Introduction to corporate governance

Former World Bank President James Wolfensohn "has equated the

importance of the governance of corporations to that of the governance of
countries." According to the Organisation for Economic Co-operation and
Development ("OECD"), "Corporate governance deals with the rights and
responsibilities of a company's management, its board, shareholders and
various stakeholders." The spectacular collapses of Enron and WorldCom in
the United States, where shareholders lost a combined $245 billion, and the
collapse of Italian dairy giant Parmalat in Europe, have transformed
corporate governance from an afterthought to the cornerstone of any firm's
or country's long-term success.

Corporate governance in a developing-country setting takes on additional

importance. Good corporate governance is vital because of its role in
attracting foreign investment. The extent of foreign investment, in turn,
shapes the prospects for economic growth for many developing countries.
This Note presents an in-depth inquiry into corporate governance in one
such developing country, India. While India's corporate-governance
framework is advanced for a developing country, it still can be significantly
improved. Part II discusses the importance of corporate governance for
developing countries.) Part III provides a brief history of corporate
governance in India. Part IV examines the current standards of corporate
governance in India. Finally, Part V recommends improvements to India's
corporate-governance framework.

Corporate governance is the set of processes, customs, policies, laws,

and institutions affecting the way a corporation (or company) is directed,
administered or controlled. Corporate governance also includes the
relationships among the many stakeholders involved and the goals for which
the corporation is governed. The principal stakeholders are the shareholders,
the board of directors, employees, customers, creditors, suppliers, and the
community at large.

Corporate governance is a multi-faceted subject. An important theme of

corporate governance is to ensure the accountability of certain individuals in
an organization through mechanisms that try to reduce or eliminate
the principal-agent problem. A related but separate thread of discussions
focuses on the impact of a corporate governance system in economic
efficiency, with a strong emphasis on shareholders' welfare. There are yet
other aspects to the corporate governance subject, such as the stakeholder
view and the corporate governance models around the world

Definitions

Adolf Berle has defined social responsibility as “the manager’s

responsiveness to
public consensus”
(www.bharatpetroleum.com).

Koontz and O’Donnell have given the definition of social

responsibility thus: “The
personal obligation of the people as they act in their own interests
to assure that the
rights and legitimate interests of others are not infringed”
(Hindu business line, 1998).

Corporate Governance can be defined as a systematic process by

which companies
are directed and controlled to enhance their wealth generating
capacity. Since large
corporations employ vast quantum of societal resources, we believe
that the
governance process should ensure that these companies are
managed in a manner
that meets stakeholders aspirations and societal expectations.
(Chartered Secretary, Oct, 1997).

To state in simple terms, corporate governance relates to a code of

conduct, the management of a company observes while exercising its
powers. Quality corporate governance not only serves the desired
corporate interest, but is also a key requirement in the best interests
of the corporates themselves.

2
 WHY CORPORATE GOVERNANCE?
Investors primarily consider two variables before making investment
decisions--the rate of return on invested capital and the risk associated with
the investment. In recent years, the "attractiveness of developing nations"
as a destination for foreign capital has increased, partly because of the high
likelihood of obtaining robust returns and partly because of the decreasing
"attractiveness of developed nations." The lure of achieving a high rate of
return, however, does not, by itself, guarantee foreign investment; the
attendant risk weighs equally in an investor's decision-making calculus.
Good corporate-governance practices reduce this risk by ensuring
transparency, accountability, and enforceability in the marketplace.

While strong corporate-governance systems help ensure a country's long-

term success, weak systems often lead to serious problems. In fact, some
contend that the "Asian financial crisis gave developing countries a lesson on
the importance of a sound corporate governance system."

The existence of a corporate-governance system is likely a part of this

decision-making process. In such a scenario, firms that are "more open and
transparent," and thus well governed, are more likely to raise capital
successfully because investors will have "the information and confidence
necessary for them to lend funds directly" to such firms. Moreover, well-
governed firms likely will obtain capital more cheaply than firms that have
poor corporate-governance practices because investors will require a smaller
"risk premium" for investing in well-governed firms.

Also, sound corporate-governance practices enable management to allocate

resources more efficiently, which increases the likelihood that investors will
obtain a higher rate of return on their investment. Finally, leading indices
show that developing countries that have good governance structures
consistently outperform developing countries with poor corporate-
governance structures. Thus, in an efficient capital market, investors will
invest in firms with better corporate-governance frameworks because of the
lower risks and the likelihood of higher returns. At a macro level, if firms in
developing countries attract investment, they will stimulate growth in the
3
local economy. If they "cannot attract equity capital, they are doomed to
remain on a small, inefficient scale," and they will be unable to stimulate
growth in their host country.

Good corporate governance benefits developing countries in a number of

ways. According to at least one scholar, good corporate-governance
practices can decrease the "likelihood of a domestic financial crisis" and the
severity if such a crisis does occur. Additionally, scholars have found strong
"evidence linking corporate governance to corporate efficiency" and have
shown that "corporate governance creates more efficient corporate
management." Finally, research shows that well-governed firms are valued
significantly higher than firms with imperfect corporate-governance
practices. It has been estimated that, by the end of this century, "funds
seeking trustworthy, productive companies in today's developing countries
are likely to top $500,000 billion." The policy challenge that exists for
governments in developing countries is to provide a hospitable environment
for such funds; a sound corporate-governance framework can play a decisive
role in creating this hospitable environment.

