Corporate governance -- why and what?
Saturday, 21 July 2007
Amitava Basu
PEOPLE who provide finance to a company are often not in the management control of the enterprise. Though shareholders are the owners of the company, in reality companies cannot be managed by shareholder referendum. Shareholders have to necessarily delegate their responsibilities as owners to the board of directors for planning corporate strategy and overseeing the operations; and a management team carries out implementation of corporate policy and strategy. Interests of those who have effective control over a company can differ from the interests of those who supply finance to the company. This symptom, commonly referred to as principal-agent syndrome, grows out of separation of ownership and management.
In absence of appropriate mechanism for disclosure of proper information and monitoring, the suppliers of finance who are not in management control over the company finds it risky and costly to protect themselves from the possible opportunistic behaviour of managers or controlling shareholders. Without meaningful protection for providers of capital, those who are in the management control of the company can use their position to inappropriately extract economic benefits, often at the expense of the long-term performance and value of the enterprise. This can deter investors in placing their funds in the capital market. In other words, underperformance of the corporate sector leads to greater vulnerability of the financial system. And, this makes it harder for companies to raise funds on favourable terms. Unfortunately, this sets back economic and social goals by a generation, and it is the poorer section of the society who shoulders the brunt of the impact.
It is in response to meeting this need of protecting the interests of the providers of capital who do not have management control over the company and for holding the balance between economic and social goals and individual and community objectives that the system of corporate governance has evolved over centuries.
The first well-documented failure of governance was the South Sea Bubble in the 1700s, which revolutionalised business laws and practices in the United Kingdom. Similarly, much of the securities law in the United States was put in place following the stock market crash in 1929. Yet, there has been no shortage of similar crises, such as the secondary banking crisis of the 1970s in the United Kingdom and the savings and loan debacle of the 1980s in the United States. The history of evolution of corporate governance has also been punctuated by a series of failures of well-known companies such as the collapse of the Bank of Credit & Commerce International and the Enron scam. Each crisis or major corporate failure -- often a result of incompetence, fraud and abuse -- was addressed by new elements of improved system of corporate governance.
Through this process of continuous change, developed countries have established a complex mosaic of laws, regulations, institutions and implementation capacity in the government and the corporate sector. The objective is not to shackle companies but rather to balance promotion of enterprise with greater accountability. The systematic enforcement of law and regulations has created a culture of compliance that has shaped the management ethos of the corporate sector, spurring it to improve as a means of attracting human and financial resources on the best possible terms.
This has also coincided with globalisation because of the setting up of the World Trade Organisation (WTO) and every member of WTO trying to bring down the tariff barriers, and making competition cutthroat. Globalisation involves movement of four economic parameters, viz., physical capital in terms of plant and machinery, financial capital in terms of money invested in capital market and in foreign direct investment, technology, and labour moving across national borders.
When investing, the investors want to be sure that not only the enterprises in which they are investing run competently but also these should have good corporate governance. Increasingly, individual investors, funds, banks and other financial institutions base their decisions not only on a company's outlook, but also on its reputation and governance. It is the growing need to access financial resources -- domestic and foreign -- and to harness the power of the corporate sector for economic and social progress that has brought corporate governance into prominence.
Increasingly for developing economies, a healthy and competitive corporate sector is fundamental for sustained and shared growth. Sustained in that it withstands economic shocks; shared in that it delivers benefits to the society. Countries realise that just as overall governance is important, so corporate governance is important because it is a source of competitive advantage and critical to economic and social progress.
Sound corporate governance does not only attract foreign capital but more especially broadens and deepens local capital market by attracting local investors - individual and institutional. Unlike international investors who can diversify their risk, domestic investors are often captive to the system and face greater risks, particularly in an environment that is opaque and does not protect the rights of the minority shareholders. As a group, domestic investors constitute a large potential pool of stable long-term resources that are critical to development. If the local capital market is to grow, corporate governance standards need to improve to give investors the protection required to encourage them to provide capital.
Only recently, corporate governance has emerged as a discipline in its own right. Yet, what constitutes corporate governance is still a topic of debate. From a company perspective, the emerging consensus is that corporate governance is about maximising shareholder value subject to meeting the company's financial, legal and contractual obligations. This definition stresses the need for balancing the interests of shareholders with those of other stakeholders - employees, suppliers, customers, and the community - in order to achieve long-term sustained value. From a public policy perspective, corporate governance is about nurturing enterprises while ensuring accountability in exercise of power and patronage by the organisations.
