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Value proposition of Corporate Governance

Sudhendu Bali

2 August, 2010

Guest Faculty

University Institute of Applied Management Sciences, Panjab University, Chandigarh

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Agenda

• The business case for Corporate Governance• Corporate Board: attributes, duties, responsibilities

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“Governance”

Oxford English Dictionary defines “Governance” as the act,

manner, fact or function of governing, sway, control

The word has Latin origins that suggest the notion of 'steering'.

It deals with the processes and systems by which an organization

or society operates.

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Definition of Corporate Governance• Corporate Governance is the system by which companies are directed and controlled…”

– Cadbury Report (UK), 1992

• Corporate governance is the system by which business corporations are directed and controlled. The CG structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as the board, managers, shareholders and other stakeholders and spells out the rules and procedures for making decisions on corporate affairs. It also provides the structure through which objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined.”

– Preamble to the OECD Principles of Corporate Governance, 2004

• “…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 2000

• “A system of checks and balances between the board, management and investors to produce an efficiently functioning corporation, ideally geared to produce long-term value”

– The Conference Board

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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

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Involved parties in the enterprise EXTERNAL• Shareholders• Institutional investors• Private investors• Banks• Stock markets• Regulators• Market intermediaries• Media• External Auditors• Government

INTERNAL• Customers• Managers• Workmen• Contractual agencies• Internal Auditors• Creditors• Debtors• Equipment suppliers

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Separation of Ownership and Managerial Control

• Basis of the modern corporation• shareholders purchase stock, becoming residual claimants• shareholders reduce risk by holding diversified portfolios• professional managers are contracted to provide decision-

making

• Modern public corporation form leads to efficient specialization of tasks• risk bearing by shareholders• strategy development and decision-making by managers

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• Risk bearing specialist (principal) Risk bearing specialist (principal) pays compensation to a pays compensation to a managerial decision-making managerial decision-making specialist (agent)specialist (agent)

Agency Relationship: Owners and

Managers

An AgencyAn AgencyRelationshipRelationship

ManagersManagers(Agents)(Agents)

ShareholdersShareholders(Principals)(Principals)

• Decision makersDecision makers

• Firm ownersFirm owners

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Agency Theory Problem

• The agency problem occurs when:• the desires or goals of the principal and agent conflict

and it is difficult or expensive for the principal to verify that the agent has behaved inappropriately

• Solution:• principals engage in incentive-based performance

contracts

• monitoring mechanisms such as the board of directors

• enforcement mechanisms such as the managerial labor market to mitigate the agency problem

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What went wrong in the recent past?

• Environment

• Loss of moral fibre of corporations

• Business environment characterized by need to compete with the new economy

• Boards

• Fundamental weaknesses in business models sought to be compensated by adoption of aggressive accounting practices

• Ignored ethics and value systems when a much hyped business strategy failed to deliver as expected and articulated to Wall Street

• Incompetence of board members and overriding of audit committees

• Managements

• Stock option heavy compensation structures

• Bonus linked to short-term revenue growth, EPS and stock price

• An inability to accept failure

• Excessive focus on beating the street

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Major Corporate Collapses UK : The Maxwell publishing group BCCI Marconi USA : Enron

World Com Tyco

Germany : Berliner Bank Babcok

Australia : OneTel Ansett Airlines

India : Satyam Pentamedia

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Why CG is needed ?• Two major changes over the past scenario:

• variety of stakeholders in a modern corporation, apart from the stake of the legal equity holders; and

• thanks to capital markets, major diversification of the equity capital leading to ever larger distance between the owners of capital and the managers.

• The decline of banking and the rise of the institutional investor• Increasing power and size of enterprises

• Complex markets• Globalization• Worldwide Shareholders • Institutional investors

• Systems of corporate governance should be reconciled with ground realities of the country in question:• Corporate ownership and control not uniform in emerging markets and

developed capital markets• Emerging markets are dominated by “family enterprises”

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The value proposition of good corporate governance

• Harvard Law School: disregard of shareholder right causes lower firm valuation and is associated with 7.4% p.a. negative abnormal returns during the 1990 – 2003 period

• Deutsche Bank Research: a portfolio of European companies with improving governance standards outperformed a portfolio of deteriorating companies by 4.4 % per annum

• Governance-focused Hermes UK Focus Fund outperformed its benchmark by an average 4.8 % each year from 1999 through 2004