Strong corporate governance has beneficial consequences even for countries

that choose to follow a development strategy that does not focus on
attracting foreign investment. Many developing countries are home to strong
distribution cartels that waste scarce resources.Good corporate governance
can reduce this wasteful behavior and, thus, "overcome the obstacles to
productivity growth." Moreover, corporate governance can play a role in
reducing corruption, and decreased corruption significantly enhances a
country's developmental prospects. Ultimately, corporate governance "is not
just one of those imported western luxuries; it is a vital imperative."

History of corporate governance

Though the terms governance, good governance and corporate

governance is increasingly used in development literature since recent
times, the concept of governance is not new. It is as old as human
civilization. The eastern civilization has enumerable examples, where
in emphasis was laid on good governance. The activity of the
government of the state, as envisaged by the great eastern thinkers
on polity relates to all aspects of human life, social, economic and
religious. Peace, order, security and justice were regarded as the
fundamental aims of the states (the largest form of corporate). State
was considered a means to the realization of decent, good and
meaningful life and justice were regarded as the fundamental aims of
the states (the largest form of corporate). State was considered a
means to the realization of decent, good and meaning full life.
4
Manu, the son of Prajapathi was the first king who brought out a
comprehensive code of conduct or governance for men, society and the
state as a whole in his treaty called Manu Dharma Shastra. In Mahabharata
while delivering his first formal discourse on polity Bhisma says in equivocal
terms that the kin should always put the interest of his subjects over that of
his own.

The great political thinker of 3rd century BC namely Kautilya in his treaty
Arthasastra has laid down the ideals at which the king was expected to aim.
In eastern literature a good society is one wherein a high, ethical standard of
life is characterized by the pursuit of wealth, enjoyment and liberation. It is
the prevalence of dharma, which characterizes an ideal society. Such a
society is possible if the governance of the country is based on clear,
efficient and effective administration and all the rulers aim at this goal in the
ancient times.

However people in the west started feeling the need for good corporate
governance in early 80’s as the corporate misdemeanours increased. In U.K.,
in 1980s, the corporate sector was beseeched with a number of problems.
Business failure, limited role of auditors, weak accounting standards
culminated in loss of control. The Cadbury committee was set up by the
London Stock Exchange to address the dreary financial aspect of corporate
performance. A few years later, director’s pay became such a live political
issue that a study group on director’s remuneration was formed under Sir
Richard Greenbury. Then came two other committees – the King Committee
and the Hampel Committee to diagnose the issue of corporate governance.
The Asian financial crisis, recent scandals in US, Italy, India have triggered
fresh initiatives of thinking towards good governance. Corporate governance
has been much talked in India particularly after 1993. Liberalisation brought
in its wake a spate of corporate scandals, the first of which was a bank scam
involving securities. CRB scam and the UTI episode made it very clear that a
serious thinking is required on the front of corporate governance. SEBI in
India has taken the initiative in framing new rules and laws to strengthen
corporate governance. Committees like Kumar Mangalam Birla Committee
(2000), Naresh Chandra Committee (2002) brought out reports on corporate
governance. SEBI has also constituted a committee on corporate governance
under the chairmanship of Sri N.R. Narayana Murthy.

In 1999, in a defining moment in India's corporate-governance history, the

Indian Parliament created the Securities and Exchange Board of India
("SEBI") to "protect the interests of investors in securities and to promote the
development of, and to regulate the securities market." In the years leading
up to 2000, as Indian enterprises turned to the stock market for capital, it
became important to ensure good corporate governance industry-wide.
Additionally, a plethora of scams rocked the Indian business scene, and

5
corporate governance emerged as a solution to the problem of unscrupulous
corporate behavior.

In 1998, the Confederation of Indian Industry ("CII"), "India's premier

business association," unveiled India's first code of corporate governance.
However, since the Code's adoption was voluntary, few firms embraced it.
Soon after, SEBI appointed the Birla Committee to fashion a code of
corporate governance. In 2000, SEBI accepted the recommendations of the
Birla Committee and introduced Clause 49 into the Listing Agreement of
Stock Exchanges. Clause 49 outlines requirements vis-a-vis corporate
governance in exchange-traded companies. In 2003, SEBI instituted the
Murthy Committee to scrutinize India's corporate-governance framework
further and to make additional recommendations to enhance its
effectiveness. SEBI has since incorporated the recommendations of the
Murthy Committee, and the latest revisions to Clause 49 became law on
January 1, 2006.

The need of corporate governance

Recent corporate failures and scandals involving mis-governance and
unethical behaviour on the part of corporates rocked the corporate
sector all over the world, shook the investor confidence in stock
markets, and caused regulators and others to question the assumption
that most companies do the right thing most of the time. These
incidences diminished reputation and goodwill of even those
corporates who enjoy the trust and confidence of public at large. These
factors highlight the importance of good corporate governance. On the
other hand, corporate governance is important because corporate
decisions impinge on its shareholders, customer, creditors, the state
and employees. Globally the objective of corporate governance is to
maximize long-term shareholder value. With the assumption that
capital and financial markets are working properly, anything that
maximizes shareholder value will necessarily maximize corporate
prosperity.
For sound governance, managers need to act as trustee of
shareholders, prevent asymmetry of benefits between sections of
shareholders, especially between owner-managers and the rest of
shareholders. They also need to be a part of societal concerns about
labour and environment. In fact stock market analysts see these days
a greater correlation between governance and returns. Investment
analysts recommend a company based on strength or weakness of a
company’s governance infrastructure. Confidence of investors, both
domestic and foreign, is the need of the hour. This is to attract
‘patient’ long –term capital that will reduce their cost of capital. Thus,
6
there is a need for intellectual honesty, integrity and transparency,
which form the basis for good corporate governance.