These two definitions provide a framework for corporate governance that reflects an interplay between the internal incentives, which define the relationship among the key players in the company; and external forces, notably policy, legal, regulatory and market that together govern the behaviour and performance of the company. In other words, corporate governance represents the value framework, the ethical framework and the moral framework under which business decisions are taken. The objective is not only to handle the capital effectively and add to creation of wealth, but also that the business decisions are taken in a manner that is not illegal or involves moral hazard. Although, corporate governance still remains an ambiguous term, three factors are becoming evident --
lTransparency in decision making
l Accountability through fixation of responsibilities for actions taken or not taken
l Safeguarding the interests of the investors and other stakeholders of the company
Implementation of corporate governance has depended upon laying down explicit codes, which companies are supposed to observe. The report of the Cadbury Committee in the United Kingdom was the starting point, which has led to a number of other codes - report of the Greenbury Committee, Combined Code of the London Stock Exchange, OECD Code on Corporate Governance, Blue Ribbon Committee on corporate governance in the United States and the Sorbones Oxley Act following the Enron debacle. However, ultimate effective corporate governance depends on the commitment of the people in the company for the principle of integrity and transparency in business operations. Secondly, it is imperative to have robust legal and administrative framework created by the government to facilitate sound corporate governance. If public governance is weak, there cannot be good corporate governance.
In the ultimate analysis, effective corporate governance needs the three way test for ethics prescribed by Normal Vincent Peale and Kenneth Blanchard in their book "The Power of Ethical Management" --
l Is the decision legal?
l Is the decision fair?
l Is the decision such that if public knows it through media, it will be shameful?
The companies need to give clear-cut signal that the words "your company" in the annual report have real meaning. This requires well functioning boards, greater disclosures, better management practices, and a more open, interactive and dynamic corporate governance environment. Quite simply, support of shareholders and creditors is vital for survival, growth and competitiveness of the companies. Such support requires the corporate sector to tone up its act today.
The author is Development Practitioner and Director, Intercontinental Consultants and Technocrats Private Limited, New Delhi, India
PEOPLE who provide finance to a company are often not in the management control of the enterprise. Though shareholders are the owners of the company, in reality companies cannot be managed by shareholder referendum. Shareholders have to necessarily delegate their responsibilities as owners to the board of directors for planning corporate strategy and overseeing the operations; and a management team carries out implementation of corporate policy and strategy. Interests of those who have effective control over a company can differ from the interests of those who supply finance to the company. This symptom, commonly referred to as principal-agent syndrome, grows out of separation of ownership and management.
In absence of appropriate mechanism for disclosure of proper information and monitoring, the suppliers of finance who are not in management control over the company finds it risky and costly to protect themselves from the possible opportunistic behaviour of managers or controlling shareholders. Without meaningful protection for providers of capital, those who are in the management control of the company can use their position to inappropriately extract economic benefits, often at the expense of the long-term performance and value of the enterprise. This can deter investors in placing their funds in the capital market. In other words, underperformance of the corporate sector leads to greater vulnerability of the financial system. And, this makes it harder for companies to raise funds on favourable terms. Unfortunately, this sets back economic and social goals by a generation, and it is the poorer section of the society who shoulders the brunt of the impact.
It is in response to meeting this need of protecting the interests of the providers of capital who do not have management control over the company and for holding the balance between economic and social goals and individual and community objectives that the system of corporate governance has evolved over centuries.
The first well-documented failure of governance was the South Sea Bubble in the 1700s, which revolutionalised business laws and practices in the United Kingdom. Similarly, much of the securities law in the United States was put in place following the stock market crash in 1929. Yet, there has been no shortage of similar crises, such as the secondary banking crisis of the 1970s in the United Kingdom and the savings and loan debacle of the 1980s in the United States. The history of evolution of corporate governance has also been punctuated by a series of failures of well-known companies such as the collapse of the Bank of Credit & Commerce International and the Enron scam. Each crisis or major corporate failure -- often a result of incompetence, fraud and abuse -- was addressed by new elements of improved system of corporate governance.
