Governance

This article is written by Devina Rathod, pursuing Diploma in Advanced Contract Drafting, Negotiation, and Dispute Resolution from LawSikho. The article has been edited by Ruchika Mohapatra (Associate, LawSikho).

What is corporate governance?

In undecorated terms, Corporate Governance refers to the way in which the companies are governed. It is a system of rules, practices and processes that a firm uses to direct the organization towards achieving its overall objectives. Corporate Governance essentially involves the management and the board of the company taking decisions and formulating policies at the corporate level. These decisions enable the management to deal with the challenges of running an organization. Corporate Governance also ensures that the interests of all the stakeholders (shareholders, employees, suppliers, customers and the community) are balanced by formulating appropriate policies, regulating the decisions and ensuring that the appropriate procedures and controls are in place.

Corporate Governance fundamentally includes formulating action plans, internal control systems, performance measurement and corporate disclosure. It plays an integral part in an organisation by directing the consumers towards the company’s vision, integrity and goodwill and as a result connecting them with the community as well as the investors. 

Corporate Governance also gains significant attention considering its impact on corporations as well as society. Some people disagree on the shareholders’ interest extended towards decision making, formulating strategies, executive remuneration, environmental policies and the likes of it. On the other hand, some people believe that the rights of other parties such as the purpose of an organization, the rights of stakeholders and the corporate decision making must be respected as well. 

What are the basic principles of corporate governance?

  • Accountability,
  • Transparency,
  • Fairness,
  • Responsibility.

Accountability

Accountability means holding an individual or a group of people responsible for one’s actions. The organizations must set various mechanisms to follow for accountability in case of variances in performance. It also helps to fix answerability in case of failed corporate governance.

Transparency

Transparency enables an outsider to analyse the company’s financial as well as the non-financial aspects such as its actions, decisions, fundamentals, technicals etc. It enables the investors to segregate good organizations with good fundamentals and management.

Fairness

The management should emphasise a balanced interest of all the stakeholders with an unbiased distribution of powers. For instance, the rights of minority shareholders must not be overlooked.

Responsibility

With regards to the board, it consists of responsibility towards all the stakeholders’ having interest in the organization and communicating responsively. With regards to management, it essentially pertains to corrective actions, penalizing mismanagement etc.

What are the 4 P’s of corporate governance?

  • People,
  • Process,
  • Performance,
  • Purpose.

People

People come first amongst the 4 P’s of Corporate Governance considering their existence in every business equation. People include the management that determines the purpose, the board that is responsible for formulating the policies and strategies, the stakeholders’ and investors having an interest in the organization along with the outside consumers and observers.

Process

The process consists of a series of actions and steps taken in order to achieve the purpose. Corporate Governance is one such process by which an organization achieves its objectives. These processes are designed by evaluating various performances at different levels in an organization. They can also be refined over time to maintain efficiency and consistency and minimize losses from external threats.

Performance

Performance analysis is one of the key skills for any organization. It means analyzing the actual performance with the standard performance to determine its efficiency. Performance analysis in Corporate Governance can be used to minimize deviations as well as to eliminate the non-performing policies and strategies.

Purpose

Every equation of Corporate Governance exists for a purpose and to achieve a purpose. The purpose is the mission statement of an organization and every strategy, policy and process should be formulated for fulfilling the purpose.

What are the benefits of corporate governance?

  1. Corporate Governance ensures financial viability and economic growth.
  2. Good Corporate Governance helps to maintain investors’ confidence.
  3. Corporate Governance can help to build strong relationships with the community with good performance.
  4. Corporate Governance helps in lowering the cost of equity and debt capital.
  5. Corporate Governance can also help to induce the corporate level managers and supervisors to merge their personal goals with the overall objectives of the organization.
  6. Good Corporate Governance builds a strong brand and can contribute towards the growth of goodwill and development.
  7. Corporate Governance minimizes risk and mismanagement and corruption.
  8. Corporate Governance ensures that the organization has a business model that is designed in a manner that fits the best interest of all.
  9. Good Corporate Governance can be a contributing factor in the case of mergers and acquisitions.

What are the various models of corporate governance?

  • Anglo-US Model,
  • The German Model,
  • The Japanese Model,
  • Social Control Model,
  • Indian Model.

