UNIT III

Capitalism at Cross Roads The beginning of the twenty-first century was marked by the emergence of corporate governance, as a solution to the collapse of several high-profile corporations, both in the USA and elsewhere. The business world was shocked beyond belief with both the scale and degree of illegal and unethical corporate practices. As a result, the need for the adoption of good corporate governance principles has been reinforced, and inevitably and inextricably, efforts to this end have gathered momentum every time a new corporate scandal came to light.1 Corporates in the very citadel of capitalism, the United States of America, were mired in problems and were going through a grave crisis of credibility during the very early years of the new millennium. Companies that were held out till then as role-models in corporate governance were being threatened with widespread exposures of accounting irregularities and fraudulent practices. The Securities and Exchange Commission (SEC) set up under the New Deal to combat the Great Depression, appeared to be inadequately equipped to deal with gigantic business conglomerates such as Xerox, WorldCom and Enron that committed deliberate frauds with a view to boosting their sales revenues and for showing highly inflated profits.

Increasing Awareness Thus, in the aftermath of economic liberalisation, corporate heavyweights have started mulling over the buzz phrase of corporate governance in hastily convened conclaves and conferences. Apart from the Department of Company Affairs and the Institute of Company Secretaries, the Federation of Indian Chambers of Commerce and Industry (FICCI), the Confederation of Indian Industry (CII), which has worked out a code of corporate governance, the Securities and Exchange Board of India (SEBI) and the Association of Mutual Funds in India (AMFI) just to name a few apex bodies, have discussed it with all the seriousness it deserved. The Industrial Credit and Investment Corporation of India (ICICI) has implemented an internal corporate governance code about ten years ago.

Global Concerns There are fewer concerns more central to international business and developmental agendas than that of corporate governance. A series of events over the last two decades have placed corporate governance issues at the centre stage both for the international business community and for international financial institutions. Apart from colossal business failures and serious frauds in the USA, several high-profile scandals in Russia and the Asian crisis have brought corporate governance issues to the forefront in developing countries and transition economies. The virtual collapse of the Russian economy in 1998 resulted in large measure from the weakness of governance mechanisms.

Theoretical Basis of Corporate Governance There are four broad theories to explain and elucidate corporate governance. These are: (i) Agency Theory (ii) Stewardship Theory (iii) Stakeholder Theory and (iv) Sociological Theory. Agency Theory Recent thinking about strategic management and business policy has been influenced by agency cost theory, though the roots of the theory can be traced back to Adam Smith who identified an agency problem (managerial negligence and profusion) in the joint stock company. The fundamental theoretical basis of corporate governance is agency costs. Shareholders are the owners of any joint stock, limited liability company, and are the principals of the same. By virtue of their ownership, the principals define the objectives of a company. The management, directly or indirectly selected by shareholders to pursue such objectives, are the agents. While the principals generally assume that the agents would invariably carry out their objectives, it is often not so. In many instances, the objectives of managers are at variance from those of the shareholders. For instance, a chief executive may want to increase his managerial empire and personal stature by using the companys funds to finance an unrelated diversification, which could reduce long term shareholder value. The shareholders and other stakeholders of the company, may not be able to counteract this because of inadequate disclosure about such a decision and because the principals may be too scattered or even not motivated enough to effectively block such a move. Such mismatch of objectives is called the agency problem; the cost inflicted by such dissonance is the agency cost. The core of corporate governance is designing and putting in place disclosures, monitoring, oversight and corrective systems that can align the objectives of the two sets of players as closely as possible and, hence, minimise agency costs.

Corporate Governance Mechanisms Why Corporate Governance? As has been pointed out earlier, the joint-stock, limited liability company has become the preferred organisation for running business throughout the world. It has proved its worth in providing employment, generating wealth, and contributing to economic and social development. The original concept of the company, which stems from the mid-nineteenth century, has proved immensely innovative, elegantly simple and highly successful. In the limited liability company, the business is incorporated as an independent legal entity, separate from its owners, whose liability for its debts is limited to the amount of equity capital they have agreed to subscribe to. In law, the company has many of the rights of a legal person to buy and sell, to own assets, to incur debts, to employ, to contract and to sue and be sued. The company has a life of its own different from those of its innumerable owners. Although this does

