Corporate Governance

A Subject Whose Time

Has Come
ARUN KUMAR TRIPATHY
MDI GURGAON
 Corporate Governance
What does a CEO do when the compensation consultant advises the board that his
compensation is too high ? (made $550million, stock 78% down)
For a company in a financial services sector, how many directors should be there having
an expertise in the given sector ?
What should an ex army general do when he participates in a tour for securities analysts
that included a fake trading floor ? (Paid $31 million)
What does a CEO do when one of the institutional investor votes against a proposed
merger ?
What does a board do when a CEO employment contract includes conviction of a felony
was not grounds of termination?
What does a board do when a special purpose entity is created to move some of its
debt off the balance sheet ?

What is wrong here ? How did so many different people in so many different roles make
so many bad decisions ?

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Evolution of Corporate Governance
In the early days, limited-liability companies were relatively
small and simple- Shareholders drawn from wealthier
classes
In those days there were no chains of financial institutions,
pension funds, hedge funds, brokers, or agents between the
investor and the boardroom.
But some companies became large and complex. Their
shareholders numerous, geographically spread, with
different needs and expectations.
The rise of the modern corporation has brought a concentration of
economic power which can compete on equal terms with the modern
state - economic power versus political power, each strong in its own
field. The state seeks in some aspects to regulate the corporation, while
the corporation, steadily becoming more powerful, makes every effort to
avoid such regulation
Berle and Means 1932, revised 1967

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Corporate Governance - Definitions
Operational: Corporate governance is the process by which
companies are directed and controlled (Cadbury Report
1992 and OECD 1999).
Relationship: Corporate Governance is a relationship
among stakeholders that is used to determine and control
the strategic direction and performance of organizations.
The primary participants are the shareholders, the
management and the board of directors (Monks and
Minow 2001).
Stakeholder: Corporate governance is the process by which
corporations are made responsive to the rights and wishes
of stakeholders (Demb and Neubauer, 1992).

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Corporate Governance Structure
The corporate governance structure specifies the distribution of
rights and responsibilities among the different participants in the
organization such as the board, managers, shareholders and other
stakeholders and lays down the rules and procedures for decision-
making (OECD 2002)
Executive management is responsible for running the enterprise:
the governing body ensures that it is running in the right direction
and being run well
Directors are responsible for setting the organizations direction,
formulating strategy and policy making.
The board is responsible for supervising management and being
accountable.
"The directors of companies, being the managers of other people's money rather than
their own, cannot well be expected to watch over it with the same anxious vigilance with
which (they) watch over their own.
Adam Smith, The Wealth of Nations

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Source: Bob Tricker-Corporate Governance

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Governance and Management

Management runs the business:

the board ensures that the business is well run
and running in the right direction

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Business- Wealth
How Business Creates Wealth ?
Inputs Outputs

Land Products
Labour Business /
Capital Services

Outputs valued more by society than the inputs used!

Division of Wealth- Profits, Consumer surplus, Taxes

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BGS Models
Market capitalism model
Business of business is business- Milton Friedman
Socialism
Which is best - Capitalist economy, Socialist
economy, or a Mixed economy?
Stakeholder model

Corporations- Limited liability

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Stakeholder Model

Ref: Book- Steiner and Steiner

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 Agency Dilemma
In simple contracts there may be just one principal and one
agent, In a limited-liability company there may be many
principals (shareholders) and their agents (directors)
Interests of the shareholders are not homogeneous as their
number and diversity increase.
As listed companies grew and their shareholders became
more diverse, the separation between owners and directors
magnified and power shifted towards the directors, which
some of them abused. (Berle and Means- 1932)
Today agency relationships can involve strings of agency
relations. Tracing the agency chain can be difficult, and
establishing the exposure to agency risk impossible.

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Agency Dilemma
The agency dilemma can occur in private companies,
joint ventures, not-for-profit charities, health and
education bodies, professional institutions, and
governmental bodies.
Wherever there is a separation between the members
and the governing body, the agency dilemma can arise
Responses to the agency dilemma include:
Demands for reporting and transparency
Requirements for accountability and audit
Independent directors
Separation of chairman and CEO
Other regulations and legal requirements
Corporate governance codes and principles

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Agency Theory
As an explanation of how the public corporation could exist, given that:
Managers are self interested, and
Context in which managers do not bear the full wealth effects of their decisions.

Contract under which one or more persons (shareholders) engage another

person/s (directors) to act on their behalf, delegating decision making
authority.

