Module-3: Corporate Governance –Definitions, Meaning, Need & Principles

 

‘Corporate’ is derived from a Latin term “corpus” which means a “body”.

‘Governance’ means administering the processes and systems placed for satisfying stakeholders expectations. CG means a set of systems, procedures, policies, practices & standards put in place by a corporate to ensure transparent, honest and smooth relationship with its stakeholders.

A.  Corporate Governance: Definitions

Noble laureate Milton Friedman defined CG as “the conduct of business in accordance with shareholders’ desire, which is to make as much money as possible, while conforming to the basic rules of the society embodied in law and local customs”

James D Wolfensohn (9th President of World Bank): “CG is about promoting corporate fairness, transparency and accountability”.

OECD: “A system by which business corporations are directed and controlled”.

Cadbury Committee, UK: “ It is the system by which companies are directed and controlled”.

Report of Kumar Mangalam Birla Committee on CG constituted by SEBI(1999) defined CG as follows:

“Strong CG is indispensable to resilient and vibrant capital markets and is an important instrument of investor protection. It is the blood that fills the veins of transparent disclosure and high quality accounting practices. It is the muscle that moves a viable and accessible financial reporting structure”.

The Institute of Company Secretaries of India(2003) find “CG is the application of best management practices, compliance of law in true letter and spirit and adherence to ethical standards for effective management and distribution of wealth and discharge of social responsibility for sustainable development of all stakeholders”.

Kautilya’s Arthashastra maintains that for good governance, all administrators including the King were considered servants of the people. Good governance and stability were completely linked. If rulers are responsive, accountable and removable, there is stability. These tenets hold good even today.

B. Stakeholder

In a corporation, a stakeholder is a member of "groups without whose support the organization would cease to exist", as defined in the first usage of the word in a 1963 internal memorandum at the Stanford Research Institute. The theory was later developed and championed by R. Edward Freeman in the 1980s

The Corporate management decisions have an impact on various people and entities associated with the company who are collectively known as stakeholders which include shareholders, directors, creditors, employees, suppliers, government agencies and society at large.

But there are only key stakeholders like shareholders, directors, officers who are active participants in corporate governance process and other stakeholders who themselves are not involved in corporate governance practices but rather are recipients of benefits derived from companies having good corporate governance practices.

•      Shareholders

•      Employees

•      Vendors

•      Creditors

•      Customers

•      Government & Regulators

•      Banks & Financial Institutions

•      Local Community and

•      Society at large

Corporate Governance is the application of best management practices, compliance of law in true letter and spirit and adherence to ethical standards for effective management and distribution of wealth and discharge of social responsibility for sustainable development of all stakeholders.



Conduct of business in accordance with shareholders desires (maximising wealth) while conforming to the basic rules of the society embodied in the Law and Local Customs

C. Why Corporate Governance

Corporate governance refers to structures andprocesses for the direction and control of companies. Corporate governance concerns the relationships among the management, board of directors, controlling shareholders, minority shareholders, and other stakeholders. Good corporate governance contributes to sustainable economic development by enhancing the performance of companies and increasing their access to outside capital.

Investors now started considering corporate governance as very essential factor before investmentespecially in view of the unstable environment in the securities market. It is considered that good corporate governance inspires, strengthens and maintains investor’s confidence by ensuring company’s commitment to higher growth and profits. Corporate Governance has become a major concern for global economies particularly the transition world. Sound corporate governance is extremely important for transition economies for creation of the key institutions, the private corporations, which drive the successful economic transformation to a market based economy, effective allocation of capital and development of financial markets, attracting foreign investment and making a contribution to the process of national development. The Corporate Governance issue has emerged primarily because of the growing importance of corporations in the national economies and their interaction with the international agencies and institutions.


