Corporate Governance

Satyam Vada Dharmam Chara

Forever speak the truth and follow the dharma - Taittariya Upanishad

Corporate Governance
A system of checks and balances between the board, management and investors to produce an efficiently functioning corporation, ideally geared to produce longterm value The Conference Board

Overview of Corporate Governance

Some Definitions
Corporate Governance is the system by which companies are directed and controlled
Cadbury Report (UK), 1992

to do with Power and Accountability: who exercises power, on behalf of whom, how the exercise of power is controlled.
Sir Adrian Cadbury, in Reflections on Corporate Governance, Ernest Sykes Memorial Lecture, 1993

An Indian Definition

fundamental objective of corporate governance is the enhancement of the long-term shareholder value while at the same time protecting the interests of other stakeholders.
SEBI (Kumar Mangalam Birla) Report on Corporate Governance, January, 2000

A Gandhian Definition
Trusteeship obligations inherent in company operations, where assets and resources are pooled and entrusted to the managers for optimal utilisation in the stakeholders interests.

Some Further Definitions

Corporate governance is essentially about leadership:
leadership for efficiency; leadership for probity; leadership with responsibility; and leadership which is transparent and which is accountable.
- PRINCIPLES FOR CORPORATE GOVERNANCE IN THE COMMONWEALTH

What is Corporate Governance?

The Manner in which a Corporation is Run
Achieving its Objectives Transparency of its Operations Accountability & Reporting Good Corporate Citizenship

The Processes & Operating Relationships that Best Achieve Organisational Goals

Driving Forces of CG in India

1) Unethical Business Practices Security Scams ---Harshad Mehtha Security Scam Equity allotments at discount rates to the controlling groups Disappearance of Companies (1993-94) - around 4,000 companies with 25,000 crores without starting business Misdeed of Companies Plantation, Sheep rearing, etc. 2) Impact of Globalization Integration with Foreign Market Foreign Investors expectations New Business Opportunities --- IT & ITES, BPO etc., New Capital formation FII, FDI 3) Impact of Privatisation New structure of ownership Multinational Companies

Brief history of corporate governance in India

Unlike South-East and East Asia, the corporate governance initiative in India was not triggered by any serious nationwide financial, banking and economic collapse The initiative in India was initially driven by an industry association, the Confederation of Indian Industry In December 1995, CII set up a task force to design a voluntary code of corporate governance. The final draft of this code was widely circulated in 1997. In April 1998, the code was released. It was called Desirable Corporate Governance: A Code. Between 1998 and 2000, over 25 leading companies voluntarily followed the code: Bajaj Auto, Hindalco, Infosys, Dr. Reddys Laboratories, Nicholas Piramal, Bharat Forge, BSES, HDFC, ICICI and many others

Brief history of corporate governance in India

Following CIIs initiative, the Securities and Exchange Board of India (SEBI) set up a committee under Kumar Mangalam Birla to design a mandatory-cum-recommendatory code for listed companies The Birla Committee Report was approved by SEBI in December 2000 Became mandatory for listed companies through the listing agreement, and implemented according to a rollout plan: 2000-01: All Group A companies of the BSE or those in the S&P CNX Nifty index 80% of market cap. 2001-02: All companies with paid-up capital of Rs.100 million or more or net worth of Rs.250 million or more. 2002-03: All companies with paid-up capital of Rs.30 million or more

Brief history of corporate governance in India

Following CII and SEBI, the Department of Company Affairs (DCA) modified the Companies Act, 1956 to incorporate specific corporate governance provisions regarding independent directors and audit committees. In 2001-02, certain accounting standards were modified to further improve financial disclosures. These were: Disclosure of related party transactions. Disclosure of segment income: revenues, profits and capital employed. Deferred tax liabilities or assets. Consolidation of accounts. Initiatives are being taken to (i) account for ESOPs, (ii) further increase disclosures, and (iii) put in place systems that can further strengthen auditors independence.

Mandated CG guidelines and disclosures

Board of Directors: frequency of meetings and composition Board must meet at least four times a year, with a maximum time gap of four months between two successive meetings. If the chairman of the Company is a non-executive then one-third of the board should consist of independent directors, and 50% otherwise. Independent defined as those directors who, apart from receiving directors remuneration do not have any other monetary relationship or transactions with the company, its promoters, management or subsidiaries, which in the view of the board may affect independence of judgment.