If both parties are utility maximizers agents will tend to act in

their own interests and not always in the best interest of their
principal.
Jensen and Meckling 1976

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Agency Issues
Agency problem arises due to asymmetrical access to information -
Directors know far more about the corporate situation than the
shareholders.
Normally, shareholders have to rely on the directors to decide what
information they should have, over and above the minimum required by
regulation and company law.
Agency theory statistically powerful,
Theoretical approach to corporate governance - statistically rigorous
results, relationship between governance attributes and
performance.

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Limitations
Focus on specific issues,
Dynamics of board behaviour.
Statistical methods will not explain the reality of the boardroom.
Agency theory takes a view on the nature of man:
that people are self-interested not altruistic
that directors will act in their own interests not the best interests of their
shareholders
essentially that people cannot be trusted

The legal concept of the corporation, and the basis of

stewardship theory takes the opposite view

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 Stewardship Theory
Underpins the legal concept of the company
Incorporated entity, shared ownership the basis of power
Conflicting societal objectives resolved by:
free markets
legislation to protect other stakeholders
- employees (e.g. employment law, safety law)
- consumers (e.g. consumer protection law)
- suppliers (e.g. contract law)
- society (e.g. environmental law)
Stewardship theory remains the theoretical foundation for companies
legislation

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 Stewardship Theory
Lord Cairns 1874
No man, acting as agent, can be allowed to put himself into a position in which his interest and his
duty will be in conflict

Concept of the company based on directors fiduciary duty - the belief that directors can be
trusted. It is by choice.
Under the law directors have a fiduciary duty to their shareholders. Directors are trusted to
be stewards for the shareholders interest
Stewardship theorists argue that, clearly, this is what most directors actually do. Some fail,
but this does not invalidate the basic concept
Critics -In listed companies shareholders are remote from the company
shareholders do not nominate the directors
financial reports have become largely unintelligible
complex corporations lack transparency
directors are not really accountable to shareholders
consolidated group accounts do not explain complex groups

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Corporate Governance -In
search of its paradigm
Pettigrew (1992):

corporategovernance lacks any form of coherence,

either empirically, methodologically or theoretically
with only piecemeal attempts to try and
understand and explain how the modern
corporation is run.
Theoretical underpinnings of the subject are still
weak, lack a conceptual framework
Blind leading the Blind

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Linkage- Governance and Performance
Does good corporate governance produce better corporate
performance?
Recent research findings
Stock market pays premium for companies seen to be well governed -
reduces their risk
Limited correlation found between good corporate governance
practices and corporate performance.
Study published by the Association of British Insurers (ABI) in 2008
(Selvaggi and Upton, 2008) suggests there is a robust causal relationship
between good corporate governance and superior company
performance.
HR- Given a choice, employees prefer working for companies having
better corporate governance practises.

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 Principal- Principal Conflicts

Principal- Agent Conflicts Profession

(PA) al
Managers

Widely-dispersed shareholders
(Principals)

Managers affiliated
Principal- Principal Conflicts with controlling
(PP) shareholders (
Principals)
Controlling
Shareholder
Source: Corporate Governance in Emerging Economies:
s A Review of the Principal- Principal Perspective Young
et al.

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 PP Vs. PA Conflicts
PA Conflicts PP Conflicts
Goal Between fragmented, dispersed Between controlling and minority
Incongruence shareholders and professional managers shareholders
Manifestations Benefit entrenched managers (e.g. shirking, Benefit controlling shareholders (e.g.
pet projects, excessive compensation, and minority shareholder expropriation,
empire building) nepotism)

Protection of Formal constraints (e.g. judicial reviews and Formal institutional protection is
minority courts) often lacking, corrupt, or un-
shareholders enforced.

Market for Active as a governance mechanism of last Inactive even in principle.

corporate control resort Concentrated ownership thwarts
notions of takeover.

Ownership Dispersed Concentrated

pattern
Board Of Legitimate legal and social institutions Yet to establish institutional
Directors legitimacy and thus are ineffective.

Top management Appointed after extensive search and Typically family members or
team scrutiny of qualifications associates.

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Board Activities

Outward
looking Providing Strategy
Accountability Formulation

Approve and work with

and through the CEO

Monitoring and Policy

Inward Making
Supervising
looking

Past and Future

present focused focused

Corporate Governance- By Bob Tricker

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BOD Requirements
BOD Legal Requirement : 50% should be NEDs, At least 1 Woman Director, 1
Resident Director. If Chair is Executive or Promoter or related than at least
50% should be IDs.
Specific requirements are put as to what the BoD should be doing : Code of
Conduct, Succession Planning, Directors Rem, Ids Role and Responsibilities
etc.
Not Covered : Speciality Mix (Depends upon nature of Company)
Minimum Representation : 1 from Legal, 1 from Finance, 1 from Strategy, 1
from HR, 1 from IT and 2 from operating sector (ED) (Considering a total
strength of 12).
Theory of BBB (Body, Brain and Beauty)
Pre Meeting Discussion, Regular Board Events, Relations & Board Mandate
Non-Discrimination amongst Board Members especially having PE
Representation.

