Corporate Governance An overview Introduction There has been renewed interest in the corporate governance practices of modern corporations

s since 2001, particularly due to the high-profile collapses of a number of large U.S. firms such as nron !orporation, "orld!om and Satyam, the fourth largest #T !ompany in #ndia. #n 2002, the US federal government passed the Sarbanes-$%ley &ct, intending to restore public confidence in corporate governance. #n a 'oard !ulture of !orporate (overnance business author (abrielle $)*onovan defines corporate governance as )an internal system encompassing policies, processes and people, which serves the needs of shareholders and other sta+eholders, by directing and controlling management activities with good business savvy, ob,ectivity and integrity. Sound corporate governance is reliant on e%ternal mar+etplace commitment and legislation, plus a healthy board culture, which safeguards policies and processes). $)*onovan goes on to say that )the perceived -uality of a company)s corporate governance can influence its share price as well as the cost of raising capital. .uality is determined by the financial mar+ets, legislation and other e%ternal mar+et forces plus the international organi/ational environment0 how policies and processes are implemented and how people are led. %ternal forces are, to a large e%tent, outside the circle of control of any board. The internal environment is -uite a different matter, and offers companies the opportunity to differentiate from competitors through their board culture. To date, too much of corporate governance debate has centered on legislative policy, to deter fraudulent activities and transparency policy which misleads e%ecutives to treat the symptoms and not the cause.) #t is a system of structuring, operating and controlling a company with a view to achieve long term strategic goals to satisfy shareholders, creditors, employees, customers and suppliers, and complying with the legal and regulatory re-uirements, apart from meeting environmental and local community needs. 1eport of S '# committee 2#ndia3 on !orporate (overnance defines corporate governance as the acceptance by management of the inalienable rights of shareholders as the

true owners of the corporation and of their own role as trustees on behalf of the shareholders. #t is about commitment to values, about ethical business conduct and about ma+ing a distinction between personal 4 corporate funds in the management of a company.5 The definition is drawn from the (andhian principle of trusteeship and the *irective 6rinciples of the #ndian !onstitution. !orporate (overnance is viewed as ethics and a moral duty. Impact of Corporate Governance The positive effect of good corporate governance on different sta+eholders ultimately is a strengthened economy, and hence good corporate governance is a tool for socioeconomic development. &fter ast &sian economies collapsed in the late 20th century, the "orld 'an+)s president warned those countries, that for sustainable development, corporate governance has to be good. conomic health of a nation depends substantially on how sound and ethical businesses are. Principles 7ey elements of good corporate governance principles include honesty, trust and integrity, openness, performance orientation, responsibility and accountability, mutual respect, and commitment to the organi/ation. $f importance is how directors and management develop a model of governance that aligns the values of the corporate participants and then evaluate this model periodically for its effectiveness. #n particular, senior e%ecutives should conduct themselves honestly and ethically, especially concerning actual or apparent conflicts of interest, and disclosure in financial reports. !ommonly accepted principles of corporate governance include8 1. Rights and Equita le !reatment of "hareholders $rgani/ations should respect the rights of shareholders and help shareholders to e%ercise those rights. They can help shareholders e%ercise their rights by effectively communicating information that is understandable and accessible and encouraging shareholders to participate in general meetings.

2. Interests of other "ta#eholders $rgani/ations should recogni/e that they have legal and other obligations to all legitimate sta+eholders. $. Role and Responsi ilities of the %oard The board needs a range of s+ills and understanding to be able to deal with various business issues and have the ability to review and challenge management performance. #t needs to be of sufficient si/e and have an appropriate level of commitment to fulfill its responsibilities and duties. There are issues about the appropriate mi% of e%ecutive and non-e%ecutive directors. The +ey roles of chairperson and ! $ should not be held by the same person. &. Integrit' and Ethical %ehavior thical and responsible decision ma+ing is not only important for public relations, but it is also a necessary element in ris+ management and avoiding lawsuits. $rgani/ations should develop a code of conduct for their directors and e%ecutives that promotes ethical and responsible decision ma+ing. #t is important to understand, though, that reliance by a company on the integrity and ethics of individuals is bound to eventual failure. 'ecause of this, many organi/ations establish !ompliance and thics 6rograms to minimi/e the ris+ that the firm steps outside of ethical and legal boundaries. (. )isclosure and !ransparenc' $rgani/ations should clarify and ma+e publicly +nown 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. *isclosure of material matters concerning the

