism with integrity. If the masses have to accept this we have to become credible
and trustworthy. Thus we have to embrace the finest principles of corporate governance
and walk and the talk." (Narayan Murthy)

Corporate governance has in recent years succeeded in attracting a good deal of public
interest because of its apparent importance for the economic health of corporations and
society in general. However, the concept of corporate governance is poorly defined
because it potentially covers a large number of distinct economic phenomena. As a
result, different individuals have come up with different definitions that basically
reflect their special interest in the field. It is hard to see that this 'disorder' will be any
different in the future so the best way to define the concept is perhaps to list a few of the
different definitions.

Definition of Corporate Governance

Corporate governance comprehends the framework of rules, relationships, systems and

Processes within and by which fiduciary authority is exercised and controlled in
corporations. Relevant rules include applicable laws of the land as well as internal rules
of a corporation. Relationships include those between all related parties, the most
important of which are the owners, managers, directors of the board (when such entity
exists), regulatory authorities and to a lesser extent, employees and the community at
large. Systems and processes deal with matters such as delegation of authority,
performance measures, assurance mechanisms, reporting requirements and
accountabilities.
Standard and Poors defined corporate governance as “the way in which a company
organizes and manages itself to ensure that all financial stakeholders receive their fair
share of a company’s earnings and assets” is increasingly a major factor in the
investment decision-making process. Poor corporate governance is often cited as one of
the main reasons why investors are reluctant, or unwilling, to invest in companies in
certain markets.
The report of SEBI Committee on Corporate Governance gives the following definition
of corporate governance.
“Corporate governance is the acceptance by management, of the inalienable rights of
shareholders as the true owners of the corporation and of their own role as trustees on behalf of
the shareholders. It is about commitment to values, about ethical business conduct and about
making a distinction between personal and corporate funds in the management of a company”.

The simplest definitions, is given by a Cadbury Report (UK). ‘Corporate Governance is

the system by which businesses are directed and controlled’.

The Cadbury Committee said, “The primary level is the company’s responsibility to
meet its material obligations to shareholders, employees, customer, suppliers, creditors,
to pay its taxes and to meet its statutory duties. The next level of responsibility is the
direct result of actions of companies in carrying out their primary task including
making the most of the community’s human resources and avoiding damage to the
environment. Beyond these two levels, there is a much less well-defined area of
responsibility, which involves in the interaction between business and society in a
wider sense.”

The ongoing nature of corporate governance indicates by the definition of the

Commission on Global Governance (1995), ‘A continuing process through which
conflicting or diverse interests may be accommodated and co-operative action may be
taken’.

Need of Corporate Governance

A corporation is a congregation of various stakeholders, namely customers, employees,

investors, vendor partners, government and society. A corporation should be fair and
transparent to its stakeholders in all its transactions. This has become imperative in
today’s globalized business world where corporations need to access global pools of
capital, need to attract and retain the best human capital from various parts of the
world, need to partner with vendors on mega collaborations and need to live in
harmony with the community. Unless a corporation embraces and demonstrates ethical
conduct, it will not be able to succeed. Corporate governance is about ethical conduct in
business. Ethics is concerned with the code of values and principles that enable a person
to choose between right and wrong and, therefore, select from alternative courses of
action. Further, ethical dilemmas arise from conflicting interests of the parties involved.
In this regard, managers make decisions based on a set of principles influenced by the
values, context and culture of the organization. Ethical leadership is good for business
as the organization is seen to conduct its business in line with the expectations of all
stakeholders.
Corporate governance is beyond the realm of law. It stems from the culture and
mindset of management and cannot be regulated by legislation alone. Corporate
governance deals with conducting the affairs of a company such that there is fairness to
all stakeholders and that its actions benefit the greatest number of stakeholders. It is
about openness, integrity and accountability. What legislation can and should do is to
lay down a common framework – the “form” to ensure standards. The “substance” will
ultimately determine the credibility and integrity of the process. Substance is inexorably
linked to the mindset and ethical standards of management. Corporations need to
recognize that their growth requires the cooperation of all the stakeholders; and such
cooperation is enhanced by the corporation adhering to the best corporate governance
practices. In this regard, the management needs to act as trustees of the shareholders at
large and prevent asymmetry of benefits between various sections of shareholders,
especially between the owner-managers and the rest of the shareholders.

Scope of Corporate Governance

Corporate governance covers the following functional areas of governance:

1. Preparation of company’s financial statements: Financial disclosure is a very

important and critical component of corporate governance. The company should
implement procedures to independently verify and safeguard the integrity of the
company’s financial reporting. Disclosure of material matters concerning the
organization should be timely and balanced to ensure that all investors have
access to clear, factual information.

2. Internal controls and the independence of entity’s auditors: Internal control is

implemented by the board of directors, audit committee, management, and other
personnel to provide assurance of the company achieving its objectives related to
reliable financial reporting, operating efficiency, and compliance with laws and
regulations. Internal auditors, who are given responsibility of testing the design
and implementing the internal control procedures and the reliability of its
financial reporting, should be allowed to work in an independent environment .

