Corporate Governance

R.Kannan

“ Corporate Governance”

• It is a broad concept and has been defined and understood differently by

different groups and at different points of time.

• The Cadbury Committee report defines it as “the system by which

companies are directed and controlled”.

• It is generally understood as the framework of rules, relationships, systems

and processes within and by which authority is exercised and controlled in

corporations.”

Corporate Governance

• A system of checks and balances between the board, management and investors to produce an efficiently functioning corporation, ideally geared to produce long-term value

• Corporate Governance is a relationship among stakeholders that is used to determine and control the strategic direction & performance of organizations.

Corporate Governance and Capital Markets

• Investment is an act of faith• Poor governance

– Undermines integrity of corporations and discourages the use of public markets as a means to intermediate savings

– Particularly the areas of transparency and disclosure have been a major factor behind instability in the financial markets across the globe

Framework of Governance

1. Supervisory Board/ Committee/ Team

2. Audit Committee

3. Internal Audit

4. Statutory Audit

5. Disclosure of information

6. Risk management framework

7. Internal Control framework

8. Whistle blower policy

Corporate Governance & Corporate Management

CORPORATE GOVERNANCE

CORPORATE MANAGEMENT

External Focus Internal Focus

Governance assumes an open system

Management assumes a closed system

Strategy- oriented Task-oriented

Concerned with where the company is going

Concerned with getting the company there

Governance

Management

Corporate Governance and Capital Markets

• Good corporate governance– Essential pre-requisite for the integrity and credibility of capital

market players

– Contributes to the development of a vibrant economy and robust capital markets

• Recent events have repeatedly proven the importance of corporate governance standards, including the collapse of large global corporations

Corporate Governance and Capital Markets

Source: A McKinsey Survey of Global Investors

Areas of failure

What went wrong in the recent past?

• Environment– Loss of moral fibre of corporations– Business environment characterized by need to compete with

the new economy

• Boards– Fundamental weaknesses in business models sought to be

compensated by adoption of aggressive accounting practices – Ignored ethics and value systems when a much hyped business

strategy failed to deliver as expected and articulated to Wall Street

– Incompetence of board members and overriding of audit committees

What went wrong in the recent past?

• Managements– Stock option heavy compensation structures– Bonus linked to short-term revenue growth, EPS and stock price– An inability to accept failure– Excessive focus on beating the street

• Auditors– Aggressive interpretation of accounting standards– Independence compromised to obtain lucrative consulting

assignments

What went wrong in the recent past ?

• Employees– Compensation linked to stock-price movement– Large disparity between the highest and lowest paid employee– Culture of greed promoted within the organization by

management– Manipulative accounting practices

• Analysts– Ever-greening of reports with an eye on investment banking

assignments– Pressurized managements to beat quarterly estimates

• Investors– Short term focus of investors

Global Reactions• Regulatory reactions

– SOX (the Sarbanes–Oxley Act of 2002 )– NYSE/NASDAQ Rules– Clause 49 of listing agreement in India

• Corporate reactions– Focus on fundamentals of business models– Focus on strengthening internal controls and information

systems– Stock options – Enhanced disclosures in MD&A and Annual Reports– Guidance– Focus on critical accounting policies

Global Reactions

• Aggressive journalism– Accounting/Governance was the main story for months

• Glorification of the whistleblower– Time Magazine’s Person of the Year

Key Themes of Current Reforms

• Independent directors and audit committees have enlarged responsibilities

• Stricter independence standards for audit committees• Enhanced role of the whistle blower• Board effectiveness and integrity targeted by regulators,

politicians and the media• Compensation structures are under attack

Key Themes of Current Reforms

• New level of discipline brought to SEC reporting and under Clause 49– CEO/CFO certifications– Improvement in processes as effectiveness of internal controls

need to be certified– Improved processes and controls have connected the board to

the day to day functioning of the company

• Real time disclosure and shortened deadlines • Auditor independence • Repeal of self regulation for the auditing profession• Analyzing the analysts

Issues in Corporate Governance

• Asymmetry of power• Asymmetry of information• Interests of shareholders as residual owners• Role of owner management• Theory of separation of powers• Division of corporate pie among stakeholders

Separation of Ownership & Managerial Control

Basis of the modern corporation

Shareholders purchase stock, becoming Residual Claimants

Professional managers contract to provide decision-making.

Modern public corporation form leads to efficient specialization of tasks.

Shareholders reduce risk efficiently by holding diversified portfolios.

Risk bearing by shareholders.Strategy development and decision-makingby managers.

Agency Relationship

Risk Bearing Specialist(Principal)

Managers (Agents)

DecisionMakers

which createswhich creates

Managerial Decision-Making Specialist

(Agent)

Hire

An agency relationship exists when:

Shareholders (Principals)

Firm Owners

Agency Theory

The Agency problem occurs when:

The desires or goals of the principal & agent conflict and it is difficult or expensive for the principal to verify that the agent has behaved appropriately.

