Module-3

Corporate Governance

Module overview
Definition, Market model and control model OECD on corporate governance Historical perspective of CG Issues, Relevance, need and importance in CG Benefits of good CG Concept of corporate and Governance Theoretical basis for CG, Obligation to society, investors, emp, customers, manager Indian Cases

What is Corporate Governance?

Corporate governance is dealing with problems that result from the separation of ownership and control. corporate governance would focus on:
The internal structure and rules of the board of directors; the creation of independent audit committees; rules for disclosure of information to shareholders and creditors; control of the management.

Definition
It is a system by which companies are directed and controlled (OECD) It is a set of relationships b/w a companys management, board, shareholders and stakeholders

How a corporation is structured

I n s t i t u t i o n a l c o n t e x t

The market model

Shareholder environment Independence and performance

Dispersed ownership
Sophisticated Institutional investors

Non-executive majority boards

Aligned incentives, effective control

C o r p o r a t e c o n t e x t

Active private equity And IPO market

High disclosure

Active take-over market

Shareholder equality Transparency and accountability 6

Capital market liquidity

Market model
Market model governance chain , there are efficient, well developed equity markets and dispersed ownership, common in the developed industrial nations such as US,UK, Canada and Australia.

I n s t i t u t i o n a l c o n t e x t

The control model

Shareholder environment Concentrated ownership Independence and C performance o Insider boards r p o Incentives aligned r with core shareholders, a ineffective control t e Limited disclosure c o n t e x t

Reliance on family, bank and public finance

Underdeveloped IPO market

Limited takeover market

Lack of minority protection Transparency and accountability 8

Capital market liquidity

Control model
The governance chain is represented by
underdeveloped equity markets, concentrated family ownership, less shareholder transparency and inadequate protection of minority and foreign shareholders.

More familiar in Asia, Latin America and some east European nations.

OECD on Corporate Governance

The OECD (org for economic corporation and development) has emphasized the foll requirements of corporate governance
Rights of shareholders Equitable treatment of shareholders Role of stakeholders in CG Disclosure and transparency Responsibilities of the board

Right of shareholders
Include secure ownership of their shares, voting rights, the right to full disclosure of information, participation in decisions on sale or any change in corporate assets (mergers). Have right to know the capital structure of the corporation Transactions should be at transparent prices and under fair conditions

Equitable treatment of shareholders

Minority and foreign shareholders should get equitable treatment. Get equal opportunity for redressal of their grievances and violation of their rights. Should not face undue difficulties in exercising their voting rights. Directors should disclose any material interest regarding transactions. Avoid situations involving conflict interest while making decisions

Role of stakeholders in CG
There are stakeholders apart from shareholders Dealers, consumers, Govt. and others like banks, bondholders and workers are imp for companies to perform and make decisions CG framework should allow emp representation on board of directors, profit sharing, creditors , involvement in insolvency proceedings.

Disclosure and transparency

Disclose key information about
financial details, operating results, governance structure and policies, BOD their remuneration, foreseeable risk factors, issues regarding emp & other stake holders.

Annual audits should be performed.

Responsibilities of the board

Functions include
corporate strategy, risk, executive compensation and performance, accounting and reporting systems, monitoring effectiveness and changing them if needed.

Historical perspective on CG
The seed of CG was sown by the Watergate scandal during the Nixon presidency in US. The need to arrest such unhealthy trend translated into the legislation of Foreign and Corrupt Practices Act of 1977 in US. The Treadway commission report (1987) to identify the misrepresentation in financial reports. Committee of sponsoring org (COSO) came into being in 1992 stipulated a control framework for the orderly functioning of corporations.

Historical perspectives on CG
In England, Sir Adrian Cadbury was entrusted in 1991, by the London stock exchange. Cadbury committee had the task of drafting a code of practices to assist corporations in defining and applying internal controls to limit their exposure to financial loss. Bank failures in west necessitated close monitoring of the banking system so the Basel committee worked in this field.