not guarantee perpetuity, it does give the company an existence independent of the life of the proprietors, who can transfer their shares to others. Corporate Governance Systems The board of directors seldom appears on the management organisation chart yet it is the ultimate decision making body in a company. The role of management is to run the enterprise while the role of the board is to see that it is being run well and in the right direction. Management always operates as a hierarchy. There is an ordering of responsibility, with authority delegated downwards through the organisation and accountability upwards to the ultimate boss. By contrast, the board members need to work together as equals, reaching agreement by consensus or, if necessary, by voting. In almost all dispensations each director bears the same duties and responsibilities under the law. A useful way of depicting the interaction between management and the board is to present the board as a circle superimposed on the hierarchical triangle of management. Indian Model of Governance The Indian corporates are governed by the Companys Act of 1956 that follows more or less the UK model. The pattern of private companies is mostly that of closely held or dominated by a founder, his family and associates. Figure 2.4 illustrates how the corporate governance system works in India. Indian corporates are governed by the Companys Act of 1956 which follows more or less the UK model. The pattern of private companies is mostly that of closely held or dominated by a founder, his family and associates. India has adopted the key tenets of the Anglo-American external and internal control mechanism after economic liberalisation.

Figure 2.4 Indian Corporate Governance Model

Available literature on corporate governance and the way companies are structured and run indicate that India shares many features of the German Japanese model, but of late, recommendations of various committees and consequent legislative measures are driving the country to adopt increasingly the Anglo-American model. In terms of the legislative mechanisms, Indian government and industry constituted three committees to study corporate governance practices in the country and suggest measures for improvement based on what has globally recognised as best practices. Significantly, most of the recommendations of the three committeesthe SEBI-appointed Kumar Mangalam Birla Committee (2000), the government-

appointed Naresh Chandra Committee(2003) and the SEBIs Narayana Murthy Committee are remarkably similar to those of Englands Cadbury Committee and Americas Sarbanes-Oxley Act, in terms of their approaches and recommendations. The emergence of corporate governance as a fair and transparent mechanism to run and administer corporations in a manner that would result in long term shareholder value and benefits to the entire society has been fairly a recent phenomenon. There has been a perceptible change in peoples minds as to the objective of a corporationfrom one which was intended to benefit the shareholders to one which is expected to benefit all its stakeholders. Besides, the corporate scams and frauds that came to light have brought about a change in the thinking of advocates of free enterprise that the system was not self-regulatory and needed substantial external regulations. These regulations should penalise the wrongdoers while those who abide by the rule....albeit Corporate Governance Committees The main committees to study and discuss issues of corporate governance and known by the names of the individuals who chaired them, are dicussed below: Cadbury Committee on Corporate Governance, 1992 The stated objective of the Cadbury Committee was to help raise the standards of corporate governance and the level of confidence in financial reporting and auditing by setting out clearly what it sees as the respective responsibilities of those involved and what it believes is expected of them.1 The Committee investigated the accountability of the board of directors to shareholders and to the society. It submitted its report and associated Code of Best Practices in December 1992 wherein it spelt out the methods of governance needed to achieve a balance between the essential powers of the board of directors and its proper accountability. World Bank on Corporate Governance The World Bank, both as an international development bank and as an institution, interested and involved in equitable and sustainable economic development worldwide, was one of the earliest international organisations to study the issue of corporate governance and suggest certain guidelines. The World Bank is one of the earliest international organisations to study the issue of corporate governance and suggest certain guidelines. The World Bank Report on corporate governance recognises the complexity of the concept and focusses on the principles such as transparency, accountability, fairness and responsibility that are universal in their applications. The World Bank Report on corporate governance recognises the complexity of the very concept of corporate governance and focusses on the principles on which it is based. These principles such as transparency, accountability, fairness and responsibility are universal in their applications. The way they are put into practice has to be determined by those with the

responsibility for implementing them. What is needed is a combination of statutory and selfregulation; the mix will vary around the world, but nowhere can statutory regulation alone promote effective governance. The stronger the partnership between the public and private sectors, the more soundly based will be their governance structures. Equally, as the report emphasises, governanc.... OECD Principles The Organisation for Economic Cooperation and Development (OECD) was one of the earliest non-governmental organisations to work on and spell out principles and practices that should govern corporates in their goal to attain long-term shareholder value.5 The OECD Principles were oft-quoted and have won universal acclaim, especially of the authorities on the subject of corporate governance. Because of the ubiquitous approval, the OECD Principles are as much trend-setters as the Codes of Best Practices associated to the Cadbury Report. A useful first step in creating or reforming the corporate governance system is to look at the principles laid out by the OECD and adopted by its member governments. McKinsey Survey on Corporate Governance There has been a continuing debate among those who hold divergent positions on corporate governance practices whether there is any quantifiable connection between good corporate governance and the market valuation of the company. In this regard, McKinsey, the international management consultant organisation conducted a survey with a sample size of 188 companies from 6 emerging markets (India, Malaysia, Mexico, South Korea, Taiwan and Turkey), to determine the correlation between good corporate governance and the market valuation of the company. The results of the survey pointed out to a positive correlation between the two. Sarbanes-Oxley Act, 2002 Corporate America has been blotted with many scandals in the recent times. Despite the fact that there have been differences between the recent scandals and the earlier ones, there is a common thread running in between them. The common thread is that governance matters, that is, good governance promotes good corporate decision-making. The recent Sarbanes-Oxley Act is a step in this direction, which codifies certain standards of good governance as specific requirements. The Act calls for protection to those who have the courage to bring frauds to the attention of those who have to handle frauds. But it ensures that such things are not left to the individuals who may or may not choose to reveal them Indian Committees and Guidelines The corporate world in India could not remain indifferent to the developments that were taking place in the UK. In fact, the developments in the UK had tremendous influence in India too. They triggered the thinking process in the country, which finally led to the government and