• CLSA Governance Scoring (including India) confirms higher stock markets valuation of firms with better governance practices

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Corporate Governance and Capital Markets

Source: A McKinsey Survey of Global Investors

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Objectives of good corporate governance

1. Strengthen management oversight functions and

accountability

2. Balance skills, experience and independence on the board

appropriate to the nature and extent of company operations

3. Establish a code to ensure integrity

4. Safeguard the integrity of company reporting

5. Risk management and internal control

6. Disclosure of all relevant and material matters

7. Recognition and preservation of needs of shareholders

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The Corporate Board (BOD)• Central to Corporate Governance

• Juxtaposed between Shareholders on the one hand, and on the other, Managers of the Entity

• Follows Distancing between Ownership and Control (Berle and Means)

• Trustee for All Shareholders• Loyalty & Commitment – Always to Company

• Provide/ Exercise • Leadership and Strategic Guidance• Objective Judgment Independent of Management• Control over the Company• Direct and Control the Management of the Company• Be Accountable at all times to All Shareholders

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Separation of Board & Management

Governance – the work of the board

Management – the work of the executive

management team

CEO

CHM

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Corporate Governance & Corporate Management

CORPORATE GOVERNANCE

CORPORATE MANAGEMENT

External Focus Internal Focus

Governance assumes an open system

Management assumes a closed system

Strategy- oriented Task-oriented

Concerned with where the company is going

Concerned with getting the company there

Governance

Management

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Board Responsibilities

Providing

Accountability

Strategy Formulation

Monitoring & Supervising

Policy Making

Outward looking

Inward looking

Past & present focus

Future focus

Approve and work with and through the CEO

Conform Perform

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ENTERPRISEGOVERNANCE

CORPORATEGOVERNANCE

BUSINESSGOVERNANCE

The two dimensions need to be in balance !

Dimensions Dimensions

(Conformance) (Performance)

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Corporate governance & Performance governance

• CG covers issues such as board structures & roles, internal controls & executive remuneration.

• The performance dimension focuses on helping the board to make strategic decisions; understand its appetite for risk and its key drivers of performance.

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Does performance depend on governance ?

• Short term performance does not necessarily depend on governance • Stock price performance is determined by market asymmetries. This

sort term focus increases risk and also creates barrier to long term growth

• We all know what happened to Enron?• Medium to long term performance requires governance• Most companies which have grown in the last 25 years have

outstanding performance and have good governance structure• A good governance structure treats all stakeholders fairly• Governance alone cannot ensure performance

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Governance Orientation Matrix

Professional

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Issues in Corporate Governance• Asymmetry of power• Asymmetry of information• Interests of shareholders as residual owners• Role of owner management• Problems in separation of powers• Division of corporate pie among stakeholders

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International scenarioYear Name of Committee/Body Areas/Aspects Covered

1992 Sir Adrian Cadbury Committee, UK Financial Aspects of Corporate Governance

1994 Mervyn E . King’s Committee , South Africa

Corporate Governance

1995 Greenbury Committee , UK Directors’ Remuneration

1998 Hampel Committee, UK Combine Code of Best Practices

1999 Blue Ribbon Committee, US Improving the Effectiveness of Corporate Audit Committees

1999 OECD Principles of Corporate Governance

1999 CACG Principles for Corporate Governance in Commonwealth

2003 Derek Higgs Committee, UK Review of role of effectiveness of Non-executive Directors

2003 ASX Corporate Governance Council, Australia

Principles of Good Corporate Governance and Best Practice Recommendations

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Indian scenarioYear Name of

Committee/BodyAreas/Aspects Covered

1998 Confederation of Indian Industry (CII)

Desirable Corporate Governance – A Code

1999 Kumar Mangalam Birla Committee

Corporate Governance

2002 Naresh Chandra Committee

Corporate Audit & Governance

2003 N. R. Narayana Murthy Committee

Corporate Governance

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Key Board Objectives

• Role of owners in electing the Board• Protection of minorities & foreign shareholders• Role of other stakeholders in management• Board structure and objectivity of the Board• System of reporting and accountability• Audit and internal control• Effective supervision and enforcement by regulators• To encourage Sustainable Development of the Company and its

stakeholders

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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

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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

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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

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Principles in developing Corporate Governance framework

Openness

Integrity

Accountability

Fairness

Transparency

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SAMPLE CG REQUIREMENTS• Board membership criteria• Separation of Chair and the CEO• Lead Director• Board size • No. of Non executive director• Definition of independence• Election term• Executive session of non-executive directors• Evaluation of Board performance• Board meetings• Number, structure and independence of committees• Outside advice• Disclosure regarding Corporate Governance• Accuracy of disclosure / liability• Share holder voting powers

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Principles of OECD code on Corporate Governance 2005

1. The corporate governance system should promote transparent and efficient markets; should be consistent with rule of law and should lay down clear roles of various regulatory and enforcement authorities.

