Evolution of Corporate Governance in India and Abroad

Corporate governance issues have attracted considerable attention, debate and research world wide in recent decades. Almost invariably, such efforts gain momentum in the wake of some major financial scam or corporate failure, as these tend to highlight the need for tighter surveillance over corporate behavior. Corporate governance has wide ramifications and extends beyond good corporate performance and financial propriety though these are no doubt essential. In India also, corporate governance has been under scrutiny and is an issue that has gained widespread importance.

No one can agree exactly how corporate governance should be incorporated in a company’s strategy. Different people have different definitions of corporate governance. The dictionary meaning of governance includes both ‘the action or manner of governing’ and ‘a mode of living, behavior, and demeanor’. Corporate governance is essentially concerned with the process by which companies are governed and managed. It is a set of standards, which aims to improve the company’s image, efficiency, effectiveness and social responsibility.

The concept of corporate governance primarily hinges on complete transparency, integrity and accountability of the management, with an increasingly greater focus on investor protection and public interest. A key element of good governance is transparency projection through a code of good which incorporates a system of checks and balances between key players – board, management, auditors and shareholders. In the debate concerning the impact of corporate governance on performance, there are basically two different models of the corporation, the shareholder model and the stakeholder model.

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In its narrowest sense (shareholder model), corporate governance describe the formal system of accountability of senior management to shareholders. According to the model the objective of the firm is to maximize shareholder wealth. The criterion by which performance is judged in this model is the market value (i. e. shareholder value) of the firm. Therefore, managers and directors have an implicit obligation to ensure that firms are run in the interests of shareholders.

In its widest sense (stakeholder model), corporate governance emphasis contributions by stakeholders that can contribute to the long term performance of the firm and shareholder value, according to the traditional stakeholder model, the company is responsible to a wider constituency of stakeholder other than shareholders. Other stakeholders may include contractual partners’ such as employees, suppliers, customers, creditors, and social constituents such as members of the community in which the firm is located, environmental interests, local and national governments, and society at large.

This view holds that corporations should be “socially responsible” institutions, managed in the public interest. According to this model performance is judged by a wider constituency interested in employment, market share, and growth in trading relations with suppliers and purchasers, as well as financial performance. The problem with the traditional stakeholder model of the firm is that it is difficult, if not impossible, to ensure that corporations fulfill these wider objectives. The corporate governance framework in many countries of the world, is largely inward-focused.

It, therefore, speaks mainly of the composition of management structure at various levels, the assumption being that the structure will automatically ensure quality of delivery. Further, a corporate responsibility to the external environment, its constituents, and other stakeholders has not received the attention it deserve in recommendations of many of the committees set up on corporate governance in different parts of the world. All corporate governance systems depend on key principles: fairness and integrity, transparency and disclosures, accountability, equal treatment to all shareholders and social responsibility.

The challenges of upholding these principles depend upon the ownership structure of the corporate sector. There are two general types of corporate ownership structure: “Insider” (concentrated) and “Outsider” (dispersed). In the concentration ownership structure, ownership control is concentrated in the hands of a small number of individuals, families, holding companies, banks or other financial companies. In concentrated ownership structures, insiders exercise control over companies in several ways. A common feature is where insiders own the majority of company’s shares and voting rights.

Most countries, especially those governed by civil laws, have concentrated ownership structure. In dispersed ownership structure, there are many owners, each of whom holds a small number of company’s shares. Small shareholders have little incentive to closely monitor company’s activities and tend not to be involved in management decisions or policies. Common law countries such as United Kingdom and United States tend to have dispersed ownership structure. Each ownership structure has corporate governance challenges. Need and Importance

The need and importance of Corporate Governance can best be conveyed with the following quotation of Benjamin Franklin: “A little neglect may breed great mischief – for the want of a nail, the shoe was lost; for the want of a shoe, the horse was lost; for the want of a horse, the rider was lost; and for want of a rider, the battle was lost. ” The absence of good corporate governance, even in a company that is performing well financially, may imply vulnerability for the shareholders because the company is not optimally positioned to deal with financial or management challenges that may arise.

