CORPORATE GOVERNANCE

NATURE OF AGENCY PROBLEM

 Adam Smith had identified, very perceptively, the
agency problem in his classic work The Wealth of
Nations:
"Like the stewards of a rich man, they (managers) are
apt to consider attention to small matters as not for
their master's honour, and very easily give themselves
a dispensation from having it. Negligence and
profusion, therefore, must always prevail, more or less,
in the management of the affairs of such a company."
 Managers are the agents of shareholders. There is
often a lack of congruence in the objectives of the
shareholders (principals) and managers (agents). This
leads to agency costs which represent a loss in the
value of the firm.
 WHAT IS CORPORATE GOVERNANCE

 Corporate governance is concerned basically

with the agency problem that arises from the
separation of finance and management (or, in
popular terms, ownership and control).
 It refers to the mechanisms and arrangements
employed by financiers (shareholders and
lenders) to induce managers, who tend to acquire
considerable residual control rights in practice,
to care for their interest.
ASSETS CONTROLLED BY
VARIOUS INDIAN COMPANIES
Total Assets
No of Controlled % of Aggregated Assets
Types of Companies Companies (Rs. Crores) Controlled
Indian Business Groups 2959 893454.61 38%
Top 50 Indian Business Groups 1151 452590.35 19%
Government Controlled Companies 462 1121816.48 48%
Foreign Companies 593 153373.82 7%
Other Companies 5689 171307.64 7%
Total 9703 2339952.55 100%
SHAREHOLDING PATTERN OF
INDIAN COMPANIES
Indian Business
Groups Controlled Government Controlled
Shareholders Companies(%) Companies (%) Foreign Companies (%)
Promoters 51.86 64.71 63.01
Mutual Funds 2.40 1.95 2.37
Banks and Insurance Companies 5.18 8.24 2.92
FIIs 3.64 6.06 2.95
Public 23.85 13.18 19.68
Others 13.07 5.86 9.06
Total 100 100 100
ASIAN OWNERSHIP
The ownership of firms in Asia is held
by a small number of very wealthy
families.