How to ensure good corporate governance

Market Forces

There is a school of thought that believes that the market forces would take
care of
the problem of corporate governance.

TIte Survival of the Fittest Argument

If, over the long run, a firm does not maximise profits, then it is behaving
inefficiently. Either it is incurring unnecessary costs or failing to cash in on
revenue opportunities. Other firms will be able to undercut its price or
provide better qualities, etc., and erode its market share. This argument is,
therefore, based on the disciplining effects
of prodzrct market coinpetition.

Market for Managers

This argument suggests that there is ajob market for managers, just as there
is one
for ordinary workers. A manager, under whom firms perform poorly, will be
able to command a lesser value on this market.

However, even if a firm is performing poorly, it is difficult for outsiders to

assess whether the firm is doing poorly because it is being poorly managed
or because it is facing adverse market conditions. Moreover, a firm has a
team of managers and it is impossible to evaluate the contribution of each
manager to the firm's performance.

Capital Market Controls

The argument goes something like this : the inefficient functioning ofthe fiml
is reflected
in poor share prices since poor dividends are declared. Suppose that the
price is Rs. 5 currently. A raider will then buy out the low price shares, gain
control over the firm and replace the existing team ofmanagers by ainore
efficient team. As the performance of the firm improves, so does its share
price. Suppose that the share price rises to Rs. 10. Then the raider can then
make a profit by selling off the shares 58 acauired earlier (at the mice of Rs.
51 at the new. hirzher price of Rs. 10.

Incentives in Organisations
One way of reconciling the aims of shareholders and managers is to offer the
latter stock option plans. These plans work on the following basis. The

7
manager is given ' the right to purchase a certain number of shares of the
fm at a fixed price p any time within a given period (say, within the next two
years). The manager then has an incentive to increase profits and dividends,
so that share prices go up within this period. The manager can then buy her
shares at price p per share and sell the shares at the higher market price of
p* and pocket the surplus p* - p per share. Another way is to give the
manager a bonus that is a straightforward percentage of sales or profit.
Incentives can also be implicit. Poor performance is punished by firing the
.manager and good performance rewarded by means of promotions and
attendant perks.

Protecting the Rights of Outside Investors

We have seen that the market forces may not guarantee good corporate
governance. In most countries, certain rights ofthe outside investors are
sought to be protected legally. In a broader sen=, good corporate
governance requires that the rights of the various stakeholders be protected
adequately. Outside investors' rights are generally sought to be protected
through the enforcement
of regulations and laws. We can mention some of these here:

* Disclosure and accounting rules seek to provide investors with the

information
they need to exercise their rights.
* Protected shareholders rights include those to receive dividends on
pro-rata
terms, to vote for directors, to participate in shareholders meetings, to
subscribe
to new issues of securities on the same terms as insiders, and so on.
* Laws protecting creditors deal with bankruptcy and reorganization
procedures.

Corporate Governance Structure

8
 Corporate governance in Indian context
The attempt to introduce good corporate governance in India has a number
of components. First, there are rules and regulations that relate to
9
operations of firms, both internal and with reference to the outside world.
Secondly, capital market controls have been sought to be introduced by
relaxing the rules governing takeovers. Finally, as we have already discussed
in detail, the Kumar Mangalarn Committee has formulated a code of
governance.

Rules and Regulations

SEBI has taken various steps to strengthen corporate governance. Some of

these are:

 Strengthening of disclosure~norrns for Initial Public Offers.

 Providing of infomation in director's report for utilisation of funds and
variation
between projected and actual use of funds.
 Declaration of quarterly results.
 Mandatory appointment of compliance officer for monitoring the share
!ransfier
process and ensuring compliance with various rules and regulations.
 Timely disclosure of price sensitive information.
 Issue of guidelines for preferential allotment at market related prices.

Factors for The Emergence of CG in India

 Corporate Scandals
– The stock market scandal (Harshad Mehta) in 1992.
– Ketan Parekh scandal in 2001
– Tata Finance scandal (Serious financial irregularities in the
amount of rupees 400crores (86.95 million dollars) were
detected )
– Accounting and financial reporting frauds
– Vanishing companies scam
 In order for the Indian capital market and Indian companies to
compete in the global market, India needs a set of good corporate
governance doctrines

Comprehensive law governing Corporate

Governance
 Clause 49 is not the only legislation on governance.
 The Companies Act, 1956 itself covers corporate governance widely
through its various provisions such as

10
 – inclusion of directors' responsibility statement in the directors'
report under Section 217(2AA),
– constitution of audit committee under Section 292A,
– fixing maximum ceiling on remuneration that can be drawn by a
director under Schedule XIII,
– Relating to oppression, mismanagement, etc.
 Further, environmental and other pieces of legislation also
protect different stakeholders' interest, ensuring, in the process, good
corporate governance.