3. Review of compensation arrangements for chief executive officer and other

senior executives: Performance-based remuneration is designed to relate some
proportion of salary to individual performance. It may be in the form of cash or
non-cash payments such as shares and share options, superannuation or other
benefits. Such incentive schemes, however, are reactive in the sense that they
provide no mechanism for preventing mistakes or opportunistic behavior, and
can elicit myopic behavior.

4. The way in which individuals are nominated for the positions on the board: The
Board of Directors have the power to hire, fire and compensate the top
management. The owners of a business who have decision-making authority,
 voting authority, and specific responsibilities, which in each case is separate and
distinct from the authority, and responsibilities of owners and managers of the
business entity.

5. The resources made available to directors in carrying out their duties: The duties
of the directors are the fiduciary duties similar to those of an agent or trustee.
They are entrusted with adequate power to control the activities of the company.

6. Oversight and management of risk: It is important for the company to be fully

aware of the risks facing the business and the shareholders should know that
how the company is going to tackle the risks. Similarly the company should also
be aware about the opportunities lying ahead.

Participants to Corporate Governance

CEO, the board of directors and management. Other stakeholders who take part include
suppliers, employees, creditors, customers, and the community at large.
Shareholders delegate decision rights to the managers. Managers are expected to act in
the interest of shareholders. This results in the loss of effective control by shareholders
over managerial decisions. Thus, a system of corporate governance controls is
implemented to assist in aligning the incentives of the managers with those of the
shareholders in order to limit self-satisfying opportunities for managers.
The board of directors plays a key role in corporate governance. It is their responsibility
to endorse the organization’s strategy, develop directional policy, appoint, supervise
and
Remunerate senior executives and to ensure accountability of the organisation to its
owners and authorities.
A key factor in an individual’s decision to participate in an organisation (e.g. through
providing financial capital or expertise or labour) is trust that they will receive a fair
share of the organisational returns. If somebody receives more than their fair return
(e.g. exorbitant executive remuneration), then the participants may choose not to
continue participating, potentially leading to an organisational collapse (e.g.
shareholders withdrawing their capital). Corporate governance is the key mechanism
through which this trust is maintained across all stakeholders.

Importance and Benefits of Corporate Governance

Policy makers, practitioners and theorists have adopted the general stance that
corporate
governance reform is worth pursuing, supporting such initiatives as splitting the role of
chairman/chief executive, introducing non-executive directors to boards, curbing
excessive executive performance-related remuneration, improving institutional investor
relations, increasing the quality and quantity of corporate disclosure, inter alia.
However, is there really evidence to support these initiatives? Do they really improve
the effectiveness of corporations and their accountability? There are certainly those who
are opposed to the ongoing process of corporate governance reform. Many company
directors oppose the loss of individual decision-making power, which comes from the
presence of non-executive directors and independent directors on their boards. They
refute the growing pressure to communicate their strategies and policies to their
primary institutional investors. They consider that the many initiatives aimed at
‘improving’ corporate governance in UK have simply slowed down decision-making
and added an unnecessary level of the bureaucracy and red tape The Cadbury Report
emphasized the
Importance of avoiding excessive control and recognized that no system of control can
completely eliminate the risk of fraud (as in the case of Maxwell) without hindering
companies’ ability to compete in a free market. This is an important point, because
human nature cannot be altered through regulation, checks and balances. Nevertheless,
there is growing perception in the financial markets that good corporate governance is
associated with prosperous companies. Institutional investment community considered
both company directors and institutional investors welcomed corporate governance
reform, viewing the reform process as a ‘help rather than a hindrance’. Specifically,
towards corporate governance reform.
The findings of (Solomon J. and Solomon A., 1999) endorsed many of the issues relating
to the agenda for corporate governance reform in UK. For example, they show, that
institutional investors agreed strongly with the Hampel view that corporate governance
is as important for small companies as for larger ones. The results also indicated
significant support from the institutional investment community for the continuance of
a voluntary environment for corporate governance. The respondents’ agreement that
there should be further reform in their investee companies also added support to the
ongoing reform process. Lastly, the institutional investors perceived a role for
themselves in corporate governance reform, as they agreed that the institutional
investment community should adopt a more activist stance.

Benefits of Corporate Governance

The initiation of the process of corporate governance in PEs is likely to result into a
series of important benefits. Firstly, the flip-flop about owning of the responsibility for
low performance would perhaps come to an end. The owners will be on enterprise
board. Secondly, goal and role clarity would improve. Enterprise would be mission –
vision driven. Thirdly, opportunity for top management to create a cultural
transformation from government entities to corporate entities, and from state-financed
to self-sustaining ones.