•      Better access to external finance

•      Lower costs of capital – interest rates on loans

•      Improved company performance – sustainability

•      Higher firm valuation and share performance

•      Reduced risk of corporate crisis and scandals

D. Pillars of Corporate Governance according to GE


The five major pillars of Corporate governance are

•      Independence

•       Procedures and structures are in place so as to minimise, or avoid completely conflicts of interest

•      Independent Directors and Advisers i.e. free from the influence of others

•      Accountability

•      Ensure that management is accountable to the Board

•      Ensure that the Board is accountable to shareholders

•      Fairness

•      Protect Shareholders rights

•      Treat all shareholders including minorities, equitably

•      Provide effective redress for violations

•      Responsibility 

•      The directors of the company are primarily responsible to the shareholders, employees and the whole society. The directors of the company should work in the best interests of the company and its employees. It is the duty of the directors to determine the responsibility of the management and employees. Also, management and employees should be held accountable to make sure that responsibilities are carried out properly. Shareholders want directors to be responsible to their needs and maximize the value of the firm. 

•      Transparency

•      Ensure timely, accurate disclosure on all material matters, including the financial situation, performance, ownership and corporate governance

Mere legislation does not ensure good governance; it flows from ethical business practices even when there is no legislation

D. Principles of Corporate Governance

The following are the main  principles of Corporate Governance

 (A).Effective Leadership:

The CEO’s leadership role in governance is fundamental(important);an indication of leadership is the effective way in which the organization as a whole works together under the CEO’s leadership. The Executives also has a collective responsibility to provide leadership ,communicating coherent governance principles throughout the agency and ensuring the operation of the checks and balances with effective governance demands.

1.Executive Leadership Group

2.Embracing better/more comprehensive management performance

3.Monitoring policies directed

4.Management Information System is in place

5.Reviewing its own process and effectiveness

 (B).Capable Management:

Capable management includes setting in place the broad principles under which the agency operates , including setting clear objectives and an appropriate ethical framework operating in the public interest; establishing due process; defining duty of care to the agencies client group etc..

(C).Diligent Monitoring:

Diligent Monitoring of risks, and the effectiveness of mitigating strategies, should include processes to access the delivery of outputs and quality of control systems overtime enabling the identification of corrective actions for continuous improvement. Systems operating in a changing environment require close monitoring.

(D).Responsible Risk Management:

Responsible risk management establishes process for identifying, analyzing and mitigating risks that could prevent the agency from achieving its business objectives

 (E).Clear Accountability and Responsibility:

  Clear accountability and responsibility is primarily through the CEO to the responsible Managers and the Executive Directors

 



General Functioning of Corporate Governance  within the above principles has a well laid out framework for operation as discussed below:


  1. The board approves corporate strategies that are intended to build sustainable long-term value; selects a chief executive officer (CEO); oversees the CEO and senior management in operating the company’s business, including allocating capital for long-term growth and assessing and managing risks; and sets the “tone at the top” for ethical conduct.
  2. Management develops and implements corporate strategy and operates the company’s business under the board’s oversight, with the goal of producing sustainable long-term value creation.
  3. Management, under the oversight of the board and its audit committee, produces financial statements that fairly present the company’s financial condition and results of operations and makes the timely disclosures investors need to assess the financial and business soundness and risks of the company.
  4. The audit committee of the board retains and manages the relationship with the outside auditor, oversees the company’s annual financial statement audit and internal controls over financial reporting, and oversees the company’s risk management and compliance programs.
  5. The nominating/corporate governance committee of the board plays a leadership role in shaping the corporate governance of the company, strives to build an engaged and diverse board whose composition is appropriate in light of the company’s needs and strategy, and actively conducts succession planning for the board.
  6. The compensation committee of the board develops an executive compensation philosophy, adopts and oversees the implementation of compensation policies that fit within its philosophy, designs compensation packages for the CEO and senior management to incentivize the creation of long-term value, and develops meaningful goals for performance-based compensation that support the company’s long-term value creation strategy.
  7. The board and management should engage with long-term shareholders on issues and concerns that are of widespread interest to them and that affect the company’s long-term value creation. Shareholders that engage with the board and management in a manner that may affect corporate decision making or strategies are encouraged to disclose appropriate identifying information and to assume some accountability for the long-term interests of the company and its shareholders as a whole. As part of this responsibility, shareholders should recognize that the board must continually weigh both short-term and long-term uses of capital when determining how to allocate it in a way that is most beneficial to shareholders and to building long-term value.
  8. In making decisions, the board may consider the interests of all of the company’s constituencies, including stakeholders such as employees, customers, suppliers and the community in which the company does business, when doing so contributes in a direct and meaningful way to building long-term value creation.