Corporate governance award in India

 ITC Ltd and Abhishek Industries Ltd received the Institute of
Company Secretaries of India National Award for Excellence in
Corporate Governance 2006.
 ITC Ltd has won the `Golden Peacock Award for Excellence in
Corporate Governance 2005', instituted by the Institute of Directors,
New Delhi, in association with the London-based World Council for
Corporate Governance and Centre for Corporate Governance.
 THE Coimbatore-based Precot Mills Ltd, in association with the
Tamilnadu Centre of ABK-AOTS Dosokai, Japan, has for the first time
instituted an award for textile units excelling in management
practices
 Good corporate governance is more an exception than a rule.
Which, perhaps, explains why the various bodies have annually been
announcing a national award for excellence in corporate governance
 The ICSI has consistently refused to rank companies for corporate
governance. Its award process judges but does not rate
companies for their governance performance
 Industry bodies put off plans for rating and rewarding companies on
corporate governance for now. There has to be a large number of
companies effectively engaged in corporate governance before
the best can be selected

11
 Corporate Governance In USA

Corporate governance is the set of processes, customs, policies, laws and

institutions affecting the way a corporation (or company) is directed,
administered or controlled. Corporate governance also includes the
relationships among the many stakeholders involved and the goals for which
the corporation is governed. The principal stakeholders are the shareholders
the board of directors, employees, customers, creditors, suppliers, and the
community at large.

Corporate governance is a multi-faceted subject. An important theme of

corporate governance is to ensure the accountability of certain individuals in
an organization through mechanisms that try to reduce or eliminate the
principal-agent problem. A related but separate thread of discussions
focuses on the impact of a corporate governance system in economic
efficiency, with a strong emphasis on shareholders' welfare. There are yet
other aspects to the corporate governance subject, such as the stakeholder
view and the corporate governance models around the world (see section 9
below).

There has been renewed interest in the corporate governance practices of

modern corporations since 2001, particularly due to the high-profile
collapses of a number of large U.S. firms such as Enron Corporation and .
(formerly WorldCom). In 2002, the U.S. federal government passed the
Sarbanes-Oxley Act, intending to restore public confidence in corporate
governance.

History - United States

Since the late 1970’s, corporate governance has been the subject of
significant debate in the U.S. and around the globe. Bold, broad efforts to
reform corporate governance have been driven, in part, by the needs and
desires of shareowners to exercise their rights of corporate ownership and to
increase the value of their shares and, therefore, wealth. Over the past three
decades, corporate directors’ duties have expanded greatly beyond their
traditional legal responsibility of duty of loyalty to the corporation and its
shareowners.[5]

In the first half of the 1990s, the issue of corporate governance in the U.S.
received considerable press attention due to the wave of CEO dismissals
(e.g.: IBM, Kodak, Honeywell) by their boards. The California Public
Employees' Retirement System (CalPERS) led a wave of institutional
12
shareholder activism (something only very rarely seen before), as a way of
ensuring that corporate value would not be destroyed by the now
traditionally cozy relationships between the CEO and the board of directors
(e.g., by the unrestrained issuance of stock options, not infrequently back
dated).

In 1997, the East Asian Financial Crisis saw the economies of Thailand,
Indonesia, South Korea, Malaysia and The Philippines severely affected by
the exit of foreign capital after property assets collapsed. The lack of
corporate governance mechanisms in these countries highlighted the
weaknesses of the institutions in their economies.

In the early 2000s, the massive bankruptcies (and criminal malfeasance) of

Enron and Worldcom, as well as lesser corporate debacles, such as Adelphia
Communications, AOL, Arthur Andersen, Global Crossing, Tyco, led to
increased shareholder and governmental interest in corporate governance.
This is reflected in the passage of the Sarbanes-Oxley Act of 2002.[3]

Principles

Key elements of good corporate governance principles include honesty, trust

and integrity, openness, performance orientation, responsibility and
accountability, mutual respect, and commitment to the organization.

Of 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. In particular, senior
executives should conduct themselves honestly and ethically, especially
concerning actual or apparent conflicts of interest, and disclosure in financial
reports.

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. They can help shareholders exercise their rights by effectively
communicating information that is understandable and accessible and
encouraging shareholders to participate in general meetings.
• 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. There are issues about the appropriate mix of
executive and non-executive directors.
• Integrity and ethical behaviour: Ethical and responsible decision making
is not only important for public relations, but it is also a necessary element in
13
 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 Program 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.
•

Issues involving corporate 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
• Nevertheless "corporate governance," despite some feeble attempts from
various quarters, remains an ambiguous and often misunderstood phrase.
For quite some time it was confined only to corporate management. That is
not so. It is something much broader, for it must include a fair, efficient and
transparent administration and strive to meet certain well defined, written
objectives. Corporate governance must go well beyond law. The quantity,
quality and frequency of financial and managerial disclosure, the degree and
extent to which the board of Director (BOD) exercise their trustee
responsibilities (largely an ethical commitment), and the commitment to run
a transparent organization- these should be constantly evolving due to
interplay of many factors and the roles played by the more
progressive/responsible elements within the corporate sector. John G. Smale,
a former member of the General Motors board of directors, wrote: "The Board
is responsible for the successful perpetuation of the corporation. That
responsibility cannot be relegated to management."[7] However it should be
noted that a corporation should cease to exist if that is in the best interests
of its stakeholders. Perpetuation for its own sake may be counterproductive

Mechanisms and controls

14
Corporate governance mechanisms and controls are designed to reduce the
inefficiencies that arise from moral hazard and adverse selection. For
example, to monitor managers' behaviour, an independent third party (the
external auditor) attests the accuracy of information provided by
management to investors. An ideal control system should regulate both
motivation and ability.

