Good Corporate Governance and Its Principles

The below mentioned article provides a complete guide to good corporate governance and its newly amended principles.

Introduction:

There is no single model of a good corporate governance.

However, Organisation for Economic Cooperation and Development (OECD) analyzing the works carried out in member countries has formulated some important principles of good corporate governance.

The principles are stated to be evolutionary in nature and should be reviewed in the light of significant changes in circumstances. Ideally, since the corporate governance is primarily based on ethical code of business conduct, the principles of good corporate governance should be non-binding on the corporate companies.

However, the government has important responsibility for regulating practices so that the misappropriation of funds and frauds do not occur. Subject to these regulations, corporate enterprises are allowed free­dom in functioning so that they can promote the interests of shareholders and other stakeholders in a framework of free markets for both securities and products.

A. Rights of Shareholders and Fair Treatment of Them:

An important principle of good corporate governance is that it should protect shareholders rights. Second, the corporate enterprise should ensure fair treatment to all stakeholders including minority shareholders and foreign shareholders.

Third, all shareholders must have opportunity for effective redress of their grievances regarding violation of their rights including the rights to information. Above all, the corporate governance structure should recognize the rights of shareholders in creating value, employment and the working of enterprises in a financially sound manner.

B. Corporate Transparency:

The principle of corporate transparency requires timely and accurate disclosure of information by a corporate company on all matters regarding the corporation including its financial situation, performance and ownership.

C. Corporate Accountability:

According to this principle the corporate governance system as shaped by the board of directors must ensure the effective monitoring of management by the board and above all responsibility of the Board and top management to the shareholders and other shareholders for any transactions made and productive activities performed by the company. Let us explain the two important principles of corporate transparency and accountability in some detail

Corporate Transparency:

Inefficiency and lack of transparency in corporate governance that often leads to scandals and frauds are major challenges facing the corporate world. These have hampered the smooth function­ing of companies and stock markets and have adversely affected long-term investment which is crucial for sustained growth of the economy. The failure of international giants like Enron, World Com., Xerox have been said to be caused by the absence of effective corporates transparency.

To eradicate poor and ineffective corporate governance, there is a paramount need for transparency in the conduct of business by corporates. In response to the poor and ineffective corporate governance several initiatives have been taken in the past some years to make the working of corporates effective and transparent.

Among them are codes of conduct, rules of business ethics to be self imposed by the companies to furnish complete information, disclosures regarding the financial position, perfor­mance of the company regarding its profitability, ownership and governance of the company to its shareholders and other stakeholders. Ajith Nivard Carbaal in his paper on “Corporate Governance, Transparency and Accountability” writes,

“Transparency involves the determination of information and data in as a complete manner as possible so as to provide, furnish and transmit information and data in a timely manner and in an understandable and knowledgeable form to shareholders about a relevant system. Transparency ensures that those who are in charge of systems, disclose the selected, specified information and its working at the given times in the pre-determined manner. Through the dissemination of such information it is believed that those who have interest in the particular system would be able to obtain an understanding and knowledge which is at least close to, if not equal to, that of those who are involved within the system.”

The transparency is important for two reasons:

First, the Board of directors and top management of corporate enterprises required to provide pre-determined information will become more conscious to ensure that their business transactions are proper and above board. This will reduce the chances of their committing frauds on shareholders, financiers and investors.

Second, the recipients having gained access to the required information and data will be better able to evaluate in which company to invest to get good return from their investment.

This will enable companies not only to attract domestic investors but also foreign capital inflows. Thus, with transparency good corporate gover­nance can be achieved which will be of great help in promoting long-term investment and sustained growth of the corporate company.

Corporate Accountability:

The principle of accountability is defined as the assignment of responsibility to specified persons or groups within the corporate enterprise for undertaking definite tasks to produce certain results or outcome and holding such persons or groups responsible for doing the assigned tasks properly.

The accountability of a corporate company to its shareholders, financiers, investors is of crucial importance to win investors confidence. It is the board of directors and top managers who are held accountable for any wrongs committed in disclosures, financial reporting and business decisions taken by them.

The accountability of different persons within the corporate system is established codes of best practices, rules and regulations to be followed in discharge of their duties. It has been observed that despite several measures taken by the government, guidelines issued by SEBI and RBI, the account­ability in the corporate sector has not been achieved to any significant degree.

As a result, shareholders and investors, lenders to the corporate firms have suffered a lot due to the lack of accountability. In the South Asian countries including India there is concern about standards of financial reporting and accountability.

Several companies in India raised funds from market project­ing inflated picture of their past performance and profitability. But actually they performed much worse than the past reported figures.

As a result, shareholders and investors suffered due to corrupt management and their investment in highly risky investments projects. Fraudulent practices were also adopted in allotting promoters shares at preferential prices disproportionate to market value. These practices adversely affected the minority holders interest. But, at least in India, no sense of accountability has been shown to the investors and losses suffered by them. However, in the USA following the failures of reputed corporate companies like Enron, World Com. which caused heavy losses to the investors due to their wrong financial reporting, the Sarbanes – Oxley Act 2002 was passed to address the issues concerning accountability.

Under this Act, the Securities and Exchange Commission initiated action against multinational accounting firms for failure to detect blatant violations of accounting standards and penalties running to several million dollars were recovered from certain multinational consultancy firms. But in India there is acute lack of accountability of corporate firms and they often indulge in corrupt practices to dupe the investors.