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Board of Directors- Overview
who is on the board ?
Irrespective of whether they are a positive force, a negative
force, or completely neglectful and ineffective, they play a
crucial role in corporate strategy, reputation, and
sustainability.
Corporate Governance challenge: how to grant managers
enormous discretionary power over the conduct of the
business while holding them accountable for the use of that
power.

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Executive Compensation
Risk Incentive trade off-
Fixed versus variable salary
Asymmetric Information
Several Ways to Pay Day
The guaranteed bonus the ultimate oxymoron
Compensation plans that are all upside and no downside,
Loans
Manipulation of earnings to support bonuses
Huge disparity between CEO and other top executives
Backdating, bullet-dodging and spring-loading option

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Executive Compensation
CEO compensation per dollar of net income earned for the 365 biggest publicly
traded American companies fell by 33 percent during 1960 and 1980.
CEOs earned more for their shareholders for steadily less and less relative compensation.

CEO compensation per dollar of net earnings produced doubled in the decade from
1980 to 1990.
CEO compensation quadrupled during 1990 to 2000.
Real performance was declining,
1933 to 1976, real compound annual return on the S&P 500 was 7.5 percent.
Since 1976,the total real return on the S&P 500 was 6.5 percent (compound annual).

In India, 50 CEOs who got Rs 10 million + (per year) in fiscal 2008

4 out of every 5 got a pay hike- even as half of the companies covered reported
lower profits or losses in 2008 over the previous year.
CEO takes 27% hike as profit dips- Economic times, 2009
Companies are based on the S&P 500. CEOs total compensation is drawn from
SEC proxy filing statements as of 8/14/2015. Ref: www.glassdoor.com
CEO Pay Vs Median Staff Pay
Company CEO Ratio Salary (in Rs)
Reliance Mukesh Ambani 205 15Cr (last 7yrs)
ITC Deveshwar 439 15Cr
Wipro Kurien 170
HDFC Keki Mistry 83
HDFC Bank Aditya Puri 117 7.4 Cr
ICICI Bank Chanda Kocher 97
Axis Bank Shikha Sharma 74
Infosys Vishal Sikka 116 (48.73Cr)
Vedanta Navin Agarwal 293 Over 15 Cr
Executive Compensation:
Current Situation
Fortune 500 companies, the average CEO pay was $13.8 million a year,
while the average median worker pay was about $77,800 and the
average ratio of CEO pay to median worker pay was 204.
The analysis of Indian CEOs salaries in top listed companies for FY 2015-
16 shows that the average remuneration paid to the top executives was
approximately Rs. 19 crore.
Average salary of (top listed private companies) Indian CEOs doubled
from 10Cr to 20Cr in two years.
AM Naik- L&T- Rs 66.14 Cr, Sikka- Infosys- Rs 48.73 Cr, Desh Bandhu-
Lupin- Rs 44.8 Cr
Companies will be required to disclose the ratio of CEO pay to median
worker pay- SEBI and SEC
 Corporate Governance - India
2000 - task force chair Dr. Sanjeev Reddy, to 'sharpen India's global competitive edge
2002 (post Enron) high-level committee chair Shri Naresh Chandra to examine
corporate auditing and independent directors
independent directors to represent at least 50% of the board of listed companies
strengthened the definition of independence
called for the rotation of audit partners (but not audit firms)

2003 - Securities and Exchange Board (SEBI) to 'evaluate the adequacy of existing
corporate governance practices.' chair Narayana Murthy, chairman of Infosys
covered:
audit committees, risk management, director remuneration, codes of conduct
role of independent directors

2007 - government issue guidelines on corporate governance in central public sector

enterprises covering the composition of boards, audit committees, management of
group companies, accounting standards and risk management

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Corporate Governance-
Unresolved Issues
A paradox
Greater a director's independence the less he is likely to know about the
company
The more a ind Director knows about the company, the greater his potential
contribution, the less his perceived independence

How should directors remuneration be determined?

Should chief executive officer ever be board chairman?
Should a retiring CEO ever become chairman of the
board?
Can external auditors really be independent?

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Thank you.
QUESTIONS