Example: Over - diversification: Greater product diversification leads to lower management employment risk & greater compensation.

Solution: Principals engage in incentive-based performance contracts, monitoring mechanisms like the board of directors & enforcement mechanisms like managerial labour market to mitigate agency problems.

Agency Theory

Product Diversification as an example of an Agency Problem

• Diversification usually increases the size of the firm – therefore complexity and an opportunity for top executives to increase their compensation.

• Diversification usually reduces top executives’ employment risk.

• Top executives have control over free cash flow and may invest in in products not associated with the firm’s current lines of business.

Ris

k

Level of Diversification

DominantBusiness

UnrelatedBusinesses

RelatedConstrained

RelatedLinked

Managerial(Employment)

Risk ProfileM

B

Shareholder (Business) Risk ProfileS

A

Manager & Shareholder Risk & Diversification

Agency Costs & Governance Mechanisms

• Managerial interests may prevail when governance mechanisms are weak.

• If the board of directors control managerial autonomy, the firm’s strategies should better reflect the interests of the shareholders.

Governance Mechanisms

Ownership Concentration

- Large block shareholders have a strong incentive to monitor management closely.

In Canada such shareholders account for 65% to 70% of publicly traded stocks (59% in the U.S.)

- Their large stakes make it worth their while to spend time, effort & expense to monitor closely.

- Institutional owners are financial institutions such as stock mutual funds and pension funds that control large-block shareholder positions.

Insiders

Outsiders

Boards of Directors

- Set compensation of CEO & decide when to replace the CEO.

- Formally monitor & control the firm’s top- level executives.

- May lack contact with day to day operations.

A firm’s CEO & other top-level managers

RelatedOutsiders

Individuals not involved with a firm’s day-to-day operations, but who have a relationship with the company

Individuals independent of a firm’s day-to-day operations and other relationships

Governance Mechanisms

Accountability of Board Members

• Increased diversity amongst board members.

• The strengthening of internal management & accounting control systems.

• The establishment & consistent use of formal processes to evaluate board’s performance.

• Directors are being required to own significant equity stakes as a prerequisite to holding a board seat.

Executive Compensation

Executive compensation: A governance

mechanism aligning the interests of managers

& owners through salaries, bonuses and long

term incentives such as stock options.

Stock options: A mechanism which links the

executive’s performance to the performance of

the company.

Market for Corporate Control

An external governance mechanism that becomes

active when a firms internal controls fail which is

triggered by a firm’s poor performance, relative

to industry competition.

A Basic List of Management Defence Tactics

Increase the costs of mounting a takeover and can entrench current management.

Greenmail Where company money is used to repurchase stock from a corporate raider to avoid takeover.

Golden Parachute Raises the cost of making changes at a take-over target due to the need to pay fired executives large severance packages.

Poison Pill When the takeover target does something to make itself unpalatable to the suitor (e.g. assume a large amount of debt and then issue dividends with the money).

Benchmarking corporate governance and value creation

The corporate value chain

The corporate value chain

Twin foci of benchmarking

• Two foci for analysis of relationships, stakeholder-wise:

• Value creation and management– An analysis of the company’s capabilities in

creating, maintaining and managing value, while balancing stakeholder interests

• Fairness and transparency in dealings– Processes in place to ensure fair and equitable

treatment of all stakeholders, prevent abuse of power, enable transparent reporting

Value creation, stakeholder-wise

Value creation, stakeholder-wise

Quality of management

Success of strategies

Track record of innovation

Reputation of management

Experience of management

Process Quality

Fairness & Transparency

Fairness & Transparency

Fairness & Transparency

Governance Mechanism & Ethical Behaviour

• Shareholders are recognized as a company’s most significant stakeholders.

• The minimum interests or needs of all stakeholders must be recognized through the firms actions.

• A firm’s strategic competitiveness is enhanced when its governance mechanisms take into consideration the interests of all stakeholders.

• Only when the proper corporate governance is exercised can strategies be formulated & implemented that will help the firm achieve strategic competitiveness & earn above average returns.