Good corporate governance is an essential part of well-managed, successful business enterprise that delivers value to shareholders. Practices that better protect investor interests can only strengthen the capital markets. Negligence in adhering to effective entities; the collapse of BCCI Bank and the epidemic of Securities Scams in India are full fledged examples of disasters resulting from defiance and negligence of the principle of corporate governance.

Corporate Governance extends beyond corporate law. Its fundamental objective is not mere fulfillment of the requirements of law but in ensuring commitment of the Board in managing the company in a transparent manner for maximizing long term shareholder value. Effectiveness of corporate governance system cannot merely be legislated by law. While enough laws exit to take care of many of these investor grievances, the implementation and inadequacy of penal provisions have left a lot to be desired. Read about Corporate Governance at Wipro

The real onus of achieving the desired level of corporate governance thus lies in the proactive initiatives taken by the companies themselves and not in the external measures. Genesis Abroad The modern trend of developing corporate governance guidelines and codes of best practice began in the early 1990’s in the U. K. , the U. S. and Canada in response to problems in the corporate performance of leading companies, the perceived lack of effective board oversight that contributes to those performance problems and pressure for change from institutional investors.

The Cadbury Report in the U. K. , on 1992, defined corporate governance as “the system by which organizations are directed and controlled”, became a pioneering reference code for stock exchange both in U. K. and abroad. General Motors Board of Directors Guidelines in the U. S. and the Dey Report in Canada has also proved to be influential sources for guideline and code initiatives adopted by other countries. In the U. K. in July 2003, the Financial Reporting Council (FRC) of the U. K. published the new Combined Code.

The U. K Code (2003) was based on the proposed revision of the Combined Code (1998) in the report by Derek Higgs on the role and effectiveness of non-executive directors, which incorporated the recommendation on audit committees by Robert Smith. The most significant changes in the Code are the expanded definition of director independence, an increase in the recommended proportion of independent directors from one-third to a majority of the Board for larger listed companies, and separate Chairman and CEO with the Chairman being an independent director.

There are also clearer specifications of non-executive directors’ duties, an increased role and more stringent guidelines on membership of the Audit Committee, as well as an increase emphasis on the need for internal audit and control functions. Further, the new code allows for some differences in corporate governance arrangements for larger and smaller companies, particularly pertaining to the number and proportion of independent directors on the Board and number of members on certain Board committees.

Following various other committee recommendations in different countries of the world, King’s Committee in South Africa, there have been efforts in the last decade to homogenize the code of Corporate Governance, particularly in listed Companies. In the U. S. in 1998, the NYSE and NASD sponsored a committee to study the effectiveness of audit committees. This committee became known as the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committee (“Blue Ribbon Committee”). In its report, the Blue Ribbon Committee recognized the importance of audit committee and issued ten recommendations to enhance their effectiveness.

In response to these recommendations, the NYSE and the NASD, as well as other exchanges, revised their listing standards relating to audit committees. In 2002, the Sarbanes-Oxley Act was passed in response to a number of major corporate and accounting scandals involving prominent companies in the United States. This Act is considered to be one of the most significant changes to federal securities laws in the United States. An interesting aspect in the Sarbanes Oxley Act is the protection to whistleblowers.

The OECD Principles of corporate Governance, originally adopted by the 30 member countries of the OECD in 1999, have provided a good insight into corporate governance framework at a macro level. Following an extensive review process that led to adoption of revised OECD Principles of Corporate Governance in 2004, they now reflect a global consensus regarding the critical importance of good corporate governance in contributing to the economic validity and stability of below reflects not only the experience of OECD countries but also that of emerging and developing economies.