regulators laying down the ground rules on corporate governance. As a result of the interest generated in the corporate sector by the Cadbury Committees report, the issue of corporate governance was studied in depth and dealt with by the Confederation of Indian Industry (CII), the Associated Chambers of Commerce and the Securities and Exchange Board of India (SEBI). Working Group on the Companies Act, 1996 Over the years, it has been felt necessary to re-write completely the Companies Act in the light of the modern-day requirements of the corporate sector, the aspirations of investors, globalisation of the economy, liberalisation etc. The government accordingly set up a Working Group in August 1996 for this purpose. The Working Group on the Companies Act has recommended a number of changes and also prepared a working draft of the Companies Bill 1997. The Bill was introduced in the Rajya Sabha on 14 August 1997, containing the following recommendations: Financial disclosures recommended by the Working Group on the Companies Act were as follows: Over the years, it has been felt necessary to re-write completely the Companies Act in the light of the present-day requirements of the corporate sector, the aspirations of investors, globalisation of the process, economy, liberalisation etc. The government accordingly set up a Working Group on the Companies Act in August 1996 for this purpose. The Confederation of Indian Industrys Initiative In 1996, the Confederation of Indian Industry (CII) took a special initiative on corporate governance, the first ever institutional initiative in Indian industry. This initiative by the CII flowed from public concerns regarding the protection of investors interest, especially of the small investor; the promotion of transparency within business and industry; the need to move towards international standards in terms of disclosure of information by the corporate sector and, through all of this, to develop a high level of public confidence in business and industry. The objective of the effort was to develop and promote a code of corporate governance to be adopted and followed by Indian companies, be they in the private sector or in the public sector, banks or financial institutions, all of which are mostly corporate entities. SEBIs Initiatives The Securities and Exchange Board of India appointed a committee on corporate governance on 7 May 1999, with 18 members under the chairmanship of Kumar Mangalam Birla with a view to promoting and raising the standards of corporate governance. The committees terms of reference were: (a) to suggest suitable amendments to the listing agreement (LA) executed by the stock exchanges with the companies and any other measures to improve the standards of corporate governance in the listed companies in areas such as continuous disclosure of material

information, both financial and non-financial, manner and frequency of such disclosures, responsibilities of independent and outside directors (b) to draft a code of corporate best practices Naresh Chandra Committee Report, 2002 While SEBI was making efforts to introduce corporate governance standards among Indian corporates, the Department of Company Affairs took another initiative in this direction. The Naresh Chandra Committee was appointed as a high-level committee to examine various corporate governance issues by the Department of Company Affairs on 21 August 2002. Naresh Chandra Committee report on Corporate Audit & Governance has taken forward the recommendations of the Kumar Mangalam Birla Committee on corporate governance which was set up by the Securities and Exchange Board of India. The Naresh Chandra Committee was appointed as a high level committee to examine various corporate governance issues by the Department of Company Affairs on 21 August, 2002. The committees recommendations mainly concerned: (i) the auditor-company relationship, (ii) disqualifications for audit assignments, (iii) list of prohibited non-audit services, (iv) independence standards for consulting, (v) compulsory audit partner rotation, (vi) auditors disclosure of contingent liabilities, (vii) auditors disclosure of qualifications and consequent action, (viii) managements certification in the event of auditors replacement, (ix) auditors annual certification of independence, (x) appointment of auditors Narayana Murthy Committee Report, 2003 The committee on corporate governance set up by SEBI under the chairmanship of N. R. Narayana Murthy which submitted its report in February 2003 was yet another committee on the subject signifying the regulators anxiety to expeditiously promote corporate governance practices in Indian companies. The committees terms of reference were the following:

To review the performance of corporate governance. To determine the role of companies in responding to rumour and other price sensitive information circulating in the market in order to enhance the transparency and integrity of the market.