Number of Percent of Assets

Firms in Widely controlled by top
Smaple Family State Held 10 families
Hong Kong 330 66.7 1.4 7 32.1
Indonesia 178 71.5 8.2 5.1 57.7
Japan 1240 9.7 0.8 79.8 2.4
Korea 345 48.4 1.6 43.2 36.8
Malaysia 238 67.2 13.4 10.3 24.8
Philippines 120 44.6 2.1 19.2 52.5
Singapore 221 55.4 23.5 5.4 26.6
Taiwan 141 48.2 2.8 26.2 18.4
Thailand 167 61.6 8 6.6 46.2
 The whole issue of corporate governance became a
matter of concern especially because of the process of
globalization and particularly the investment by the
foreign financial institutions in the emerging markets
 The investors had to ensure that the companies in
which they invested were not only managed properly
but also had proper corporate governance.
 Management involves the optimum use of the
resources available for an enterprise like human,
physical & financial resources as well as time.
 Corporate governance relates to the issue of the
framework of values under which an enterprise
performs
 the issue of corporate governance is an issue of
agency function namely how to ensure that the
interests of the investors are taken care of.
 This is not only in terms of return on investment by
effective management but also ensuring that the
enterprises do not indulge in corrupt practices or acts
which are unethical and which may have greater
consequences.
 corporate governance is going to depend on two factors.
 The first is the internal factor of the philosophy, values, mission etc. adopted by the
top management of the company.
 So far as the internal factors are concerned, the thinking as a result of the various
processes in different countries on the issue of corporate governance appears to be
veering to the option of having supervisory board.
 This board will look into the corporate governance aspect and executive board,
which looks into the management aspect. This is the pattern in Germany.
 Malaysia had made it mandatory for every corporate directors to undergo annual
reorientation training programmes, so that they would be able to cope with the
changing dynamics of globalization.
 Also, it was mandatory that the corporates must appoint independent directors to
one-third of their boards and that they must get themselves rated for corporate
governance annually, besides doing quarterly reporting their corporate performance
PARTIES TO C G
 Parties involved in corporate governance include the
regulatory body (e.g. the CHIEF EXECUTIVE OFFICER,
the BOARD OF DIRECTORS, MANAGEMENT and
SHAREHOLDERS).
 Other stakeholders who take part include suppliers,
employees, creditors, customers and the community at
large.
 In corporations, the shareholder delegates decision rights to
the manager to act in the principal's best interests.
 This separation of ownership from control implies a loss of
effective control by shareholders over managerial decisions.
Partly as a result of this separation between the two parties,
a system of CORPORATE GOVERNANCE controls is
implemented to assist in aligning the incentives of
managers with those of shareholders.
 With the significant increase in equity holdings of
investors, there has been an opportunity for a
reversal of the separation of ownership and control
problems because ownership is not so diffuse.
 A board of directors often plays a key role in
corporate governance. It is their responsibility to
endorse the organisation's strategy, develop
directional policy, appoint, supervise and remunerate
senior executives and to ensure accountability of the
organisation to its owners and authorities
 The COMPANY SECRETARY is a high ranking professional
who is trained to uphold the highest standards of corporate
governance, effective operations, compliance and administration.
 All parties to corporate governance have an interest, whether
direct or indirect, in the effective performance of the organisation.
Directors, workers and management receive salaries, benefits and
reputation, while shareholders receive capital return.
 Customers receive goods and services; suppliers receive
compensation for their goods or services. In return these
individuals provide value in the form of natural, human, social
and other forms of capital.
 A key factor is an individual's decision to participate in an
organisation e.g. through providing financial capital and trust that
they will receive a fair share of the organisational returns.
 If some parties are receiving more than their fair return then
participants may choose to not continue participating leading to
organizational collapse.
PRINCIPLES
 Commonly accepted principles of corporate governance
include:
 Rights and equitable treatment of shareholders:
Organizations should respect the rights of shareholders and
help shareholders to exercise those rights.
 Interests of other stakeholders: Organizations should
recognize that they have legal and other obligations to all
legitimate stakeholders.
 Role and responsibilities of the board:
The board needs a range of skills and understanding to be able
to deal with various business issues and have the ability to
review and challenge management performance. It needs to be
of sufficient size and have an appropriate level of commitment
to fulfill its responsibilities and duties.
 Integrity and ethical behaviour: Ethical and responsible decision
making is not only important for public relations, but it is also a
necessary element in risk management and avoiding lawsuits.
 Organizations should develop a code of conduct for their directors
and executives that promotes ethical and responsible decision
making.

 Disclosure and transparency: Organizations should clarify and

make publicly known the roles and responsibilities of board and
management to provide shareholders with a level of accountability.
 They should also implement procedures to independently verify and
safeguard the integrity of the company's financial reporting.
 Disclosure of material matters concerning the organization should be
timely and balanced to ensure that all investors have access to clear,
factual information.
GOVERNANCE PRINCIPLES
INCLUDE:
 internal controls and internal auditors
 the independence of the entity's external auditors and the
quality of their audits
 oversight and management of risk
 oversight of the preparation of the entity's financial
statements
 review of the compensation arrangements for the chief
executive officer and other senior executives
 the resources made available to directors in carrying out
their duties
 the way in which individuals are nominated for positions
on the board
 DIVIDEND policy
 Integrity and ethical behaviour: Ethical and responsible decision
making is not only important for public relations, but it is also a
necessary element in risk management and avoiding lawsuits.
Organizations should develop a code of conduct for their directors and
executives that promotes ethical and responsible decision making. It is
important to understand, though, that reliance by a company on the
integrity and ethics of individuals is bound to eventual failure. Because
of this, many organizations establish Compliance and Ethics Programs
to minimize the risk that the firm steps outside of ethical and legal
boundaries.
 Disclosure and transparency: Organizations should clarify and make
publicly known the roles and responsibilities of board and management
to provide shareholders with a level of accountability. They should also
implement procedures to independently verify and safeguard the
integrity of the company's financial reporting. Disclosure of material
matters concerning the organization should be timely and balanced to
ensure that all investors have access to clear, factual information.
 In India the Bajaj Committee has
recommended that we need not go in for two
tier system for running of enterprise and
governance of the corporations are concerned.
 This brings the other alternative of having
external part time directors for companies who
in turn would play the role of a watchdog to the
board not only for protecting the interests of
the stakeholders but also from the point of view
of corporate governance.
 The formation of an ethics committee and a
finance committee seems to be the pattern.
CORPORATE GOVERNANCE IN
INDIA : PRIVATE SECTOR
 Historically, promoters, financial institutions, and
individual investors, on average, were more or less equal
shareholders.
 In recent years, promoters and financial institutions have
gained at the expense of individual investors.
 For electing the directors, the majority rule voting system
is typically followed.
 Company boards comprise of three types of directors :
promoter directors, professional directors, and
institutionally nominated directors.
 In general, institutional investors have been supportive of
promoters.
 Individual shareholders have, by and large, been benign,
tolerant, and ignorant.
CORPORATE GOVERNANCE IN INDIA :
PUBLIC SECTOR