Internal corporate governance controls

Internal corporate governance controls monitor activities and then take

corrective action to accomplish organisational goals. Examples include:

• Monitoring by the board of directors: The board of directors, with its

legal authority to hire, fire and compensate top management, safeguards
invested capital. Regular board meetings allow potential problems to be
identified, discussed and avoided. Whilst non-executive directors are thought
to be more independent, they may not always result in more effective
corporate governance and may not increase performance. [8] Different board
structures are optimal for different firms. Moreover, the ability of the board to
monitor the firm's executives is a function of its access to information.
Executive directors possess superior knowledge of the decision-making
process and therefore evaluate top management on the basis of the quality
of its decisions that lead to financial performance outcomes, ex ante. It could
be argued, therefore, that executive directors look beyond the financial
criteria.
• Internal control procedures and internal auditors: Internal control
procedures are policies implemented by an entity's board of directors, audit
committee, management, and other personnel to provide reasonable
assurance of the entity achieving its objectives related to reliable financial
reporting, operating efficiency, and compliance with laws and regulations.
Internal auditors are personnel within an organization who test the design
and implementation of the entity's internal control procedures and the
reliability of its financial reporting
• Balance of power: The simplest balance of power is very common; require
that the President be a different person from the Treasurer. This application
of separation of power is further developed in companies where separate
divisions check and balance each other's actions. One group may propose
company-wide administrative changes, another group review and can veto
the changes, and a third group check that the interests of people (customers,
shareholders, employees) outside the three groups are being met.
• Remuneration: Performance-based remuneration is designed to relate some
proportion of salary to individual performance. It 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 mistakes or opportunistic
behaviour, and can elicit myopic behaviour

15
External corporate governance controls

External corporate governance controls encompass the controls external

stakeholders exercise over the organisation. Examples include:

• competition
• debt covenants
• demand for and assessment of performance information (especially financial
statements)
• government regulations
• managerial labour market
• media pressure
• takeovers

Systemic problems of corporate governance

• Demand for information: In 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.
• Monitoring costs: A 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 market hypothesis (in finance, the efficient
market hypothesis (EMH) asserts that financial markets are efficient), which
suggests that the small shareholder will free ride on the judgements of larger
professional investors.
• Supply of accounting information: Financial accounts form a crucial link in
enabling providers of finance to monitor directors. Imperfections in the
financial reporting process will cause imperfections in the effectiveness of
corporate governance. This should, ideally, be corrected by the working of
the external auditing process.

16
 Corporate Governance In UK
Brief History

In the UK thinking about corporate governance was much influenced by the

report of the Committee chaired by Sir Adrian Cadbury (1992)* on the
financial aspects of corporate governance. The report's proposals and its
code of best practice emphasised the importance of independent non-
executive directors, with independence defined as “independent of
management and free from any business or other relationship which could
materially interfere with the exercise of independent judgement, apart from
their fees and share-holding”. Audit committees were advocated. Some
critics of the report argued that the report went too far - the emphasis on the
importance of non-executive directors would introduce the controls of the
European two-tier supervisory board by the back door: others felt that the
report did not go far enough - it lacked teeth by proposing de-listing rather
than legally enforceable sanctions.

Developments in the 1990s - in theory

Corporate governance, as yet, does not have an accepted theoretical base or
commonly accepted paradigm. In the words of Pettigrew (1992), corporate
governance lacks any form of coherence, either empirically,
methodologically or theoretically with any piecemeal attempts to try and
understand and explain how the modern corporation is run.

Many theoretical insights have been applied to research in the subject.

17
Taking a human relations/sociological perspective Pettigrew and McNulty
(1995)* explored power and influence around the board room. From the
viewpoint of jurisprudence in Australia and the UK, Stapledon (1995)*
explored the potential for institutional activism. Kay and Silbertson (1995)
take the view of two Oxford economists. See also Kester (1992)*. The paper
by Turnbull (1997:1)* attempts to provide an overview of the state of the art
in corporate governance theory.

Stemming from the work of Coarse (1936), the concepts of agency theory
were developed by researchers such as Williamson (1979)* and Fama and
Jensen 1983*. In essence, the theory presents the governance relationship
as a contract between the director and the shareholder. Directors, seeking to
maximise their own personal utility will take actions that are advantageous
to themselves but detrimental to the shareholders. Consequently the
transactions costs of appropriate checks and balances, such as disclosure to
shareholders, the use of independent outside directors, audit committees
and the separation of chairman and CEO, are desirable. Evidence of such
actions is not hard to find anecdotally and serious scholarship has
demonstrated linkages between various attributes of governance, such as
board structure, the duality of chairman and CEO and director remuneration,
and company performance.

Critics of agency theory argue that the reality of governance involves inter-
personal and political relationships that are just not reflected in a two-person
contract. Moreover, they suggest, the theory takes a rather low view of the
nature of man - that he cannot be trusted. Stewardship theory, the
alternative perspective, takes an altogether broader frame of reference,
being based on the original and legal view of the corporation in which
directors have a fiduciary duty to their shareholders to be stewards for their
interests. This, they argue is clearly what most directors actually do.
Moreover, other contemporary scholarship is discovering that not only does
increasing governance conformance and compliance not add to corporate
performance - it can actually detract. [Donaldson and Davies (1994)]* Muth
and Donaldson (1997) also challenged the shibboleths of agency theory,
which underpin conventional assumptions about the benefits of checks and
balances. Boards with well connected, executive directors perform better
than those that meet the paradigms of conventional governance thinking,
they found.

The philosophical debate

The UK Hampel Committee's dismissal of stakeholder notions - “ directors
are responsible for relations with stakeholders, but are accountable to the
shareholders” - undoubtedly reflects the conventional wisdom in boardrooms
in both the UK and the USA. Despite the views in a report from the Royal
Society of Arts, titled Tomorrow's Company, which advocated wider
recognition of corporate responsibility to stakeholders such as suppliers,
customers and employees. The Harvard Business Review published the
18
results of a working group on corporate governance - A new compact for
owners and directors (1991)*. Handy (1993)* posed the question 'what is a
company for?' suggesting that a social organisation mirrored reality better
than a legal entity defined by ownership. But the issue has not been
resolved.