OECD Principles of Corporate Governance:

1. Ensuring the basis for an effective corporate governance framework: The corporate governance framework should promote transparent and efficient markets, be consistent with the rules of law and clearly articulate the division of responsibility among different supervisory, regulatory and enforcement authorities.
2. The rights of shareholders and key ownership functions: The corporate governance framework should protect and facilitate the exercise of shareholders’ rights.
3. 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.
4. The role of stakeholders in corporate governance: The corporate governance framework should recognize the right of stakeholders established by law or through mutual agreements and encourage active cooperation between corporations and stakeholders in creating wealth, jobs and the sustainability of financial sound enterprises.
5. Discloser 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.
6. 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. Genesis in India In India, the Companies Act, 1956 was the principle legislation providing the formal structure for corporate governance.

Apart from this, the Monopolies and Restrictive Trade Practices Act, 1969, the Foreign Exchange Regulation Act,1973 (which has now been replaced by Foreign Exchange Management Act,1999), the Industries (Development and Regulation) Act, 1951 and other legislation also have a bearing on the corporate governance principles. Till May 1992, the office of the Controller of Capital Issues was the regulation authority for the capital market. Therefore, the Securities and Exchange Board of India has assumed a primary role in this regard.

The experience after about five decades of the revamped Companies Act, 1956, confirms the fact that the law can never be the promulgator of excellence but it can only provide that too with a wavering zeal for enforcement, for bare minimum standards of responsibility of corporate arrangements towards the shareholding community. The number of sick industrial companies with the Board for Industrial and Financial Reconstruction (BIFR) provides ample testimony to the failure of minimal standards of corporate performance, leave alone governance.

The entry of Indian, as well as foreign institutional investors, mutual funds, banks and private sector players, also activated the capital market rapidly and a need was realized to do away with large paper work involved in transfers and holding of securities running into crores of rupees. Management exercised their rights to veto transfer of ownership of shares in favors of persons who bought them in the normal course, when they envisaged a threat to the existing management. The depositary legislation of 1996 abridged this right by deleting some of the provisions of the Securities Contracts (Regulation) Act and the Companies Act.

This step further established the confidence into the true ownership of shareholding without the fear of the same being declared as benami, bogus or tainted securities in future. It has also improved the capital market scenario and helped the management in serving and protecting the shareholders’ interest, which is one of the most important aspects of Corporate Governance. Developments in India In India, whilst management processes were widely explored, till recently relatively little attention was paid to the processes by which companies were governed.

The various aspects of this issue crept into India after the report of the Cadbury Committee in the U. K. in 1992, which evoked considerable interest from Indian companies. The Confederation of Indian Industries (CII) thereafter published a Desirable Code of Corporate Governance, which some companies voluntarily adopted. The issue came into prominence with the report of the Shri Kumar Mangalam Birla Committee set up by SEBI to suggest changes in the listing agreement to promote governance. Corporate governance has an important role to play as an instrument of investor protection.

The development of the capital market is dependent on good corporate governance without which investors do not repose confidence in the companies. Companies with basic corporate governance principles are more likely to attract investors. Many companies voluntarily established high standards of corporate governance; however, there were many other who did not pay adequate attention to the interest of the shareholders. They did not attend to investor grievances such as delay in transfer of shares, dispatch of share certificates and dividend warrants, non-receipt of dividend warrants.

Besides, capital from the market at very high premium. SEBI initiated several steps for strengthening corporate governance through the amendment of the listing agreement like:

• Strengthening of disclosure norms for Initial Public Offering (IPO) following the recommendations of the Malegam Committee;
• Providing information in directors’ report for utilization and end use of funds and variation between projected and actual use of funds;
• Declaration of un audited quarterly results;
• Mandatory appointment of compliance officer for monitoring the share transfer process and ensuring compliance with various rules, regulations;
• Dispatch of one copy of complete balance sheet to every household and abridged balance sheet to all shareholders. However, SEBI continued to receive a large number of investor complaints daily. To further improve the level of corporate governance, it was felt that a more comprehensive approach was needed at that stage of development of the capital market.