organi/ation should be timely and balanced to ensure that all investors have access to clear, factual information. Issues involving corporate governance principles include* 1. #nternal controls and the independence of the entity)s auditors0 2. $versight and management of ris+0 9. $versight of the preparation of the entity)s financial statements0 :. 1eview of the compensation arrangements for the chief e%ecutive0 ;. $fficer and other senior e%ecutives0 <. The resources made available to directors in carrying out their duties0 =. The way in which individuals are nominated for positions on the board0 and >. *ividend policy. 5!orporate (overnance5 despite some feeble attempts from various -uarters has remained ambiguous and often misunderstood phrase. ?or -uite some time it was confined to only corporate management. #t is not so. #t is something much broader for it must include a fair, efficient and transparent administration to meet certain well defined ob,ectives. !orporate governance also must go beyond law. The -uantity, -uality and fre-uency of financial and managerial disclosure, the degree and e%tent to which the board of *irector 2'$*3 e%ercise their trustee responsibilities and the commitment to run transparent organi/ation- these should evolve due to interplay of many factors and the role played by more progressive elements within the corporate sector. #n #ndia, a strident demand for evolving a code of good practices by the corporate themselves is emerging. Internal Corporate Governance Controls #nternal corporate governance controls monitor activities and then ta+e corrective action to accomplish organi/ational goals. %amples include8 +onitoring ' the %oard of )irectors The board of directors, with its legal authority to hire, fire and compensate top management, safeguards invested capital. 1egular board meetings allow potential problems to be identified, discussed and avoided. "hilst non-e%ecutive directors are thought to be more independent, they may not always result in more effective corporate governance and may not increase performance. *ifferent board structures are optimal for different firms.

@oreover, the ability of the board to monitor the firm)s e%ecutives is a function of its access to information. %ecutive directors possess superior +nowledge of the decision-ma+ing process and therefore evaluate top management on the basis of the -uality of its decisions that lead to financial performance outcomes, ex ante. #t could be argued, therefore, that e%ecutive directors loo+ beyond the financial criteria. Remuneration 6erformance-based remuneration is designed to relate some proportion of salary to individual performance. #t may be in the form of cash or non-cash payments such as shares and share options, superannuation or other benefits. Such incentive schemes, however, are reactive in the sense that they provide no mechanism for preventing mista+es or opportunistic behaviour, and can elicit myopic behaviour. E,ternal Corporate Governance Controls %ternal corporate governance controls encompass the controls e%ternal sta+eholders e%ercise over the organi/ation. %amples include8 !ompetition *ebt covenants *emand for and assessment of performance information (overnment regulations @anagerial labour mar+et @edia pressure Ta+eovers "'stemic Pro lems of Corporate Governance *emand for information8 & barrier to shareholders using good information is the cost of processing it, especially to a small shareholder. The traditional answer to this problem is the efficient mar+et hypothesis 2in finance, the efficient mar+et hypothesis 2 @A3 asserts that financial mar+ets are efficient3, which suggests that the shareholder will free ride on the ,udgments of larger professional investors. @onitoring costs8 #n order to influence the directors, the shareholders must combine with others to form a significant voting group which can pose a real threat of carrying resolutions or appointing directors at a general meeting.

Supply of accounting information8 ?inancial accounts form a crucial lin+ in enabling providers of finance to monitor directors. #mperfections in the financial reporting process will cause imperfections in the effectiveness of corporate governance. This should, ideally, be corrected by the wor+ing of the e%ternal auditing process. Role of the Accountant ?inancial reporting is a crucial element necessary for the corporate governance system to function effectively. &ccountants and auditors are the primary providers of information to capital mar+et participants. The directors of the company should be entitled to e%pect that management prepare the financial information in compliance with statutory and ethical obligations, and rely on auditors) competence. !urrent accounting practice allows a degree of choice of method in determining the method of measurement, criteria for recognition, and even the definition of the accounting entity. The e%ercise of this choice to improve apparent performance 2popularly +nown as creative accounting3 imposes e%tra information costs on users. #n the e%treme, it can involve non-disclosure of information. $ne area of concern is whether the accounting firm acts as both the independent auditor and management consultant to the firm they are auditing. This may result in a conflict of interest which places the integrity of financial reports in doubt due to client pressure to appease management. The power of the corporate client to initiate and terminate management consulting services and, more fundamentally, to select and dismiss accounting firms contradicts the concept of an independent auditor. !hanges enacted in the United States in the form of the Sarbanes-$%ley &ct prohibit accounting firms from providing both auditing and management consulting services. Similar provisions are in place under clause :B of S '# &ct in #ndia. The nron collapse is an e%ample of misleading financial reporting. nron concealed huge losses by creating illusions that a third party was contractually obliged to pay the amount of any losses. Aowever, the third party was an entity in which partner in charge of auditing, views inevitably led to the client prevailing. nron had a substantial economic sta+e. #n discussions of accounting practices with &rthur &ndersen, the

Aowever, good financial reporting is not a sufficient condition for the effectiveness of corporate governance if users don)t process it, or if the informed user is unable to e%ercise a monitoring role due to high costs. Corporate Governance +odels around the -orld &lthough the US model of corporate governance is the most notorious, there is a considerable variation in corporate governance models around the world. The intricate shareholding structures of +eiretsus in Capan, the heavy presence of ban+s in the e-uity of (erman firms, the chaebols in South 7orea and many others are e%amples of arrangements which try to respond to the same corporate governance challenges as in the US. This internationally agreed benchmar+ consists of more than fifty distinct disclosure items across five broad categories are8 1. &uditing 2. 'oard and management structure and process 9. !orporate responsibility and compliance :. ?inancial transparency and information disclosure ;. $wnership structure and e%ercise of control rights The "orld 'usiness !ouncil for Sustainable *evelopment "'!S* has done wor+ on corporate governance, particularly on accountability and reporting, and in 200: created an #ssue @anagement Tool8 Strategic challenges for business in the use of corporate responsibility codes, standards, and framewor+s. This document aims to provide general information, a 5snap-shot5 of the landscape and a perspective from a thin+-tan+Dprofessional association on a few +ey codes, standards and framewor+s relevant to the sustainability agenda. Corporate Governance and .irm Performance #n its )(lobal #nvestor $pinion Survey) of over 200 institutional investors first underta+en in 2000 and updated in 2002, @c7insey found that >0E of the respondents would pay a premium for well-governed companies. They defined a well-governed company as one that had mostly out-side directors, who had no management ties, undertoo+ formal evaluation of its directors, and was responsive to investors) re-uests for information on governance issues. The si/e of the premium varied by mar+et, from 11 per cent in !anada