Anglo-US Model

The Anglo-US model is also recognized as the Anglo-Saxon model of corporate governance. It holds bases in Britain, Canada, America, Australia and CommonWealth Countries including India. It is a shareholder-oriented model, meaning, the rights of shareholders’ are given importance. The organizations are run by managers having negligible ownership stakes and the Directors are rarely independent of management. Small investors are encouraged and large investors and discouraged from actively participating in corporate governance. Institutional investors like banks and mutual funds have the right to sell their shares if they are not satisfied with the performance of the organisation.

The German Model

The German Model is also recognized as the European model or Continental model. This model considers the workers as the key stakeholders and they should have the right to participate in the management of the company. Corporate governance through the German model is carried via a two-tier board model. These two boards are-

  • Supervisory Board- The members of the supervisory board are elected by the shareholders’ of the organization. The employees also elect their representatives which can essentially constitute one-third or half of the board.
  • Executive Board- The Executive Board is appointed by the Supervisory board and is monitored by the same. The Supervisory board reserves the right to dismiss or re-institute the Executive board.

The Japanese Model

The Japanese model recognizes the organisations raising a significant part of their capital through banks and other financial institutions. As a result, these banks and institutions work closely with the management as they have high stakes in the business of the company. The concentration of power amongst various Japanese corporations and banks results in a lack of transparency. Individual investors are not considered as important as the business entities, the union groups and the government.

Social Control Model

The social control model emphasizes a full-fledged representation of the stakeholders’. The stakeholders’ board would result in the improvement of internal control systems along with good management. The Stakeholders Board consists of representation from shareholders, employees, major consumers, major suppliers, lenders etc.

Indian Model

The Indian model can be essentially seen as a mix of the Anglo-US model and the German model of corporate governance. This mix is essential as there are various kinds of companies that are incorporated in India i.e. Private Companies, Public Companies and Public Sector Undertakings (PSU’s) with distinct shareholding patterns. The framework should be such as to uphold the principles of fair representation, transparency and integrity.

Examples of corporate governance

  • Spelling out ethical expectations for the management as well as the employees and investors to abide by.
  • The powers of the board members to interfere in public matters, their authority over the Chief Executive Officer (CEO), and their rights while making major decisions.
  • Prescribing the manner in which the company distributes its financial reports.
  • Framing policies regarding finance, leadership and legal issues that are upheld by all.
  • Allocating funding and resources efficiently towards achieving the overall objectives.

Consequences of bad corporate governance

  • Loss of shareholder’s confidence.
  • Loss of prestige and weak business reputation in the market.
  • Hindrance to business growth and development.
  • Poor customer relations and impact on public perception of the business.
  • Negative impact on the larger economy due to bad corporate governance.
  • Impairment of performance due to inefficient processes, unregulated procedures and lack of accountability.
  • Risk of fraud by insiders.

Questions to ask for good corporate governance

  • How does the interpretation of corporate culture differ across various countries and regions?
  • Is the organization’s board aware of the shareholders’ effective approach to shareholders’ engagement?
  • Do the directors and managers of the organization have a shared understanding?
  • Does the overall objective of the directors run parallel to the personal goals of the managers?
  • Does the board have the right composition?
  • Are the mechanisms for exercising control and setting accountability sufficient?
  • Does the organization have an efficient process, structure and rules to carry out its responsibilities?
  • What is the role of other parties in protecting the rights of shareholders, investors, employees and customers from injuries caused due to bad corporate governance?

Conclusion

Corporate Governance is the soul of an organization hence it should be strictly adhered to while indulging in business to work towards social and economic development. Corporate Governance essentially acts as a guiding principle to direct operations, supervise processes, analyse procedures, penalize mismanagement, impact on the climate etc. A strong corporate governance structure benefits all the stakeholders as well as the organization as a whole while maintaining integrity. A bad corporate governance structure can lead to insolvency, frauds and scandals and in extreme cases, can lead to the breakdown of the business. 

References

  1. https://www.investopedia.com/terms/c/corporategovernance.asp
  2. https://www.oecd.org/corporate/
  3. https://corporatefinanceinstitute.com/resources/knowledge/other/corporate-governance/

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