 

E. Elements of Good Corporate Governance(GCG)

It is all about governing a company with Transparency, Honesty, Openness and Conscience.

According to Organisation for Economic Cooperation and Development (OECD) the GCG is a system of process, practices, customs, polices, laws by which the companies are directed and controlled.

The Organisation for Economic Co-operation and Development (OECD) is an international organisation that works to build better policies for better lives

The importance of GCG goes beyond the interest of an individual company and it is crucial to the integrity and credibility of our market system.

The Organization of Economic Cooperation and Development released its first set of corporate governance principles in 1999. A revised version was then released in 2004.

The principles were developed and endorsed by the ministers of OECD member countries in order to help OECD and Non-OECD governments in their efforts to create legal and regulatory frameworks for corporate governance in their countries.

The six OECD Principles are:

  • Ensuring the basis of an effective corporate governance framework
  • The rights of shareholders and key ownership functions
  • The equitable treatment of shareholders
  • The role of stakeholders in corporate governance
  • Disclosure and transparency
  • The responsibilities of the board

Ensure the basis of an effective corporate governance framework

The corporate governance framework should promote transparent and efficient markets, be consistent with the rule of law and clearly articulate the division of responsibilities among different supervisory, regulatory and enforcement authorities.

The rights of shareholders and key ownership functions

The corporate governance framework should protect and facilitate the exercise of shareholders’ rights.

Basic shareholder rights should include the right to:

  1. Secure methods of ownership registration;
  2. Convey or transfer shares;
  3. Obtain relevant and material information on the corporation on a timely and regular basis;
  4. Participate and vote in general shareholder meetings;
  5. Elect and remove members of the board; and
  6. Share in the profits of the corporation.

The equitable treatment of shareholders

The corporate governance framework should ensure the equitable treatment of all shareholders, including minority and foreign shareholders. All shareholders should have the opportunity to obtain effective redress for violation of their rights. The principles also state that:

  • All shareholders of the same series of a class should be treated equally
  • Insider trading and abusive self-dealing should be prohibited
  • Members of the board and key executives should be required to disclose to the board whether they, directly, indirectly or on behalf of third parties, have a material interest in any transaction or matter directly affecting the corporation.

The role of stakeholders in corporate governance

The corporate governance framework should recognize the rights of stakeholders established by law or through mutual agreements and encourage active co-operation between corporations and stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises.

Disclosure and transparency

The corporate governance framework should ensure that timely and accurate disclosure is made on all material matters regarding the corporation, including the financial situation, performance, ownership, and governance of the company.

The responsibilities of the board

The corporate governance framework should ensure the strategic guidance of the company, the effective monitoring of management by the board, and the board’s accountability to the company and the shareholders.

 

F.  Advantages/Benefits of Corporate Governance

 

(1). Enhancing overall company performance.

(2). Preparing a small enterprise for growth, and so helping to secure new business opportunities when they arise.

(3). Increasing attractiveness to investors and lenders , which enables faster growth.

(4). Increasing the company’s ability to identify and mitigate risks, manage crises and respond to changing market trends.

(5). Increasing market confidence as a whole.

(6). All companies suffer from corporate scandals, which scare potential investors away from the market.

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