Issues in CG
1. Distinguishing the roles of board and management 2. Composition of the board and related issues 3. Separation of the roles of the CEO and chairperson 4. Should the board have committees? 5. Appointments to the board and directors reelection

Issues in CG
6. Directors and executives remuneration 7. Disclosure and audit 8. Protection of shareholder rights and their expectations 9. Dialogue with institutional shareholders 10.Should investors have a say in making a company socially responsible

Distinguishing the roles of board and management

The board of a listed company has the foll functions
Select, decide the remuneration and evaluate on a regular basis and when necessary, change the CEO Oversee the conduct of the co. business to evaluate whether or not it is being correctly managed Review and approve co. financial objectives and corporate plans Render advice and counsel top mgmt Identify and recommend candidates to shareholders for electing them to BOD Review system to comply all applicable laws and regulations

Composition of board and related issues

BOD- committee selected by the shareholders of a limited co. to be responsible for the policy of the co.
Board of Directors
Non-executive directors

Executive directors

Independent directors

Affiliated directors (nominee directors)

Composition of board and related issues

Executive director is one who is an executive of the co. and also a member of the BOD Non-executive director has no separate employment relationship with the co. Independent non-executive directors are those directors on the board who are free from any business or other relationships which could materially interfere, with the exercise of their independent judgment in the process of decision making as a member of a board. An affiliated director or a nominee director is a non executive director who has some kind of independence, impairing relationship with the co.

Separation of the roles of the CEO and the chairperson

The role of CEO is to lead the senior management team in managing the enterprise. The role of the chairperson is to lead the board, imp responsibility of the board is to evaluate the performance of senior executives including the CEO

Should the board have committees?

Committees on CG have recommended appointment of special committees for
Nomination Remuneration Auditing

These committees lessen the burden of the board and enhance its effectiveness

Appointments to the board and directors re-election

Shareholders are a legion in large co. and also scattered and to have them together to elect the directors will be expensive and time consuming In actual practice, the board or its committee selects and appoints the prospective director and gets the person formally elected by the shareholders at the ensuring annual general body meeting

Directors and executives remuneration

CG laid emphasis on issues such as
Transparency Pay for performance Process for determination Severance payments Pensions for non-executive directors

Disclosure and audit

Cadbury report and Bosch report stressed that the BOD has a bounden responsibility to present the shareholders a lucid and balanced assessment of the co. financial position through audited financial statements.

Protection of shareholder rights and their expectations

Corporate practices vary from country to country. Various committees and org that have addressed the issues
Should co. adhere to one share one vote principle? Should co. retain voting by a show of hands or by poll? Should shareholder approval be required for all major transactions? Can shareholders resolution be bundled?

Dialogue with institutional shareholders

Cadbury committee recommends that institutional investors should maintain regular and systematic contact with co. apart from their participation in general meetings of shareholders, use voting rights, take interest in composition of BOD.

Should investors have a say in making a co. socially responsible corporate citizen?
Conflict b/w 2 schools of thought 1- based on assumption that socially responsible behavior of corporations such as ecological preservation, anti-pollution measures and producing quality and environment friendly products 2- who work to make their gains
Dove chemicals, Johnson & Johnson, Pfizer, to prove this

Relevance of CG
The separation of ownership from management creates an issue of trust. Management has to be trusted to run the company in the interest of shareholders and stakeholders. Information is not available to all stakeholders in the same form at the same time. In real world of imperfect information, each agent will use whatever information advantage he may have.

Need and importance of CG

Corporations are multinational/transnational in nature- impact on citizens of several counties across the globe If things go wrong it will affect many countries It is needed to create a corporate culture of consciousness, transparency and openness It will lead to increase in customer satisfaction and shareholder value and wealth Environment is being ensured to be transparent and accountable.

Benefits of good CG
1. Creation and enhancement of a corporations competitive advantage 2. Enabling a corporation perform efficiently by preventing fraud 3. Providing protection to shareholders interest 4. Enhancing the valuation of an enterprise 5. Ensuring compliance of laws and regulations

Concept of Corporate
Corporate has contributed much to the growth of market driven economies. Corporate is the nucleus of all business activities in modern economies Lawyers and economists describe the corporate as a nexus of contracts the corporation is nothing more than the sum of all of the agreements leading to its creation.

What is a corporate?
A corporation is an association of persons recognized by the law as having a collective personality. Characteristics of a corporate:
Incorporated association Artificial legal existence Perpetual existence Extensive membership Separation of management and ownership Limited liability and transferability of shares

What is a corporate?
The corporate of today differs from individual capitalist in 2 aspects
The life span of the corporation is much longer It is more rational in decision making by virtue of the fact that it has the benefit of the collective wisdom of the BOD. They take decisions using the principles of cost accounting, budget analysis, data collection and processing and managerial consulting

The concept of governance

Governance means the process of decision making and the process by which decisions are implemented Governance focuses on the formal and informal players involved in decision making and implementing the decisions made.

