Your Ad Here

October 26, 2009

Corporate Governance

The last few years have seen some major scams and corporate collapse across the globe. In India, the major example is Satyam which is one of the largest IT companies in India. All these events have caused the pendulum of public faith to shift away from free market to a more closely regulated one. However "corporate governance," inspite of being the new object of interest and inquisitiveness from various quarters, remains an ambiguous and often misunderstood phrase. So before delving further on the subject it is important to define the concept of corporate governance.

To get a fair view, it would be prudent to give a narrow as well as broad definition of corporate governance. In a narrow sense, it involves a set of relationships amongst the company’s management, its board of directors, its share holders, auditors and other stakeholders. These relationships which involve various rules and incentives provide the structure through which the objectives of a company are set and the means of attaining and monitoring performance are determined. In a broader sense, corporate governance is important for overall market confidence, the efficiency of capital allocation, the growth and development of countries’ industrial basis and ultimately the nations’ overall wealth and welfare. In both narrow as well as in the broad definitions, the following concepts occupy a centre stage:

· Rights and equitable treatment of shareholders

· Interests of other stakeholders

· Role and responsibilities of the board

· Integrity and ethical behavior

· Disclosure and transparency

Ever since the first writings on the subject appeared there have been many debates as to whom should corporate governance really represent: the interest of the shareholders or that of all stakeholders. The shareholder primacy is embodied in the finance view of corporate governance, i.e., the primary justification for the existence of the corporation is to maximise shareholders’ wealth. Since ownership and control are separate the issue here is to align the objectives of management with the objective of shareholder wealth maximisation.

The issue raised in the stakeholder theories is whether the recognition of a wider set of claims than those of shareholders alone is the legitimate concern of corporate governance. It is argued that the new technology world has reduced the opportunity, ability and the motivation of consumers to engage in rational decision making. So the development of inclusive stakeholder relationships rather than production at a lower price will be the most important determinant of viability and success. It implies searching for a balance among the distinct company interest groups – i.e., shareholders, workers, banks etc. - and also looks for their participation.

A natural question to ask is why do we need to impose particular governance regulations. There are at least three reasons for regulatory intervention:

1) If the founder of the company was allowed to design and implement a corporate charter he likes. He may not clearly address the issues faced by other shareholders and thus conjure inefficient rules. E.g. in the absence of regulations founders could employ anti-takeover defences excessively but shareholders may favour takeovers that increase the value of their shares even if they involve greater losses for unprotected creditors or employees. So the collective bargaining process may not yield socially acceptable solutions and may be at the mercy of few stakeholders.

2) Another argument comes from the externality argument. An externality may be defined as a good generated as the result of an economic activity, whose benefits or costs do not accrue directly to the parties involved in the activity. E.g. one corporate scandal can erode shareholder trust in the whole of the corporate sector. In such cases where private action fails to resolve widespread externalities involving many parties the state has the responsibility to intervene and prevent market failure.

3)Regulation is also needed to avoid a situation where efficient rules are designed initially but due to lack of active tracking by dispersed shareholders, are altered or broken later.

While regulations are necessary, there are however, a few issues that need to be considered. The first relates to policing and punishment. The SEBI envisages that all these corporate governance norms will be enforced through listing agreements between companies and the stock exchanges but for companies with little floating stock deregulation because of non compliance is hardly a credible threat. The second issue has to do with form vs. Substance. There is a fear that by legally mandating several aspects of corporate governance the regulators encourage the practise of companies following the letter of the law instead of focussing on the spirit of good governance. The third concern relates to apprehension about excessive interference that unwittingly leads to micro-management of companies.

Considering these apprehensions, what we need is a small corpus of legally mandated rules, buttressed by much larger body of self-regulation and voluntary compliance.

So after careful weighing of all pros and cons it is not tough to conclude that good Corporate Governance makes for good business sense. It increases confidence of shareholders in the company leading to better stock prices. Research has shown that the good Corporate Governance brings down the cost of capital for the company. Good disclosure practices lead to a more liquid market for the company. This lowers cost of debt. Thus for the CEOs of today, there is a clear business case for complying with principles of good Corporate Governance.