International scenarioYear Name of Committee/Body Areas/Aspects Covered

1992 Sir Adrian Cadbury Committee, UK

Financial Aspects of Corporate Governance

1994 Mervyn E . King’s Committee , South Africa

Corporate Governance

1995 Greenbury Committee , UK Directors’ Remuneration

1998 Hampel Committee, UK Combine Code of Best Practices

1999 Blue Ribbon Committee, US Improving the Effectiveness of Corporate Audit Committees

1999 OECD Principles of Corporate Governance

1999 CACG Principles for Corporate Governance in Commonwealth

2003 Derek Higgs Committee, UK Review of role of effectiveness of Non-executive Directors

2003 ASX Corporate Governance Council, Australia

Principles of Good Corporate Governance and Best Practice Recommendations

Indian scenarioYear Name of

Committee/BodyAreas/Aspects Covered

1998 Confederation of Indian Industry (CII)

Desirable Corporate Governance – A Code

1999 Kumar Mangalam Birla Committee

Corporate Governance

2002 Naresh Chandra Committee

Corporate Audit & Governance

2003 N. R. Narayana Murthy Committee

Corporate Governance

Objectives of good corporate governance

1. Strengthen management oversight functions and accountability

2. Balance skills, experience and independence on the board appropriate to

the nature and extent of company operations

3. Establish a code to ensure integrity

4. Safeguard the integrity of company reporting

5. Risk management and internal control

6. Disclosure of all relevant and material matters

7. Recognition and preservation of needs of shareholders

Clause 49 in Listing agreement

• The Listing agreement was first introduced by Bombay

Stock Exchange and later followed by other stock

exchanges

• SEBI, vide its circular dated February 21, 2000, specified

principles of corporate governance and introduced a new

clause 49 in the Listing agreement of the Stock

Exchanges.

• The Listing agreement contains 51 clauses

Clause 49 in Listing agreement

• Listing means admission of the securities

to dealings on a recognised stock

exchange. The securities may be of any

public limited company, Central or State

Government, quasi governmental and

other financial institutions/corporations,

municipalities, etc.

Clause 49 in Listing agreement

• Listing helps in free transferability , leads

to transparency in disclosure of

information and ensures official quotation

is available. 

Applicability of clause 49

All listed entities having a paid up share capital of Rs 3 crores and above or

net worth of Rs 25 crores or more at any time in the history of the company

For other listed entities which are not companies, but body corporate (e.g.

private and public sector banks, financial institutions, insurance companies

etc.) incorporated under other statutes, the revised Clause 49 will apply to

the extent that it does not violate their respective statutes and guidelines or

directives issued by the relevant regulatory authorities.

The revised Clause 49 is not applicable to Mutual Funds

Revised clause 49 has come into effect from January 1, 2006

Bird’s eye view of Clause 49

Annexure ContentsAnnexure I Clause 49 - Corporate Governance

Annexure I A Information to be placed before Board of Directors

Annexure I B Format of Quarterly Compliance Report on Corporate Governance

Annexure I C Suggested List of Items to Be Included in the Report on Corporate Governance in the Annual Report of Companies

Annexure I D Non-Mandatory Requirements

Annexure I

I. Board of Directors

II. Audit Committee

III. Subsidiary Companies

IV. Disclosures

V. CEO/CFO certification

VI. Report on Corporate Governance

VII. Compliance

Overview of Clause 49 - Corporate Governance

I. Board of Directors

(A) Composition of Board

(B) Non executive directors’ compensation and disclosures

(C) Other provisions as to Board and Committees

(D) Code of Conduct

II. Audit Committee

(A) Qualified and Independent Audit Committee

(B) Meeting of Audit Committee

(C) Powers of Audit Committee

(D) Role of Audit Committee

(E) Review of information by Audit Committee

Overview of Clause 49…

III. Subsidiary Companies

IV. Disclosures

(A) Basis of related party transactions

(B) Disclosure of Accounting Treatment

(C) Board Disclosures – Risk management

(D) Proceeds from public issues, rights issues, preferential issues etc.

(E) Remuneration of Directors

(F) Management

(G) Shareholders

Overview of Clause 49….V. CEO/CFO certification

a) Financial Statements

(i) Do not contain any materially untrue statement.

(ii) Present true and fair view of the state of affairs and are in compliance with AS and applicable laws..

b) No transactions entered is fraudulent or illegal.

c) Accepted the responsibility for establishing and maintaining Internal Controls for the purpose of financial reporting(amended on 13.1.2006)

d) Disclosed to the auditors and Audit Committee deficiencies in the design or operation of internal control.

VI. Report on Corporate Governance

VII. Compliance

Audit Committee

• Section 292A of The Companies

Act,1956

• Clause 49 II(A) Qualified and independent audit committee

(B) Meeting of audit committee

(C) Powers of audit committee

(D) Role of audit committee

(E) Review of information by audit committee

Section 292A Companies Act,1956

• Provision of this section came into effect on 13th December 2000

• Applicability to every Public Limited Company having a paid up capital of 5

Crores or more

• Three directors should be the member of Audit Committee (Two should be

non-executive)

• Chairman can be any Director

• Default in compliance shall be punishable with imprisonment for a term

which may extend to one year, or with fine which may extend to fifty

thousand rupees, or with both.