Mandated CG guidelines and disclosures

Board of Directors: frequency of meetings and composition The frequency of board meetings and board committee meetings, with their dates, must be fully disclosed to shareholders in the annual report of the company. The attendance record of all directors in board meetings and board committee meetings must be fully disclosed to shareholders in the annual report of the company. Full and detailed remuneration of each director (salary, sitting fees, commissions, stock options and perquisites) must be fully disclosed to shareholders in the annual report of the company. Loans given to executive directors are capped (no loans permitted to non-executives), and must be fully disclosed to shareholders in the annual report of the company.

Mandated CG guidelines and disclosures

Board of Directors: information that must be supplied Annual, quarter, half year operating plans, budgets and updates. Quarterly results of company and its business segments. Minutes of the audit committee and other board committees. Recruitment and remuneration of senior officers. Materially important legal notices and claims, as well as any accidents, hazards, pollution issues and labor problems. Any actual or expected default in financial obligations. Details of joint ventures and collaborations. Transactions involving payment towards goodwill, brand equity and intellectual property. Any materially significant sale of business and investments. Foreign currency and other risks and risk management. Any regulatory non-compliance.

Mandated CG guidelines and disclosures

Board of Directors: Audit Committee Audit Committee is mandatory. Must have minimum of three members, all non-executive directors, the majority of whom are independent. Chairman must be an independent director, and must be present at the annual shareholders meeting to answer audit or finance related questions. At least one member must be an expert in finance/accounts. Must have at least three meetings per year, including one before finalisation of annual accounts. Must meet with statutory auditors and internal auditors; have the powers to seek any financial, legal or operational information from the management; obtain outside legal or professional advice.

Mandated CG guidelines and disclosures

Board of Directors: Audit Committee functions Oversight of the companys financial reporting process to ensure that the financial statement is correct, sufficient and credible Appointment / removal of external auditor and fixing of audit fees Reviewing with management the annual financial statements before submission to the board, focusing on: Changes in accounting policies and practices Major accounting entries Qualifications in draft audit report Significant adjustments arising out of audit The going concern assumption Compliance with accounting standards, with stock exchange and legal requirements Any related party transactions

Mandated CG guidelines and disclosures

Board of Directors: Audit Committee functions Adequacy of internal audit and internal control systems, through discussion with internal and statutory auditors as well as management. Significant findings, follow-up and action taken reports. Discussion with internal and statutory auditors about scope and design of audits. Reviewing financial and legal risks and companys risk management policies. Examining reasons behind any materially significant default to creditors, bond-holders, suppliers and shareholders.

Mandated CG guidelines and disclosures

Disclosures to shareholders in addition to balance sheet, P&L and cash flow statement Board composition (executive, non-exec, independent). Qualifications and experience of directors. Number of outside directorships held by each director (capped at director not being a member of more than 10 board-level committees, and Chairman of not more than 5). Attendance record of directors. Remuneration of directors. Relationship (familial or pecuniary) with other directors. Warning against insider trading, with procedures to prevent such acts. Details of grievances of shareholders, and how quickly these were addressed. Date, time and venue of annual general meeting of shareholders.

Mandated CG guidelines and disclosures

Disclosures to shareholders in addition to balance sheet, P&L and cash flow statement Dates of book closure and dividend payment. Details of shareholding pattern. Name, address and contact details of registrars and/or share transfer agents. Details about the share transfer system. Stock price data over the reporting year, and how the companys stock measured up to the index. Financial effects of stock options. Financial effects of any share buyback. Financial effects of any warrants that are to be exercised. Chapter reporting corporate governance practices

Mandated CG guidelines and disclosures

Disclosures to shareholders in addition to balance sheet, P&L and cash flow statement Detailed chapter on Management Discussion and Analysis focusing on markets, operations, finances, accounts, risks, opportunities and threats, internal control systems. Consolidated financial statement, incorporating accounts of all subsidiaries (over 50% shares held by reporting company). Details of all significant related party transactions. Detailed segment reporting (revenues, costs, operating profits and capital employed). Deferred tax liabilities and assets and debit/credit in the P&L for the reporting year

Recent Misconducts: The List Goes On

Computer Associates:
Artificially inflated revenue and improperly rewarded top executives.

CMS Energy
Overstated revenues in 2000 and 2001 thru round trip energy trades?

Dynegy
Transactions to cut taxes and artificially increase cash flow ?

Kmart
Suspected improper accounting for vendor allowances

Lucent Technologies
Adjusted fiscal 2000 revenues by $679 million.

