TYBFM

Business Ethics & Corporate

Governance – Unit 2
 Corporate Governance (CG)
 The word “governance” comes from Latin word
“gubernare” i.e. to steer (guide & control)
 Governance simply means process of decision
making and the process by which decisions are
implemented
 A set of processes, customs, policies affecting the
way a corporation is directed or controlled
 Aims at ensuring accountability of certain
individuals in an organization through proper
mechanisms
 Definition as per Cadbury Report (UK), 1992
3 Pillars of Corporate Governance

Transparency Accountability

Equanimity
 Aspects of CG
1. The power given to management and control
over management’s use of power

2. Management’s accountability to stakeholders

3. The formal and informal processes by which

stakeholder’s influence management
decisions (voting rights, % of ownership, etc.)
 Factors influencing CG
• Ownership structure (private/public/MNC)

• Structure of company boards (BOD)

• Financial structure (debt: equity)

• Institutional environment (legal, regulatory

and political environment)
 Reasons/Need for CG
• Collapses of prominent businesses (Lehman
Brothers, Enron Corporation)
• Corporate scams or scandals (Harshad Mehta)
• Changing patterns of share ownership
• Protection of investment
• Technological advances in communication
• Provide confidence to external investors to raise
funds at lower cost (Globalization)
• To improve transparency & accountability as
greater expectations from society
• Huge increase in top management compensation
 Objectives of CG
• A properly structured board is in place
• Balanced representation of non-executive and
independent directors on the board
• Decisions based on transparent information
• Serve the concerns of stakeholders
• Inform shareholders about the developments
impacting the company
• Monitor the functioning of management team
• Effective control of company by the board
• Maximize long term value and shareholders
wealth
 *Importance/Benefits of CG*
To business organization:
• Protects interests of all stakeholders
• Avoids disturbing ethics policies
• Creates transparency in all activities
• Good image about the organization
• A way of maintaining responsibility towards
society
 *Importance/Benefits of CG*
• Investors ready to put extra money
• Repeat orders by customers
• Loan at cheaper rates
• Discounts by suppliers
• Better results achieved by employees
• Government exemption & privileges
 *Importance/Benefits of CG*
To various parties involved:
• Good returns for investors
• Timely payments to lenders
• Timely payments to suppliers & more orders
• Good products at fair prices to customers
• Good remuneration to employees
• Direct/Indirect taxes to government
• Economic development & employment for
society
 Scope of CG
• To set high standards of business ethics
• To enhance long term value and economic
efficiency
• To use resources in productive, effective and
economic ways
• To increase market confidence of the firm
• To make the decision making process transparent
• To generate accurate and reliable information
• To improve the standard of living of society
• To ensure a open & participative style of
management for free exchange of ideas
Enterprise’s triple ethical effect on society
 Constituents of CG
1. Board of Directors:
• Accountable to stakeholders
• Directs and controls the management
• Sets goals and oversees their implementation
• Keeps check on activities & progress
2. Shareholders:
• Appoint directors and auditors
• Hold board accountable for proper
governance
• Seek required information about the company
 Constituents of CG
3. Management:
• Take steps to do activities as per Board’s
instructions
• Report information to the board on timely
basis about completion of those activities
• Accountable to the BOD
 Evolution of CG (International View)
1. US:
• The Foreign Corrupt Practices Act, 1977 made
provisions regarding establishment, maintenance
of systems of internal control
• 1979 – US Securities Exchange Commission –
mandatory reporting on internal financial controls
• 1985 – Treadway Commission – Need of
independent committees & boards and internal
audit
• 1992 – Committee of Sponsoring Organizations
formed to prescribe control framework
 Evolution of CG (International View)
2. UK:
• Scandals & financial collapses in 1980s & 1990s –
made shareholders and bank worry about
investments
• UK Gov. – insufficient existing legislation and
control – insufficient governance practices
• Cadbury Committee – set up by London Stock
Exchange – May 1991 – to raise standards of
corporate governance
• July 2002 – The Sarbanes-Oxley Act –
fundamental changes in auditor independence,
financial disclosure, severe penalties for willful
default by managers and auditors
 Evolution of CG (International View)
3. France:
• In no other industrialized country in the world
except Japan does state play as powerful role as
France
• Any non European company desirous to buy more
than 20% of the capital of a French company
(takeover) must require prior approval of the
government
• Banks, insurance companies are the main
providers of capital to French industry, thus the
state indirectly controls private companies also
 Evolution of CG (International View)