Sternberg (1997)* argued that stakeholder ideas are fundamentally flawed,

strongly advocating the ownership rights perspective. Turnbull (1997:2)*
took the opposite view, advancing the benefits of a broader cybernetic (and
stakeholder) view. Stakeholder thinking continues to attract in a society.
The frontiers of corporate governance are being pushed out rapidly, just as
the seriousness of governance issues increasingly challenges directors and
boards, investors and regulators. In a 1990 paper, your editor called for the
highly successful, but now outgrown, concept of the corporation to be
redesigned [Tricker (1990)*]. There is now a need for a taxonomy of
companies which reflects the complex and diverse range of governance
arrangements and structures around the world. We also need an appropriate
conceptual framework that will adequately reflect the reality of governance.
At the moment various theoretical insights cast light on different aspects of
the play, highlighting some, leaving others in the shadow: we need a
viewpoint that can light up the entire stage and all of the players.

THE COMBINED CODE ON CORPORATE

GOVERNANCE

SEC 1 COMPANIES

A. DIRECTORS

A.1 The Board

Every company should be headed by an effective board, which is

collectively responsible for the success of the company.

Code Provisions

The board should meet sufficiently regularly to discharge its duties

effectively. There should be a formal schedule of matters specifically
reserved for its decision. The annual report should identify the chairman,
the deputy chairman (where there is one), the chief executive, the senior
independent director and the chairmen and members of the nomination,
audit and remuneration committees. It should also set out the number of
meetings of the board and those committees and individual attendance by
19
directors. The chairman should hold meetings with the non-executive
directors without the executives present. Led by the senior independent
director, the non-executive directors should meet without the chairman
present at least annually to appraise the chairman’s performance and on
such other occasions as are deemed appropriate. Where directors have
concerns which cannot be resolved about the running of the company or a
proposed action, they should ensure that their concerns are recorded in the
board minutes. On resignation, a nonexecutive director should provide a
written statement to the chairman, for circulation to the board, if they have
any such concerns. The company should arrange appropriate insurance
cover in respect of legal action against its directors.

A.2 Chairman and chief executive

There should be a clear division of responsibilities at the head of

the company between the running of the board and the executive
responsibility for the running of the company’s business. No one
individual should have unfettered powers of decision.

Code Provisions

The roles of chairman and chief executive should not be exercised by the
same individual. The division of responsibilities between the chairman and
chief executive should be clearly established, set out in writing and agreed
by the board. The chairman should on appointment meet the independence
criteria set out in . A chief executive should not go on to be chairman of the
same company. If exceptionally a board decides that a chief executive
should become chairman, the board should consult major shareholders in
advance and should set out its reasons to shareholders at the time of the
appointment and in the next annual report.

A.3 Board balance and independence

The board should include a balance of executive and non-executive

directors (and in particular independent non-executive directors)
such that no individual or small group of individuals can dominate
the board’s decision taking.

Code provisions

The board should identify in the annual report each non-executive director it
considers to be independent. The board should determine whether the
director is independent in character and judgement and whether there are

20
relationships or circumstances which are likely to affect, or could appear to
affect, the director’s judgement.

_ has been an employee of the company or group within the last five years;

-Has, or has had within the last three years, a material business relationship
with the company either directly, or as a partner, shareholder, director or
senior employee of a body that has such a relationship with the company;

_ has received or receives additional remuneration from the company apart

from a director’s fee, participates in the company’s share option or a
performance-related pay scheme, or is a member of the company’s pension
scheme;

_ has close family ties with any of the company’s advisers, directors or senior
employees;

_ holds cross-directorships or has significant links with other directors

through involvement in other companies or bodies;

_ represents a significant shareholder; or

_ has served on the board for more than nine years from the date of their
first election.

A.4 Appointments to the Board

There should be a formal, rigorous and transparent procedure for

the appointment of new directors to the board.

Code Provisions

There should be a nomination committee which should lead the process for
board appointments and make recommendations to the board. A majority of
members of the nomination committee should be independent non-
executive directors. The chairman or an independent non-executive director
should chair the committee, but the chairman should not chair the
nomination committee when it is dealing with the appointment of a
successor to the chairmanship. The nomination committee should make
available its terms of reference, explaining its role and the authority
delegated to it by the board.

A.5 Information and professional development

21
The board should be supplied in a timely manner with information in
a form and of a quality appropriate to enable it to discharge its
duties. All directors should receive induction on joining the board
and should regularly update and refresh their skills and knowledge.

Code Provisions

The chairman should ensure that new directors receive a full, formal and
tailored induction on joining the board. As part of this, the company should
offer to major shareholders the opportunity to meet a new non-executive
director. The board should ensure that directors, especially non-executive
directors, have access to independent professional advice at the company’s
expense where they judge it necessary to discharge their responsibilities as
directors. Committees should be provided with sufficient resources to
undertake their duties. All directors should have access to the advice and
services of the company secretary, who is responsible to the board for
ensuring that board procedures are complied with. Both the appointment
and removal of the company secretary should be a matter for the board as a
whole.

A.6 Performance evaluation

The board should undertake a formal and rigorous annual

evaluation of its own performance and that of its committees and
individual directors.