Several more names, respected world-over

AOL Time Warner, Bristol-Myers, Elan,Halliburton, ImClone Systems, Microstrategy, Mirant, Network Associates, Reliant Resources, Vivendi Universal, Xcel Energy, Xerox.

Corporate Mis-Governance

Some Governance Models

Finance or the Principal-Agent Model
Markets for Capital, Managerial Talent and Corporate Control, Key determinant In general, profit-maximisation goal is co-functional with social-welfare-maximisation Shareholders as Residual Claimants have superior control rights

Exclusive Accountability to Shareholders

Risk-bearing Entrepreneurs Residual Claimants Winding-up Ranking: Last in Pecking Order Boards Appointed by Shareholders Non-congruence of Stakeholder Interests

Residual Claimant Theory

shareholders residual claimants to the firms income. Creditors have fixed claims and employees remunerations negotiated in advance of performance .. Gains and losses from abnormally good or bad performance .. The lot of shareholders, who stand last in the queue .. Shareholders make discretionary decisions and bear consequences .. As such, .. Owners of business with important control rights The Economic Structure of Corporate Law, Frank H Easterbrook and Daniel R Fischel (1991) OUP

The Stakeholder Case

Firm Objective must be defined more widely than just shareholder-value-maximisation, since risk capital is not the only, or even the major input Residual Claimant Rights Not Universally Valid, eg, Circumscribed in case of pre-bankruptcy (US Chapter XI) Situations Other Such: Employees with Firm-specific Specialised Skills, Customers/Vendors with Substantial Stake in the Business, etc

Towards an Integrated Model

One-Size does not Fit All Circumstances A Combination of Shareholder/Stakeholder Models Necessary Some Argue, While Shareholder Claim Well Established, Stakeholder Claims Need to be Proved Tailor Model to Suit Unique Circumstances

The Corporate Board

Central to Corporate Governance
Juxtaposed between Shareholders on the one hand, and on the other, Managers of the Entity (Cadbury) Follows Distancing between Ownership and Control (Berle and Means) Trustee for All Shareholders Loyalty & Commitment Always to Company

Board Role & Responsibility

Provide/ Exercise
Leadership and Strategic Guidance Objective Judgement Independent of Management Control over the Company

Direct and Control the Management of the Company Be Accountable at all times to All Shareholders

Dimensions of Board Responsibility

Direction involves
Formulation & Review of Company Policies, Strategies, Budgets and Plans, Risk Management Policies, Top Level HR Policies, etc Setting Objectives & Monitoring Performance Oversight of Acquisitions, Divestitures, Projects, Financial and Legal Compliance, etc

Dimensions of Board Responsibility

Control Involves
Prescribing Codes of Conduct, Overseeing Disclosure & Communication Processes, Ensuring Control Systems to Protect Company Assets Reviewing Performance & Realigning Action Initiatives to Achieve Company Objectives

Dimensions of Board Responsibility

Accountability Involves
Creating, Protecting and Enhancing Company Wealth and Resources Timely and Transparent Reporting Good Corporate Citizenry including Discharge of Stakeholder Obligations and Societal Responsibilities without Compromising the Shareholder Wealth Maximisation Goal

Is There More to Business than just the Financial Numbers?

An Enterprises Triple Effect on Society

Sustainable Development Waste Control Equal Opportunities Education & Culture Community Regeneration

Emissions Business Impact Energy Use Product Life-cycle Product Value Wealth Generation Productive Employment Ethical Trading

Economic

Human Rights Employee Volunteers

The Triple-Bottomline Impact

economics

Business Impact environment society

Governance Orientation Matrix

Governance Orientation & Sustainable Profits

N Y
T A IN A B FIT IN

T WA

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

Reasons for the Growing Demand for Corporate Governance

Inadequacies and failures of an existing system often bring to the fore the need for norms and codes to remedy them. This is true of corporate governance too.

Deficiencies in the Accounting Standards became more evident after many companies, in their eagerness to increase earnings and accelerate growth, exploited the weaknesses in the accounting standards to show inflated profits and understate liabilities.