A detailed analysis of several UK corporate governance reports are given below-

CADBURY REPORT (1992) - The Cadbury Report, titled ‘Financial Aspects of Corporate Governance’ is a report of a committee chaired by Adrian Cadbury that sets out recommendations on the arrangement of company boards and accounting systems to mitigate corporate governance risks and failures. The report was published in 1992. The report's recommendations have been adopted in varying degree by the European Union, the United States, the World Bank, and others.

Ethics and corporate governance: The issues raised by the Cadbury report in the United Kingdom :

In the late 1980s there was a series of sensational business scandals in the United Kingdom. The City of London responded by creating a special committee to examine the financial aspects of corporate governance. To reduce the power of executive directors in the boardroom the committee recommended a greater role for non-executive directors, changes in board operations, and a more active role for auditors.

GREENBURY REPORT (1995) - The Greenbury Report released in 1995 was the product of a committee established by the United Kingdom Confederation of Business and Industry on corporate governance. It followed in the tradition of the Cadbury Report and addressed a growing concern about the level of director remuneration.

HAMPEL REPORT (1998) - The Hampel Report (Committee on Corporate Governance) in 1998 was designed to be a revision of the corporate governance system in the UK. The remit of the committee was to review the Code laid down by the Cadbury Report. It asked whether the code's original purpose was being achieved. Hampel found that there was no need for a revolution in the UK corporate governance system. The Report aimed to combine, harmonise and clarify the Cadbury and Greenbury recommendations.

TURNBULL REORT (1999) - The Turnbull Report - "Internal Control: Guidance for Directors on the Combined Code", published by the Internal Control Working Party of the Institute of Chartered Accountants in England and Wales - sets out how directors of listed companies should comply with the UK's Combined Code requirements in respect of internal controls, including financial, operational, compliance and risk management. Organisations that wish to be good corporate citizens, whether publicly quoted, privately owned or in the public sector, look to the Combined Code - and therefore to the Turnbull Report - for guidance on how to do this.

THE HIGGS REVIEW (2003) - In April 2002 the Secretary of State, Patricia Hewitt, and the Chancellor, Gordon Brown, appointed Derek Higgs to lead a short independent review of the role and effectiveness of non-executive directors and of the audit committee, aiming at improving and strengthening the existing Combined Code. Derek Higgs published his report 'Review of the Role and Effectiveness of Non-Executive Directors' on 20th January 2003.Higgs strongly backed the existing non-prescriptive approach to corporate governance: "comply or explain". Yet he advocated more provisions with more stringent criteria for the board composition and evaluation of independent directors.

SMITH REPORT (2003) - The Smith Report was a report on corporate governance submitted to the UK government in 2003. It was concerned with the independence of auditors in the wake of the collapse of Arthur Andersen and the Enron scandal in the US in 2002. Its recommendations now form part of the Combined Code on corporate governance, applicable through the Listing Rules for the London Stock Exchange.It was substantially influenced by the views taken by the EU Commission. One important point was that an auditor himself should look at whether a company's corporate governance structure provides safeguards to preserve his own independence.

UK COMBINED CODE ON CORPORATE GOVERNANCE – UK incorporated companies listed on the UK Stock Exchange are subject to the Combined Code on Corporate Governance. The most recent (2003) version of the Code combines the Cadbury and Greenbury reports on corporate governance, the Turnbull Report on Internal Control (revised and republished as the Turnbull Guidance in 2005), the Smith Guidance on Audit Committees and elements of the Higgs Report. The Combined Code is, in 2006, subject to a review.

The Financial Reporting Council (FRC) is the independent UK regulator and is also responsible for the statutory oversight and regulation of auditors and of the professional accountancy and actuarial bodies. The UK Combined Code works on what is known as a ‘Comply or Explain’ basis; in other words, companies may choose not to comply with specific provisions but, in that case, will have to provide a proper public explanation of their decision.

AIM Companies - Companies listed on AIM in the UK are not formally required to comply with the Combined Code. Some choose to do so. The QCA (Quoted Companies Alliance) published, in July 2005, the Corporate Governance Guidelines for AIM companies, which are based on the Combined Code and are voluntary.