and around :0 per cent for companies where the regulatory bac+drop was least certain countries 2those in @orocco, gypt and 1ussia3. $ther studies have lin+ed broad perceptions of the -uality of companies to superior share price performance. #n a study of five year cumulative returns of ?ortune @aga/ine)s survey of )most admired firms), &ntunovich et al found that those 5most admired5 had an average return of 12; per cent whilst the )least admired) firms returned >0 per cent. #n a separate study 'usiness "ee+ enlisted institutional investors and )e%perts) to assist in differentiating between boards with good and bad governance and found that companies with the highest ran+ings had the highest financial returns. $n the other hand, research into the relationship between specific corporate governance controls and firm performance has been mi%ed and often wea+. The following e%amples are illustrative. %oard Composition Some researchers have found support for the relationship between fre-uency of meetings and profitability. $thers have found a negative relationship between the proportion of e%ternal directors and firm performance, while others found no relationship between e%ternal board membership and performance. #n a recent paper 'agahat and 'lac+ found that companies with more independent boards do not perform better than other companies. #t is unli+ely that board composition has a direct impact on firm performance. Remuneration/Compensation The results of previous research on the relationship between firm performance and e%ecutive compensation have failed to find consistent and significant relationships between e%ecutives) remuneration and firm performance. Fow average levels of pay-performance alignment do not necessarily imply that this form of governance control is inefficient. Got all firms e%perience the same levels of agency conflict, and e%ternal and internal monitoring devices may be more effective for some than for others. Some researchers have found that the largest ! $ performance incentives came from ownership of the firm)s shares, while other researchers found that the relationship between share ownership and firm performance was dependent on the level of ownership. The results suggest that increases in ownership above 20 per cent cause management to become more entrenched, and less interested in the welfare of their shareholders.

Some argue that firm performance is positively associated with share option plans and that these plans direct managers) energies and e%tend their decision hori/ons toward the longterm, rather than the short-term, performance of the company. Aowever, that point of view came under substantial criticism circa in the wa+e of various security scandals including mutual fund timing episodes and, in particular, the bac+dating of option grants as documented by University of #owa academic ri+ Fie and reported by Cames 'lander and !harles ?orelle of the "all Street Cournal. ven before the negative influence on public opinion caused by the 200< bac+dating scandal, use of options faced various criticisms. & particularly forceful and long running argument concerned the interaction of e%ecutive options with corporate stoc+ repurchase programs. Gumerous authorities 2including U.S. ?ederal 1eserve 'oard economist "eisbenner3 determined options may be employed in concert with stoc+ buybac+s in a manner contrary to shareholder interests. These authors argued that, in part, corporate stoc+ buybac+s for U.S. Standard 4 6oors ;00 companies surged to a H;00 billion annual rate in late 200< because of the impact of options. & compendium of academic wor+s on the optionDbuybac+ issue is included in the study Scandal by author @. (umport issued in 200<. & combination of accounting changes and governance issues led options to become a less popular means of remuneration as 200< progressed, and various alternative implementations of buybac+s surfaced to challenge the dominance of 5open mar+et5 cash buybac+s as the preferred means of implementing a share repurchase plan. References 1. ?or a good overview of the different theoretical perspectives on corporate governance see !hapter 1; of *ignam, & and Fowry, C 2200<3 !ompany Faw, $%ford University 6ress #S'G-198 B=>-0-1B-B2>B9<-9 2. !orporate (overnance #nternational Cournal, 5& 'oard !ulture of !orporate (overnance, Iol < #ssue 9 220093 9. !rawford, !urtis C. 2200=3. The 1eform of !orporate (overnance8 @a,or Trends in the U.S. !orporate 'oardroom, 1B==-1BB=. *octoral dissertation, !apella University. :. SS1G-(ood !orporate (overnance8 &n #nstrument for "ealth @a%imisation by Ira,lal Sapovadia ;. 'hagat 4 'lac+, 5The Uncertain 1elationship 'etween 'oard !omposition and ?irm 6erformance5, ;: 'usiness Fawyer3 <. Gational &ssociation of !orporate *irectors 2G&!*3 J *irectors @onthly, 5 nlightened 'oards8 &ction 'eyond $bligation5, Iol. 91Gumber 12 2200=3, 6g 19.