Code Provision

The board should state in the annual report how performance evaluation of
the board, its committees and its individual directors has been conducted.
The non-executive directors, led by the senior independent director, should
be responsible for performance evaluation of the chairman, taking into
account the views of executive directors.

A.7 Re-election

All directors should be submitted for re-election at regular

intervals, subject to continued satisfactory performance. The board
should ensure planned and progressive refreshing of the board.

Code Provisions

All directors should be subject to election by shareholders at the first annual

general meeting after their appointment, and to re-election thereafter at

22
intervals of no more than three years. The names of directors submitted for
election or re-election should be accompanied by sufficient biographical
details and any other relevant information to enable shareholders to take an
informed decision on their election. Non-executive directors should be
appointed for specified terms subject to re-election and to Companies Acts
provisions relating to the removal of a director. The board should set out to
shareholders in the papers accompanying a resolution to elect a non-
executive director why they believe an individual should be elected. The
chairman should confirm to shareholders when proposing re-election that,
following formal performance evaluation, the individual’s performance
continues to be effective and to demonstrate commitment to the role. Any
term beyond six years (e.g. two three-year terms) for a non-executive
director should be subject to particularly rigorous review, and should take
into account the need for progressive refreshing of the board. Non-executive
directors may serve longer than nine years (e.g. three three-year terms),
subject to annual re-election. Serving more than nine years could be
relevant to the determination of a non-executive director’s independence .

B. REMUNERATION

B.1 The Level and Make-up of Remuneration

Levels of remuneration should be sufficient to attract, retain and

motivate directors of the quality required to run the company
successfully, but a company should avoid paying more than is
necessary for this purpose. A significant proportion of executive
directors’ remuneration should be structured so as to link rewards
to corporate and individual performance.

Code Provisions

Remuneration policy

The performance-related elements of remuneration should form a significant

proportion of the total remuneration package of executive directors and
should be designed to align their interests with those of shareholders and to
give these directors keen incentives to perform at the highest levels. In
designing schemes of performance-related remuneration, the remuneration
committee should follow the provisions in Schedule A to this Code.
Executive share options should not be offered at a discount save as
permitted by the relevant provisions of the Listing Rules. Levels of
remuneration for non-executive directors should reflect the time
commitment and responsibilities of the role. Remuneration for nonexecutive
23
directors should not include share options. If, exceptionally, options are
granted, shareholder approval should be sought in advance and any shares
acquired by exercise of the options should be held until at least one year
after the non-executive director leaves the board. Holding of share options
could be relevant to the determination of a non-executive director’s
independence .

Service Contracts and Compensation

The remuneration committee should carefully consider what compensation

commitments (including pension contributions and all other elements) their
directors’ terms of appointment would entail in the event of early
termination. The aim should be to avoid rewarding poor performance. They
should take a robust line on reducing compensation to reflect departing
directors’ obligations to mitigate loss.

B.2 Procedure

There should be a formal and transparent procedure for developing

policy on executive remuneration and for fixing the remuneration
packages of individual directors. No director should be involved in
deciding his or her own remuneration.

Code Provisions

The board should establish a remuneration committee of at least three, or in

the case of smaller companies13 two, members, who should all be
independent non-executive directors. The remuneration committee should
make available14 its terms of reference, explaining its role and the authority
delegated to it by the board. Where remuneration consultants are appointed,
a statement should be made available15 of whether they have any other
connection with the company. hareholders should be invited specifically to
approve all new long-term incentive schemes (as defined in the Listing
Rules) and significant changes to existing schemes, save in the
circumstances permitted by the Listing Rules.

C. ACCOUNTABILITY AND AUDIT

C.1 Financial Reporting

The board should present a balanced and understandable

assessment of the company’s position and prospects.

Code Provisions

24
 The directors should explain in the annual report their responsibility for
preparing the accounts and there should be a statement by the auditors
about their reporting responsibilities. The directors should report that the
business is a going concern, with supporting assumptions or qualifications as
necessary.

C.2 Internal Control

Main Principle

The board should maintain a sound system of internal control to

safeguard shareholders’ investment and the company’s assets.

Code Provision

The board should, at least annually, conduct a review of the effectiveness of

the group’s system of internal controls and should report to shareholders
that they have done so. The review should cover all material controls,
including financial, operational and compliance controls and risk
management systems.

C.3 Audit Committee and Auditors

Main Principle

The board should establish formal and transparent arrangements

for considering how they should apply the financial reporting and
internal control principles and for maintaining an appropriate
relationship with the company’s auditors.

Code provisions

The board should establish an audit committee of at least three, or in the

case of smaller companies18 two, members, who should all be independent
non-executive directors. The board should satisfy itself that at least one
member of the audit committee has recent and relevant financial
experience. The main role and responsibilities of the audit committee should
be set out in written terms of reference and should include:

D. RELATIONS WITH SHAREHOLDERS

25
Main Principle

There should be a dialogue with shareholders based on the mutual

understanding of objectives. The board as a whole has
responsibility for ensuring that a satisfactory dialogue with
shareholders takes place.20

Code Provisions

The chairman should ensure that the views of shareholders are

communicated to the board as a whole. The chairman should discuss
governance and strategy with major shareholders. Non-executive directors
should be offered the opportunity to attend meetings with major
shareholders and should expect to attend them if requested by major
shareholders. The senior independent director should attend sufficient
meetings with a range of major shareholders to listen to their views in order
to help develop a balanced understanding of the issues and concerns of
major shareholders.

D.2 Constructive Use of the AGM

Main Principle

The board should use the AGM to communicate with investors and
to encourage their participation.