UK COMPANIES ACT 2004 - The UK’s Companies (Audit, Investigations and Community Enterprise) Act of 2004 placed a statutory duty on officers and employees (including ex-employees) to provide auditors with information (other than legally privileged information) and explanations in respect of any issue related to their audit of the company’s accounts. The directors are required to make a statement that they have disclosed (having taken appropriate steps to ascertain it) all relevant information to the auditors and making a false statement is a criminal offence.

The UK’s Financial Reporting Review Panel (the FRRP), which was originally set up in 1990 to look into instances of corporate accounting non-compliance with UK GAAP, gained new powers to require companies, directors and auditors to provide documents, information and explanations if there might be an accounts non-compliance with relevant reporting requirements. With the exception of small and medium enterprises, UK companies will be required to make detailed disclosure of non-audit services supplied by their auditors.

UK COMPANIES ACT 2006 - The Companies Act 2006, which received royal assent at the end of 2006, is coming into law in stages and will be fully in effect by October 2008. This Act replaces virtually all the previous UK companies legislation. The first commencement order contained requirements on disclosure of company information and made provisions for the use of e-communications.

Corporate Governance in US
Post Enron and WorldCom failures, the US Government had been heavily criticized, which in turn, served as catalysts for legislative change (Sarbanes-Oxley Act of 2002) and regulatory change (new governance guidelines from the NYSE and NASDAQ).
Sarbanes- Oxley Act: - The Sarbanes-Oxley Act of 2002 (enacted July 30, 2002), also known as the Public Company Accounting Reform and Investor Protection Act of 2002 and commonly called Sarbanes-Oxley, Sarbox or SOX, is a United States federal law enacted on July 30, 2002, as a reaction to a number of major corporate and accounting scandals like Tyco International, Enron, Adelphia, Peregrine Systems and WorldCom. These scandals, which cost investors billions of dollars when the share prices of affected companies collapsed, shook public confidence in the nation's securities markets. The legislation set new or enhanced standards for all U.S. public company boards, management and public accounting firms. It does not apply to privately held companies. The act contains 11 titles, or sections, ranging from additional corporate board responsibilities to criminal penalties, and requires the Securities and Exchange Commission (SEC) to implement rulings on requirements to comply with the new law. No legislation is ever flawless but once pressed into force is especially likely to contain imperfections. Although there have been complaints about this law from managers and directors, on the whole, it has worked better than might have been expected.
The provisions of the law target top managers, board members, and the auditing profession, especially firms that oversee the accounting and financial reporting of companies. The chief executive officer (CEO) and the chief financial officer (CFO) of such companies are required to certify that their financial reports accurately depict the company’s financial status. False statements are treated as a criminal act. The law also prevents executives from receiving loans from their companies. Despite the real and perceived issues, the act seems to have contributed to improved financial reporting and good corporate governance. It has focused attention on transparent reporting and improved accounting controls.
Supporters of SOX contend the legislation was necessary and has played a useful role in restoring public confidence in the nation's capital markets by, among other things, strengthening corporate accounting controls. Opponents of the bill claim it has reduced America's international competitive edge against foreign financial service providers, saying SOX has introduced an overly complex regulatory environment into U.S. financial markets. However the debate continues over the perceived benefits and costs.
Current state of corporate governance in United States:
Sporadic attempts have been made to give shareholders more influence in the governance process. The reality is that U.S. shareholders participate in governance as they always have: by following the “Wall Street rule.” They sell stock when they are unhappy with a company’s performance and they buy when a company’s future seems promising.

In spite of the scandals of the early years of the 21st century, there is much that is positive to report about corporate governance in the United States. Many boards of directors are improving their oversight and guidance of their companies. The relationship between the directors and their auditors has been clarified and strengthened by the Sarbanes-Oxley Act.

Of course, more progress is needed. The process of board improvement is ongoing and needs to reach even more board rooms. The greatest challenge of all will be for the business community and policymakers to find a path forward which enhances the role of shareholders in the governance process, even though the majority of them seem more like short-term renters of shares than long-term owners.

No comments:

Post a Comment

Your Ad Here