Corporate Governance Environment and Outcomes

Factors Influencing Corporate Governance

Ownership structure Structure of company boards Financial structure Institutional Environment

Mechanisms of Corporate Governance

Companies Act, 1956 Securities Law Discipline of the capital market Nominees on company boards Statutory audit Codes of conduct

Mechanisms of Corporate Governance

Current status on corporate governance

Comparison of Board structure Indian top 50 Vs U.S. top 50 Key Findings
Parameter Ownership pattern Board size India (Nifty Fifty companies) 48% of Indian companies have largest shareholder holding over 50%
Largest 44%

US (top 50 out of NYSE 100 index) Largest shareholder holds less than 10% in all cases
Largest 66%

board size 17. smallest 5

board size 18. smallest 10

of the top 50 companies have more than 12 directors

of the top 50 companies have more than 12 directors companies have a board majority of independent directors

Board independence

58%

of companies have a board majority of independent directors

12%

All

have less than 1/3rd of their directors independent Boards of 49 companies out of 50 have less than 25% executive directors Only 20% have separate Chairman and CEO 20 companies have lead independent directors
All

Executive directors in board Chairman and CEO Lead independent director Board committees

In 35 companies 50% of the directors or more are executive directors 60% have separate Chairman and CEO 3 companies have lead independent directors
All

companies have audit committees 54% have fully independent Audit Committees
33

companies have fully independent audit remuneration and nomination committees

companies have remuneration committees of these 14 fully independent and 16 have majority independent committees
9

companies have nomination committees 6 are fully independent and 3 have majority independent committees

Source: Crisil Report on Corporate Governance

Roll of Honour
Rankings 1 2 3 4 5 6 7 8 9 10 Infosys Technologies Tata Steel Wipro HDFC Bank HDFC Tata Motors Reliance Industries ITC Ranbaxy Laboratories Hindustan Lever 11 12 13 14 15 16 17 18 19 20 Hero Honda Motors Larsen & Toubro State Bank of India Bajaj Auto ONGC Gujarat Ambuja Cement Hindalco Industries Grasim Industries Cipla BPCL

(Source: ET Corporate Governance Survey)

Recommendations of Birla Committee

The Birla Committee Report is the first formal and comprehensive attempt to evolve a Code of Corporate Governance, in the context of prevailing conditions of governance in Indian companies, as well as the state of capital markets. The Committee, felt that the recommendations should be divided into mandatory and non-mandatory categories.

 Applicability: The recommendations will apply to all the listed private and public sector companies, in accordance with the schedule of implementation. This is a mandatory recommendation. Board of Directors: Board of Directors should have an optimum combination of executive and non-executive directors. The CII Code has also laid down that no individual should be a director on the boards of more than 10 companies at any given time; non-executive directors should be active, have defined responsibilities, and be conversant with P & L accounts; directors who have not been present for at least 50 per cent of board meetings should not be re-appointed.

 Audit Committee and Remuneration Committee: One of the items of the CII Code is that there should be an Audit Committee, which shall have access to all financial information. The Birla Committee has recommended an Audit Committee to act as a catalyst for effective financial reporting, with powers to investigate any activity within its terms of reference and to seek information from any employee.

 Accounting Standards and Financial Reporting: companies are required to give consolidated accounts in respect of all its subsidiaries in which they hold 51% or more of the share capital. Management: While the Board is responsible for ensuring that the principles of corporate governance are adhered to and enforced, the real onus of implementation lies with the management which is responsible for translating into action the policies and strategies of the Board and implementing its directives to achieve corporate objectives of the company framed by the Board. It is, therefore, essential that the board should clearly define the role of the management.

These are mandatory recommendations. Shareholders: The shareholders are the owners of the company and as such they have certain rights and responsibilities. The Committee believes that the General Body Meetings provide an opportunity to the shareholders to address their concerns to the board of directors and comment on and demand any explanation on the annual report or on the overall functioning of the company. The Committee has also recommended that the institutional shareholders take an active interest in the composition of the Board of Directors and evaluate the corporate governance performance of the company.

Governance and Performance measurement issues

Is governance behavior motivated by legislation? Do standards vary with jurisdictions or do you adopt the best option? Do you choose the right thing to do irrespective of whether its mandatory or not? Is performance evaluation limited to valuation metrics? Is it only ROE, Net margin, growth, shareholder wealth creation? Do performance measures need to be holistic? We need to encompass all stakeholders Governance is an enabler for holistic performance How do managers better understand governance requirements? Do we need market research for governance requirements?

Investing in Corporate Governance

Companies need to invest in good governance
Corporate governance has a direct bearing on business performance and thereby ROI Leverage the power of IT

On average, businesses with superior governance practices generate 20 percent greater profits than other companies
A study based on 256 companies conducted at the MIT Sloan School of Management