 Boards comprise of functional directors,

government directors, and outside directors.
 There can be a good deal of political and
bureaucratic influence over the management of
PSUs.
 PSUs are constrained by various regulations and
administrative guidelines.
 The short tenure of CEOs may induce myopia.
 In general, performance standards are soft,
compensation levels low, incentives for
performance poor, and ‘real’ accountability
weak.
 THE COMPANIES
ACT

The key legal provisions with respect to

corporate boards are as follows:
 Strength A public limited company must have at
least three directors
 Meetings The board of directors must meet at least
once in a quarter
 Composition There is no fixed number of non-
executive directors.

No person can be a director of more than twenty
companies.

Powers The board of directors has the
powers to (a) borrow, lend, and invest funds,
(b) recommend dividends, and (c) appoint
the managing director.
 Remuneration The total remuneration of
the directors is subject to a ceiling of 11
percent of net profits.
 In addition, board members can be paid a
sitting fees upto Rs.20000 per meeting.
 Duties The board has the duty to present
the annual report to the members.
 Liabilities The board is punishable for
breach of trust, dishonesty, and fraud.
 CONFLICT OF INTEREST

 According to Lambert and Larcker, there are

three principal sources of conflict between the
interest of managers (agents) and the interest of
shareholders (principals).
 Excessive perquisites
 Differential risk attitudes
 Varying time horizons

 Theexecutive compensation system can be an

important means of reconciling the conflicts.
 DESIGNING AN INCENTIVE COMPENSATION PLAN

 Integrate the incentive plan into the total compensation

architecture
 Choose the appropriate level of risk posture and time
focus
 Use objective criteria
 Select the right set of performance measures
 Reward relative performance
 Discourage parochial behaviour
 Abandon attempts to measure what executives control
 Lengthen the decision making horizon of the executives
 Employ stock options judiciously
 Ensure tax efficiency
 EMPLOYEE STOCK OPTION PLAN

 In India, stock options which were virtually

unheard of till the late 1990s are gaining
popularity and a lot of attention, particularly in
knowledge-intensive sectors like information
technology, entertainment, and health care.
 This trend is expected to gather momentum
because it is generally believed that stock options
align closely the interest of managers with those
of shareholders.
 After all, the value of a stock option depends
mainly on the share price which is the dominant
component of shareholders' total return.
SHAREHOLDER VALUE CREATION NETWORK

Creating shareholder
Corporate objective Shareholder return
value
• Dividends
• Capital gains

Valuation
components Cash flow from operations Discount rate Debt

Value • Value growth • Cost of

drivers duration • Sales growth • Working capital capital
• Operating profit investment
margin • Fixed capital
• Income tax rate investment

Management decisions Operating Investment Financing

Source : Alfred Rappaport, Creating Shareholder Value : A Guide for Managers and Investors.