Through this process of continuous change, developed countries have established a complex mosaic of laws, regulations, institutions and implementation capacity in the government and the corporate sector. The objective is not to shackle companies but rather to balance promotion of enterprise with greater accountability. The systematic enforcement of law and regulations has created a culture of compliance that has shaped the management ethos of the corporate sector, spurring it to improve as a means of attracting human and financial resources on the best possible terms.
This has also coincided with globalisation because of the setting up of the World Trade Organisation (WTO) and every member of WTO trying to bring down the tariff barriers, and making competition cutthroat. Globalisation involves movement of four economic parameters, viz., physical capital in terms of plant and machinery, financial capital in terms of money invested in capital market and in foreign direct investment, technology, and labour moving across national borders.
When investing, the investors want to be sure that not only the enterprises in which they are investing run competently but also these should have good corporate governance. Increasingly, individual investors, funds, banks and other financial institutions base their decisions not only on a company's outlook, but also on its reputation and governance. It is the growing need to access financial resources -- domestic and foreign -- and to harness the power of the corporate sector for economic and social progress that has brought corporate governance into prominence.
Increasingly for developing economies, a healthy and competitive corporate sector is fundamental for sustained and shared growth. Sustained in that it withstands economic shocks; shared in that it delivers benefits to the society. Countries realise that just as overall governance is important, so corporate governance is important because it is a source of competitive advantage and critical to economic and social progress.
Sound corporate governance does not only attract foreign capital but more especially broadens and deepens local capital market by attracting local investors - individual and institutional. Unlike international investors who can diversify their risk, domestic investors are often captive to the system and face greater risks, particularly in an environment that is opaque and does not protect the rights of the minority shareholders. As a group, domestic investors constitute a large potential pool of stable long-term resources that are critical to development. If the local capital market is to grow, corporate governance standards need to improve to give investors the protection required to encourage them to provide capital.
Only recently, corporate governance has emerged as a discipline in its own right. Yet, what constitutes corporate governance is still a topic of debate. From a company perspective, the emerging consensus is that corporate governance is about maximising shareholder value subject to meeting the company's financial, legal and contractual obligations. This definition stresses the need for balancing the interests of shareholders with those of other stakeholders - employees, suppliers, customers, and the community - in order to achieve long-term sustained value. From a public policy perspective, corporate governance is about nurturing enterprises while ensuring accountability in exercise of power and patronage by the organisations.
These two definitions provide a framework for corporate governance that reflects an interplay between the internal incentives, which define the relationship among the key players in the company; and external forces, notably policy, legal, regulatory and market that together govern the behaviour and performance of the company. In other words, corporate governance represents the value framework, the ethical framework and the moral framework under which business decisions are taken. The objective is not only to handle the capital effectively and add to creation of wealth, but also that the business decisions are taken in a manner that is not illegal or involves moral hazard. Although, corporate governance still remains an ambiguous term, three factors are becoming evident --
lTransparency in decision making
l Accountability through fixation of responsibilities for actions taken or not taken
l Safeguarding the interests of the investors and other stakeholders of the company
Implementation of corporate governance has depended upon laying down explicit codes, which companies are supposed to observe. The report of the Cadbury Committee in the United Kingdom was the starting point, which has led to a number of other codes - report of the Greenbury Committee, Combined Code of the London Stock Exchange, OECD Code on Corporate Governance, Blue Ribbon Committee on corporate governance in the United States and the Sorbones Oxley Act following the Enron debacle. However, ultimate effective corporate governance depends on the commitment of the people in the company for the principle of integrity and transparency in business operations. Secondly, it is imperative to have robust legal and administrative framework created by the government to facilitate sound corporate governance. If public governance is weak, there cannot be good corporate governance.
In the ultimate analysis, effective corporate governance needs the three way test for ethics prescribed by Normal Vincent Peale and Kenneth Blanchard in their book "The Power of Ethical Management" --
l Is the decision legal?
l Is the decision fair?
l Is the decision such that if public knows it through media, it will be shameful?
The companies need to give clear-cut signal that the words "your company" in the annual report have real meaning. This requires well functioning boards, greater disclosures, better management practices, and a more open, interactive and dynamic corporate governance environment. Quite simply, support of shareholders and creditors is vital for survival, growth and competitiveness of the companies. Such support requires the corporate sector to tone up its act today.
The author is Development Practitioner and Director, Intercontinental Consultants and Technocrats Private Limited, New Delhi, India