Theoretical basis of CG
4 broad theories to explain and elucidate CG
Agency theory Stewardship theory Stakeholder theory Sociological theory

Agency theory
In modern corporation, where share ownership is widely held, managerial actions depart from those required to maximize shareholder returns. In agency theory terms, the owners and the principals and the managers are the agents and there is an agency loss, which is the extent to which returns to the owners fall. Agency theory specifies mechanisms that reduce agency cost

Agency theory
There are 2 broad mechanisms that help reduce agency costs and hence, improve corporate performance through better governance
Fair and accurate financial disclosures Efficient and independent BOD

Stewardship theory
This theory assumes that managers are basically trustworthy and attach significant value to their own personal reputations. It defines situations in which managers are stewards whose motives are aligned with the objectives of their principles. A stewards behavior will not depart from the interests of his/her org. Control can be potentially counterproductive, because it undermines the pro-organizational behavior of the steward by lowering his/her motivation.

Behavioral differences
Agency theory Stewardship theory

Manager acts as agent

Governance approach is materialistic Behavior pattern is individualistic, opportunistic, self-serving Managers are motivated by their own objectives Interests of the managers and principals differ

Managers act as stewards

Governance approach is sociological and psychological Behavioral pattern is collective, proorganizational, trustworthy Managers are motivated by the principals objective Interests of the manager and principals converge

The role of the management is to monitor The role of the management is to and control facilitate and empower Owners attitude is to avoid risks Principal manager relationship is based on control Owners attitude it to take risks Principal manager relationship is based on trust

Psychological mechanisms
Agency theory Motivation revolves around Lower orders Extrinsic needs Social comparison is b/w compatriots There is little attachment to the company Power rests with the institution Stewardship theory Motivation revolves around Higher order needs Intrinsic needs Social comparison is b/w principals There is great attachment to the company Power rests with the personal

Situational mechanisms
Agency theory Management philosophy is control oriented To deal with increasing uncertainty and risk, the theory advocates exercise of Greater controls More supervisions Risk orientation is done through a system of control Time frame is short term The objective is cost control Cultural difference revolve around Individualism Larger power distance Stewardship theory Management philosophy is involvement oriented To deal with increasing uncertainty and risk, the theory advocates exercise of Training and empowering people Making jobs more challenging and motivating Risk orientation is done through trust Time frame is long term The objective is improving performance Cultural difference revolve around Collectivism Small power distance

Stakeholder theory
The theory is grounded in many normative, theoretical perspectives including ethics of care, the ethics of fiduciary relationships, social contract theory, theory of property rights, and so on. Stakeholder theory is often criticized mainly because it is not applicable in practice by corporations.

Sociological theory
This theory has focussed mostly on board composition and wealth distribution. Under this theory, board composition, financial reporting, and disclosure and auditing are of utmost importance to realize the socio-economic objectives of corporations.

Obligations to society at large

A corporation is a creation of law, as an association of persons forming part of the society in which it operates. Its activities are bound to impact the society as the societys values would have an impact on the corporation. Therefore, they have mutual rights and obligations to discharge for the benefit of each other.

Obligations to society at large

National interest Political non-alignment Legal compliances Rule of law Honest and ethical conduct Corporate citizenship Ethical behavior Social concerns CSR

Obligations to society at large

Environment friendliness Healthy and safe working environment Competition Trusteeship Accountability Effectiveness and efficiency Timely responsiveness Corporation should uphold the fair name of the country

Obligations to investors
Towards shareholders Measures promoting transparency and informed shareholder participation Transparency Financial reporting and records

Obligation to employees
Fair employment practices Equal opportunities employer Encouraging whistle blowing Humane treatment Participation Empowerment Equity and inclusiveness Participative and collaborative environment

Obligation to customers
Quality of products and services Products at affordable prices Unwavering commitment to customer satisfaction

Managerial obligation
Protecting companys assets Behavior towards government agencies Control Consensus oriented Gifts and donations Role and responsibilities of corporate board and directors Direction and management must be distinguished Managing and whole time directors

END OF MODULE-3
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