4. Japan:
• Powerful government intervention by the
Japanese Ministry of Finance to maintain strong
regulatory control on every industrial activity
• Cross-shareholding by affiliated companies to
counter hostile takeover
• Features affecting Japanese attitudes towards
Corporate Governance:
i. Concept of obligation
ii. Concept of family
iii. Concept of consensus
 Development of CG in India
• Old concept dating back to 3rd Century B.C. where
Chanakya elaborated fourfold duties of a King -
Raksha, Vriddhi, Palana & Yogakshema
• Substituting the king with CEO/BOD the principles of
CG will be protecting shareholders wealth (Raksha),
enhancing the wealth (Vriddhi), maintenance of
wealth (Palana) and safeguarding the interests of
shareholders (Yogakshema)
• Not much importance till the financial crisis of 1990s,
later companies act amended few times and
measures adopted to enhance CG – Empowerment of
SEBI, Shareholders nominee on the Board, limits on
number of directorships, etc.
 Major CG initiatives in India
1. The CII Code:
• Due to the Cadbury Committee Report of UK, the
Confederation of Indian Industry (CII) took an
initiative to develop & promote a code of CG to be
adopted by Indian companies (private & public)
• Draft code was circulated in 1997 & Final code
released – “Desirable Corporate Governance
Code” released in Apr 1998
• The code was voluntary and contained detailed
provisions with focus on listed companies
 Major CG initiatives in India
2. Kumar Mangalam Birla Committee Report:
• Need for a statutory rather than a voluntary code
• Committee set up by SEBI under the chairmanship
of Kumar Mangalam Birla in 1999 to raise the
standards of good corporate governance
• In 2000, SEBI accepted recommendations of this
committee and incorporated it in Clause 49 of the
Listing Agreement of the Stock Exchanges
• The recommendations provided the standards of
CG divided into mandatory and non-mandatory
provisions
 Major CG initiatives in India
2. Kumar Mangalam Birla Committee Report:
• These recommendations are applicable to all
listed companies with paid-up capital of Rs. 3
crore and above or net worth of Rs. 25 crore or
more at any time in the history of company
• The responsibility of putting the
recommendations to practice rests directly with
the BOD & management of the company
 Major CG initiatives in India
3. Naresh Chandra Committee Report:
• Due to Enron debacle in 2001 involving
relationship between auditor and corporate client
& scams in US, led the Ministry of Finance &
Company Affairs to appoint a committee in Aug
2002 under the chairmanship of Naresh Chandra
to examine amendments to the law involving
auditor-client relationships
• The committee made recommendations in 2 key
aspects:
i. Financial and non-financial disclosures
ii. Independent auditing
 Major CG initiatives in India
4. Narayan Murthy Committee Report:
• Need to look beyond mere systems if investors
interests are to be protected
• SEBI instituted a committee under the
chairmanship of Narayan Murthy for reviewing the
implementation of CG code (Clause 49) by listed
companies
• The committee made recommendations related to
audit committees, audit reports, independent
directors, related party transactions, directorships
and director compensation, etc.
 Clause 49 – Legal Framework of CG
• Appointment of non-executive directors
• Place constraints on management power &
ownership concentration
• Ensuring proper disclosure of financial
information & executive compensation
 Companies Act, 2013 - Provisions
• Significant changes to composition of BOD
• At least 1 resident director on board
• Nominee directors shall not be treated as
independent director
• Listed companies & specified class of public
companies to appoint independent directors & at
least 1 women director on board
• Prescribes duties of directors
• Following committees to be constituted – Audit
Committee, Nomination & Remuneration
Committee, Stakeholders relationship Committee,
Corporate Social Responsibility Committee
 Principles of CG
• Adequate disclosures
• Effective decision making
• Transparency in business transactions
• Statutory & legal compliances
• Protection of shareholder interests
• Commitment to values & ethical conduct of
business
 Characteristics of a good CG Policy
• Participatory
• Consensus oriented
• Accountable
• Transparent
• Responsive
• Equitable & inclusive
• Follow the rule of law
 Elements of good CG
• Transparency in board’s processes &
independence in the functioning of board
• Accountability & fairness to stakeholders
• Social, regulatory & environmental factors
• Clear & unambiguous legislation
• A healthy management environment
• Clearly documented objectives
• Well composed audit committee
• Mechanism for review of internal & external risks
• A clear whistle blower policy
4 P’s of CG
 Theories of CG
1. Agency Theory: (Alchian & Demsetz, further
developed by Jensen & Meckling)
 Theories of CG
2. Shareholder Theory: (Milton Friedman – 1970)
• There is one and only one responsibility of
business: to use its resources to engage in
activities designed to increase its profits so long
as it stays within the rules of the game, which is
to say engages in open & free competition,
without deception & fraud.