Code Provisions

The company should count all proxy votes and, except where a poll is called,
should indicate the level of proxies lodged on each resolution, and the
balance for and against the resolution and the number of abstentions, after
it has been dealt with on a show of hands. The company should ensure that
votes cast are properly received and recorded.

26
 Corporate governance in china

Since China started its economic reform in the late 1970s, its gross domestic
product has been growing at an average annual rate of 9.73 percent.
Chinese stock markets have also been growing rapidly, especially since late
2005, when share merger reform started. Today, there are more than 1,500
publicly traded Chinese companies, and the total market capitalization
surpassed 24.5 trillion renminbi (RMB) in August 2007.

Despite this rapid growth, corporate governance has been very weak in
China. In a survey by the World Economic Forum, China ranked 44 out of 49
studied countries in terms of corporate governance (Liu, 2006). Corporate
governance is critically important to a country’s economic growth and
stability, because it provides the credibility and confidence in management
that is fundamental to capital markets.

Development of corporate governance in china

The historical development of corporate governance in China has gone

through four stages.

In the first stage, from 1949 to 1983, state-owned enterprises (SOEs)

dominated the Chinese economy, and the state commanded and controlled
almost every aspect of the economy. Western-style corporate governance
did not exist in China.

The second stage, from 1984 to 1993, involved the beginning of the
separation of government and enterprise in China. During this period, China
formally established the Shanghai Stock Exchange (SSE) and the Shenzhen
Stock Exchange (SZSE), and a new government body, the China Securities
Regulatory Commission (CSRC), was created to be the country’s main
regulator of the newborn stock market.

The third stage, from 1994 to 2005, marked the beginning of

experimentation in modern
enterprise structure, including passage of the first Company Law—the first
comprehensive law that fully delineated the rights and responsibilities for
modern companies in China. Although the Company Law has had a far-
reaching impact on corporate governance and the economy as a whole in

27
China, state shareholders still enjoyed overwhelming favoritism over
individual investors.

The final stage, from 2006 onward, has witnessed the continuing growth of
corporate
governance in China, including legislation aimed at balancing the power
asymmetry between state shareholders and individual shareholders in
companies.

The Institutional Framework

Many entities both inside and outside companies play a role in shaping the
behavior and governance of Chinese companies. The inner circle of oversight
consists of shareholders’ general meetings, boards, and management
personnel who are engaged in operating the companies and are directly
responsible for their governance. The outer circle is composed of regulators
(chiefly, the CSRC), stock exchanges (the SSE and SZSE), the Chinese legal
system, the auditing system, and institutional investors. These players have
a significant impact on companies’ corporate governance, but they mainly
do this through regulation, codes of conduct, certifi-cation of financial
reports, and legal enforcement. Besides these institutional pillars, there are
other agents who may also affect corporate governance (e.g., consumers,
suppliers, employees, media, and nongovernmental organizations).

Problems of Corporate Governance in China

Despite recent reforms made in corporate governance controls and
institutions in China, a number of problems still remain. First, there is
concentration of state ownership. Approximately two-thirds of
companies listed in the SSE are state enterprises, which leads to in efficiency
in capital allocation, whether it comes directly from a government body or
through a brokerage firm.

Second, a direct result of ownership concentration is the lack of

independence among
board directors. Given the overwhelming governmental dominance of
Chinese boards of directors, the supervisory board in China has not yet
played a significant and effective governance role.

Third, insider trading is a very serious problem among China’s listed

companies. Reasons for this include the lack of a well-defined concept for
fiduciary duty, inefficient enforcement of securities laws, the absence of
class actions in China, and the lack of any incentive mechanism to
encourage reporting or whistle-blowing about insider trading.

28
Fourth, false financial disclosures by companies remain a significant
problem. According to a random check by the Ministry of Finance, a
significant number of Chinese companies forged their earnings in annual
reports in 2001.
Finally, China continues to suffer from immature capital markets,
characterized by the
Chinese banks’ preferential treatment of SOEs, difficulties in issuing
corporate bonds, and the absence of preferred shares as a
financing/investment option.

Conclusion

China has made rapid progress in corporate governance, in part because of

the gradual removal of ownership and personnel barriers, coupled with an
increasingly globalized and mature busi ness environment. However, despite
this rapid progress, serious problems abound in various aspects of Chinese
corporate governance, ranging from company ownership structures to the
media environment in which Chinese companies and security markets
operate.

Several options have been proposed to deal with these problems, including
more clearly
defining the functions of the supervisory boards, making it easier for
whistleblowers to sue management, toughening legal obligations for
managers involved in insider trading, lowering the minimum required
number of shares for shareholders to raise proposals, increasing the legal
obligation of controlling shareholders, and developing a long-term focus
incentive compensation system for directors and executives (e.g., long-term
nontradable options).

In addition, we propose reviving and institutionalizing the once-banned,

regional, overthe- counter markets, because doing so would offer an
opportunity to improve the corporate governance of Chinese enterprises,
while providing a buffer zone for companies facing the risk of delisting in the
stock exchanges. Similarly, accelerating the development of the corporate
debt market could help meet the needs of the more risk-averse investors
and, thereby, increase the capital supply for Chinese companies in need of
steady capital input.

Finally, we suggest establishing an incentive mechanism to encourage the

reporting of insider trading. Increasing the organizational performance of the

29
CSRC and stock exchanges and promulgating the concept of fiduciary duty
will take a considerable amount of time and cost. By contrast, providing
incentives for exposing insider trading would likely cost less and could be
more effective as a governance mechanism in China than in the United
States.

30