2. Corporate governance system should protect and facilitate shareholder rights

3. The system should facilitate equitable treatment of all shareholders, including minority and foreign shareholder

4. Corporate governance should recognize the rights of stakeholders established by law or mutual contract; should encourage cooperation between the corporate and the stakeholders to create value

5. Disclosure and transparency: system should ensure timely and accurate information about the financial situation, performance, ownership and governance

6. Responsibilities of the Board

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NEW YORK STOCK EXCHANGE REGULATIONS

• Majority of Board to comprise of independent directors• Definition of independent director tightened

• Non-executive directors to meet at regular intervals without the management• Listed companies to compulsorily establish following committees consisting of independent directors

only –• Corporate Governance Committee • Compensation Committee• Audit Committee

• Listed companies to have an internal audit function• Listed companies to frame and disclose corporate governance guidelines, consisting the following

matters –• director qualification standards• director’s responsibilities• director’s access to management• director’s compensation• management succession• annual performance evaluation of the Board

• Listed companies to compulsorily adopt a Code of Business Conduct and Ethics for directors, officers and employees

• CEO to certify annually that there are no listing agreement violations

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PROVISIONS OF SARBANES OXLEY ACT

• CEO and CFO to certify appropriateness of financial statements• Forfeiture of bonuses and profits in certain circumstances• Officer and director Bars and Penalties; Equitable relief:

• If there is a restatement of financial statements due to material non-compliance, the CEO/CFO reimburse the company for its losses

• Prohibition on personal loans to executives• Disclosure of transactions involving management and principal

stockholders:• Directors, officers and 10% shareholders to report designated

transactions within 1 day• Annual report to contain a report by management on internal control

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Indian Legal Framework

• New Companies Act – inducing good CG practices through self regulation, responsive legal framework based on shareholders’ democracy; disclosure based regime; rational penal provisions with built-in deterrence and effective protection

• Amendments to the Acts governing three professional institutes (ICAI/ICSI/ICWAI) with a view to strengthen the disciplinary mechanism and bring transparency in their working.

• Notification of Accounting Standards with a view to bring the disclosure norms in tune with the international reporting standards;

• SEBI – Clause 49 – Appointment of IDs, Audit committee, Code of conduct, disclosures of related party transactions, remunerations, compliance of accounting standards, certifications of CEO & CFO, Compliance Certification & Whistle-blower policy (optional);

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Current status on corporate governance

• Insistence on forms and structures• Overarching regulations • Regulatory overkill • Lack of adequate number of strong, independent

directors• Large liabilities for companies and officers• For the first time in the decade-long history of the Index

of Economic Freedom, the U.S. is no longer among the top ten “most free” countries; however India not in the Top 20

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Current status on corporate governance

Comparison of Board structure – Indian top 50 Vs U.S. top 50 – Key Findings

Parameter India (Nifty Fifty companies) US (top 50 out of NYSE 100 index)

Ownership pattern 48% of Indian companies have largest shareholder holding over 50%

Largest shareholder holds less than 10% in all cases

Board size Largest board size – 17. smallest – 5 Largest board size 18. smallest – 10

44% of the top 50 companies have more than 12 directors

66% of the top 50 companies have more than 12 directors

Board independence 58% of companies have a board majority of independent directors

12% have less than 1/3rd of their directors independent

All companies have a board majority of independent directors

Executive directors in board In 35 companies 50% of the directors – or more – are executive directors

Boards of 49 companies out of 50 have less than 25% executive directors

Chairman and CEO 60% have separate Chairman and CEO Only 20% have separate Chairman and CEO

Lead independent director 3 companies have lead independent directors 20 companies have lead independent directors

Board committees All companies have audit committees – 54% have fully independent Audit Committees

33 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

All companies have fully independent audit remuneration and nomination committees

Source: Crisil Report on Corporate Governance

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THANK YOU