• Maximize shareholders interests in a way which is

permitted by law or social values
 Theories of CG
3. Stakeholder Theory: (Edward Freeman – 1988)
• Any group or individual who can affect or is
affected by the achievement of the org’s objectives
• Broader then shareholders theory
• Shareholders, employees, suppliers, customers,
local and world community, environment
• Business leader’s duty to balance the shareholders
interest with other stakeholders interest
• Interest of all stakeholders should be considered
• Network of relationship with suppliers, employees
and business partners
 Theories of CG
4. Stewardship Theory: (Davis, Schoorman &
Donaldson – 1997)
• Alternative view of agency theory
• Managers are stewards whose behaviors are aligned
with the objectives of principal
• A steward protects & maximizes shareholders wealth
through firm performance, because by doing so, the
steward’s utility functions are maximized
• Stewards are satisfied & motivated when
organizational success is attained

*steward – manage or look after another’s property

 Practicing Framework of CG
• Supervisory Board
• Audit committee
• Internal audit
• Statutory audit
• Disclosure of information
• Risk management framework
• Internal control framework
• Whistle blower policy
 Types of Disclosure
An effective Disclosure Based Regulation (DBR) is
necessary to promote investor activism. The
disclosures can be done through electronic or
physical means & it is of following types:

1. Initial Disclosure: (IPO, FPO, Private placement)

2. Continuous Disclosure:
• Financial Disclosure
• Non-Financial Disclosure
 Issues involving CG
• Independence of entity’s external auditors
• Quality of their audits
• Preparation of entity’s financial statements
• Compensation arrangement of CEO/Executives
• Resources available to directors for carrying out
duties
• Way in which individuals are nominated for
positions on board
• Dividend Policy
 Checklist of an effective Board
• Board members must share common & clear vision
• Commitment for achievement of the vision
• Possess necessary resources, competencies,
technology and capabilities for successful
implementation
• Strategic projects assigned to select directors
• Fresh governance needs for expanding into
international network
• Mutual trust & respect to supplement & complement
each other’s responsibilities & contributions
 Responsibilities of Org towards
employees
• Adequate compensation
• Good working conditions
• Respect employee’s health & dignity
• Act on employee’s suggestions, ideas &
complaints
• Avoid discriminatory practices
• Protect employees from injury & illness at
workplace
• Assist employees in acquiring required skills &
knowledge