This is still happening despite the recommendations of Kumar Manglam Birla Committee, Naresh Chandra Committee, the Sebi Committee on Corporate Governance regarding the adoption of best practices of governance for protecting interests of shareholders and other stakeholders. Therefore, in case of India also the law on the lines of the US Sarbanes-Oxley-Act 2002 needs to be passed and strictly enforced if accountability of corporate companies is to be ensured.

Generally, in management science, accountability means ensuring that the person or division of the company who is assigned to perform a task actually performs it effectively and honestly. A corporate can easily lack accountability if various so called ‘Profit Centres’ in it do not perform well according to the established standards.

Any business enterprise is run by managers of different divisions or departments (often called profit centres) and are given the resources (i.e. inputs) needed to accomplish the assigned task and therefore they are held accountable if things go wrong and they do not produce the expected results or outcome (i.e. output).

According to Ajit Nivard Cabraal, “Organisations tends to focus on the quantum of funds that are allocated-to respective departments or divisions without considering carefully as to what “outcomes” are expected from such ‘inputs’..” This shortcoming invariably leads to those divisions or departments not having to or being asked to account to the organisation for the funds entrusted to them. Even if there are some seemingly transparent controls in the application and disbursement of the funds, but if there are no clear per­formance or output criteria set out and expected outcomes identified, it is almost impossible to hold the responsible official accountable for the funds “thus expanded”.

However, the concept of corporate governance generally applies to the accountability of board of directors and top management who control and supervise the corporate enterprise and have sufficient authority to get things done properly. They are expected to adopt good and healthy principles and codes of good governance and avoid corruption in their dealings, especially with the shareholders and investors. They are expected to observe established standards of financial probity.

Corporate Governance and New Companies Bill:

After Satyam fiasco in January 2009, the Government was under pressure to improve the governance of corporate companies and fix roles and responsibility of corporate management. On August 3, the Government introduced the Companies Bill in the Lok Sabha which will replace the Companies Act of 1956.

The new bill provides for articulation of shareholders democracy with protection of rights of minority stakeholders and responsible self-regulation with disclosures and accountability. “Sharehold­ers associations or group of shareholders will be enabled to take legal action in case of any fraudulent action on part of the company and to take part in investor protection activities in class action suits,” the bill said. Under current norms, a person holding shares worth Rs. 1 lakh or less in a company is categorized as a small investor.

However, while large investors can question corporate strategies through voting rights and other means, small investors do not have any specific instrument to hold promoters of companies accountable. The provision of class action suit is aimed at suitably empowering small and minority stake­holders in case of any wrong doing by promoters or management of a firm. A class action or a repre­sentative action is a form of lawsuit where large groups of people collectively bring a claim to court.

The bill has also proposed several provisions; apart from setting accounting and auditing standards it also defines the role and responsibilities of an independent director. An “independent director” according to the bill, should be a person of integrity with relevant experience and should not have any monetary relationship or transaction with the company, its subsidiaries, or promoters.

A single forum for approval of mergers and acquisitions along with a shorter merger process for holding and wholely-owned subsidiary companies has also been introduced in the new companies act. Highlights of the Changes Made in the New Amended Companies Bill 2011. To ensure good corporate governance, the new amended Companies Bill 2011 which was passed by parliament in Aug. 2013 has made several important changes for the working of corporate companies.

Some important changes are the following:

1. Social Responsibility for Companies:

It is stipulated in the new companies act that compa­nies will have to spend 2% their average net profit during three years on corporate social responsibil­ity (CSR) activities in the local areas of their operations. In case of non-compliance, the broad of a company will have to explain why spending on CSR activities has fallen short in a particular year.

2. Independent Directors:

To improve the proper and impartial working of the corporate companies it has been provided that every board of a listed company will have at least one-third of its directors as independent directors. Listed companies can have one independent director representing small shareholders. Further, no director can be on the boards of more than 20 companies.

3. Tightening of Rules for Auditors:

To ensure strict financial control over the companies to prevent any financial bungling by the companies it has been had down that auditors can be appointed for 5 years at a time. Besides, in a limited company an auditor cannot get two consecutive 5 year terms. Further, one auditor cannot audit more than 20 companies.

4. More Powers to Shareholders:

Shareholders can taken legal action against a company for fraud, shareholders or depositors of the companies can file class-action suits against a company in case of any fraud done with them. However, banking companies have been exempted from this.

5. Measures to Check Corporate Frauds:

Fraud and wrongful gain has been defined first time in this new amended company bill. Serious fraud investigation office (SFIO) has received statutory recognition. Once SFIO starts investigating any alleged case of fraud no other agency can be involved. The new bill allows assets of companies under investigation to be frozen for use as evidence. As mentioned above, shareholders can take legal action against the company for fraud.

6. Employees Protection in Failed Companies:

If a company winds up its operations, it must pay two years’ salary to its employees. Rights of employees will supersede even those of even se­cured creditors. Companies law tribunal will have powers to sanction compromise solutions among various stakeholders.

7. Strict Rules for Raising Funds:

In the new bill tighter rules for raising funds have been laid down. Only banking companies, non-banking financial companies (NBFCs) and firms allowed by regulators can accept deposits from the public. For violation of this rule strict penalties with minimum of Rs. 1 crore can be imposed.

8. Transparency in Managerial Remuneration:

Listed companies will have to disclose ratio of each director’s remuneration to median salary. Besides, a director’s remuneration should not exceed five per cent of a company’s net profit. The implementation of above rules, both in letter and spirit, will go a long way in ensuring transparency in working of corporate companies and better corporate governance with social service responsibility.