This promoted SEBI to constitute a Committee under the chairmanship of Shri Kumar Mangalam Birla, member, SEBI Board to suggest changes in the Listing Agreement to promote Corporate Governance. The terms of reference of the Committee were as follows:

To suggest suitable amendments to the listing agreement executed by the stock exchanges with the companies and other measures to improve standards of corporate governance in listed companies, in areas such as:

• Continuous disclosure of both financial and non-financial material information,
• Accounting information,
• Manner and frequency of such disclosure,
• Responsibilities of independent and outside directors.

To draft a code of corporate best practices; and To suggest safeguards to be instituted within companies to deal with insider information and against trading. The Committee’s report was made public. Board on the recommendations of the Committee and the feedback received, the SEBI Board at its meeting held on January 25, 2000 considered the recommendations of the Committee and decided to make amendments to the Listing Agreement in pursuance of these recommendations.

It was advised that a new clause, namely clause 49 be incorporated in the Listing Agreement covering the following primary areas:

• Board of Directors (specifying a minimum number of independent directors and board procedures)
• Audit Committee (introducing the mandatory requirement of an audit committee and its roles and responsibility)
• Directors’ remuneration (disclosure of Directors’ remuneration)
• Disclosure (mandatory Management Discussion and Analysis section in Annual Report and other disclosure)

Broadly, eight points on which provisions were included:

1.  Board of Directors and its composition
2. Audit Committee
3. Remuneration of Directors
4. Board Procedure
5. Management Discussion and Analysis Report
6. Shareholders/Investors Grievance Committee and other shareholders’ issues
7. Report on Corporate Governance
8. Certificate of Compliance. The Naresh Chandra Committee (2002)

In august 2002, the Department of Company Affairs (DCA) under the Ministry of Finance and Company Affairs appointed a High Level Committee, under the Chairmanship of Naresh Chandra, former Cabinet secretary “to examine the Auditor-Company relationship, role of independent directors, and disciplinary mechanism over auditors in the light of irregularities committed by companies in India and abroad”. The Committee was also mandated to examine the concepts of CEO/CFO certification newly introduced by the recently passed Sarbanes-Oxley Act in the U. S.

The Narayana Murthy Committee (2003) In late 2002, SEBI, having analyzed the disclosure made by companies under Clause 49 and after a review of a large number of company annual reports, observed that there was considerable variance in the extent and quality of disclosure made by companies in their annual reports and concluded that there was a need to review the extent and quality of disclosure made by companies in their annual reports and concluded that there was also a need to review the existing code on corporate governance to: • Assess adequacy of existing practices, and Suggest improvements to the existing practices. Thus, the SEBI Committee on Corporate Governance was constituted under the Chairmanship on N R Narayana Murthy to look into these matters. The Narayana Murthy Committee report (February 2003), reviewed existing best practices in corporate governance and also drew upon the recommendations of the Kumar Mangalam Birla Committee and the Naresh Chandra Committee to recommend further improvements in the existing system of corporate governance applicable to Indian companies.

The Revised Clause 49 In October 2004, SEBI amended Clause 49 of listing agreement in alignment with the recommendations of the Narayana Murthy Committee. These changes primarily strengthened the requirement in the following areas:

• Board composition and procedure
• Audit committee responsibilities
• Subsidiary companies
• Risk management
• CEO/CFO certification of financial and internal controls
• Legal compliance
• Other disclosure

Since a large number of companies were not in a state of preparedness to be fully compliant with the requirements of the Revised Clause 49, it was felt that more time should be allowed to them, to confirm to the provisions of the Revised Clause 49. Accordingly, SEBI has extended the date for ensuring compliance with the Revised Clause 49 of the Listing Agreement to December 31, 2005.

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