Role of Corporate Governance

The role of effective corporate governance is of immense significance to the society as a

whole. It can be summarized as follows:
 1. Corporate governance ensures the efficient use of resources.
2. It makes the resources flow to those sectors or entities where there is efficient
production of goods and services and the return is adequate enough to satisfy
the demands of stakeholders.
3. It provides for choosing the best managers to administer scarce resources.
4. It helps managers remain focused on improving performance and making sure
that they are replaced when they fail to do so.
5. It pressurises the organization to comply with the laws, regulations and
expectations of society.
6. It assists the supervisor in regulating the entire economic sector without
partiality and nepotism.
7. It increases the shareholders’ value, which attracts more investors. Thus,
corporate governance ensures easy access to capital.
8. As corporate governance leads to higher consumer satisfaction, it helps in
increasing market share and sales. It also reduces advertising and promotion
costs.
9. Employees are more satisfied in organizations that follow corporate governance
policies. This reduces the employee turnover, which results in the reduction in
the cost of human resource management. Only a satisfied employee can create a
satisfied customer.
10. Corporate governance reduces the procurement and inventory cost. It helps in
maintaining a good rapport with suppliers, which results in better and more
economical inventory management system.
11. Corporate governance helps in establishi7ng good rapport with distributors
providing not only better access to the market, but also reducing the cost of
production.

Issues involved in Corporate Governance

Corporate governance involves the following issues:

Internal Control
The Board of Directors should maintain a sound system of internal control to safeguard
the investment of shareholders and the assets of the company, the board should
conduct a review of the effectiveness of internal controls.

Correct Preparation of Financial Statements

The Board of Directors should present a balanced and understandable assessment of the
company's position and future prospects. There should be a statement by the auditors
about their reporting responsibilities.

Compensation of CEO and other Directors

There should be a formal and transparent procedure for developing policy on executive
remuneration for CEO and other directors. No director should be in a position of
deciding his or her own remuneration. The Board of Directors should establish a
remuneration committee of at least three. This committee should have delegated
responsibility for setting remuneration for all executive directors and the chairman,
including pension rights and any other compensation.

Nomination of Members of the Board of Directors

Appointments to the Board of Directors should be made on merit. Adequate care
should be taken to ensure that all the directors have enough time available to devote to
the job. This criterion is more important in the case of chairman. The appointments to
the board should be made in such a way so as to maintain an appropriate balance of
skills and experience. There should be a nomination committee, which should process
the appointments for the board and make recommendations. A majority of members of
this nomination committee should be independent, non-executive directors so as to
evaluate the balance of skills, knowledge and experience. For the purpose of the
appointment of chairman, the nomination committee should prepare a job specification,
time commitment expectation and crisis management abilities.

Disclosure Norms

The annual report should record:

1. How decisions are taken by the board;

2. The names of chairman, CEO and other directors;
3. The number of meetings and the individual attendance by directors;
4. How performance evaluation of the board has been made; and
5. The steps taken by the board to develop an understanding of the views of major
Shareholders about their company.

The annual report should also include the work of the nomination committee and the
remuneration committee.

Rights of Corporation

A corporation is a legal entity with the following rights:

1. The ability to sue and be sued.

2. The ability to hold assets in its own name.
3. The ability to hire agents.
4. The ability to sign contracts.
5. The ability to make by-laws to govern its internal affairs.

Historical Perspective of Corporate Governance

Corporate ownership structure has been considered as having a strongest influence on
systems of corporate governance, although many other factors affect corporate
governance, including legal systems, cultural and religious traditions, political
environments and economic events. All business enterprises need funding in order to
grow, and it is the ways in which companies are financed which determines their
ownership structures. It became clear centuries ago that individual entrepreneurs and
their families could not provide the finance necessary to undertake developments
required to fuel economic and industrial growth. The sale of company shares in order to
raise the necessary capital was an innovation that has proved a cornerstone in the
development of economists worldwide. However, the road towards the type of stock
market seen in the UK and US today has been long and complicated. Listed companies
in their present form originate from the earliest form of corporate entity, namely the
sole trader. From the middle ages, such traders were regulated by merchant guilds,
which over saw a diversity of trades. The internationalization of trade, with traders
venturing overseas, led gradually to regulated companies arising from the medieval
guild system. Members of these early companies could trade their own shares in the
company, which lead ultimately to the formation of the joint stock companies.
The first company to combine incorporation, overseas trade and joint stock was the East
India Company, which was granted a royal charter in 1600, for merchants of London
trading into the East Indies. The early governance structures of this company were
reminiscent of CG structures and mechanisms in today’s companies (Farrar and
Hannigan, 1998; Cadbury, 2002).

Summary

Corporate governance comprehends the framework of rules, relationships, systems and

Processes within and by which fiduciary authority is exercised and controlled in
corporations.

Corporate governance deals with conducting the affairs of a company such that there is
fairness to all stakeholders and that its actions benefit the greatest number of
stakeholders.

The initiation of the process of corporate governance in PEs is likely to result into a
series
of important benefits.

Corporate ownership structure has been considered as having a strongest influence on

systems of corporate governance, although many other factors affect corporate
governance, including legal systems, cultural and religious traditions, political
environments and economic events.