This article has been written by Apeksha Choubey pursuing a Diploma in US Corporate Law for Company Secretaries and Chartered Accountants at LawSikho, and has been edited by Shashwat Kaushik.
This article has been published by Sneha Mahawar.
Table of Contents
Introduction
From the past few decades, we have been going through lots of developments in every field: education, infrastructure, art, industries, trading, manufacturing, Stock exchange transactions, mass media and communication, entertainment, etc. With the expansion in every area, there is a need to put up some type of code and ethics to conduct the business of companies to protect the interests of large numbers of people related to these companies and society at large. Hence, the term corporate governance is gaining more and more awareness all over the world. It consists of two words “Corporate” which means any company, and “Governance”, which denotes some type of control. Through this article, we will try to focus on thoroughly understanding it and its various aspects.
What is corporate governance and its relation with internal policies
As we know, various types of activities are required to perform and run a company’s business. Corporate governance is the system of code, ethics, internal controls, rules, and regulations through which the business of the company is conducted and controlled. This is a kind of framework which is binding on the company to achieve its goals and objectives in such a way as not to dilute the interests of all parties related to the company, such as employees, shareholders, customers, government, etc. The boards of directors are responsible for creating, managing, and controlling this framework to support the company’s goals by having a sound and effective internal control system.
A good corporate governance framework can be achieved by installing a few golden principles in the internal control system of the company. Effective, transparent, and detailed internal policies (employee manual code of conduct, customers, suppliers, Human resources, production, shareholders, compliance, security, audit, governance, etc.) are the foundation for making a sound and effective internal control system. These internal policies are an indispensable part of the internal control system, which ultimately provides sufficient assurance to all parties in a company that it has good corporate governance. It is crucial to have an appropriate internal control system that is efficient enough to detect fraud and errors on time and save the company from any major losses and negative goodwill. Now, we have seen how internal policies are closely related to good corporate governance for a company. On the contrary, bad corporate governance in a company can result in major financial and goodwill losses and failure to achieve objectives.
Further, various other aspects are explained in later headings below.
Benefits and need of good corporate governance and internal policies
- Better management and control: It creates a clear and effective code of conduct, rules and regulations, and sound internal control to manage the company’s affairs and activities with clarity and achieve company goals and objectives in line with the expectations of shareholders, investors, and other parties involved who are spread across the world.
- Goodwill: It builds greater amounts of trust and confidence among shareholders, investors, and other parties involved, the community at large, and the government.
- Social responsibility: Every company has a social responsibility towards society to protect the environment, control pollution, promote social development and upliftment of the poor, and provide better goods and services at reasonable prices. All these social plans can only be met through good corporate governance.
- Frauds and errors: Both monetary and non monetary losses are the result of weak internal control systems and policies in the company, as internal and external people continuously perform fraud and errors in some way or another, which sometimes damage the company’s reputation as well. Hence, companies must have good corporate governance with sound internal control and policies in place to reduce the chances of fraud, errors, financial loss, and corruption.
- Long term sustainability and returns: Good corporate governance fosters long term sustainability, financial soundness, numerous growth and expansion opportunities, and a higher rate of return to the company.
- Facilitate easy capital and market share: It helps in raising capital requirements in the market easily, whether through an IPO or loans. High share prices on the stock exchange are also directly correlated with it. Good corporate governance results in good market sentiment and boosts investors confidence in the company.
Principles of corporate governance
- Fair treatment: It is the duty of the Board of Directors to provide equal and fair treatment to shareholders, customers, investors, suppliers, and employees. Every party should know their rights and have the power to exercise them in the correct manner.
- Responsibility and accountability: The Board of Directors is responsible for managing the affairs of the company as per the rules and policies defined and acting best in its interests. Moreover, they are also held accountable for decision-making and the execution of short and long term development plans for the company- success and failure lie in the hands of the board of directors.
- Transparent: The Board of Directors is also responsible for providing clear and timely information which is critical to compliance related and legal decisions to all related parties, such as annual financial statements and announcements of key policy changes, appointment of auditors, etc.
- Risk management: Managing every type of risk is also one of the most crucial functions performed by the Board of Directors. It is related to designing robust accounting and internal control systems that help in detecting fraud and errors in the early stages and reduce financial and non financial losses to the company. Risk could arise either due to external or internal factors such as internal fraud, market risk , legal risk, technological risk, etc.
Bad and good cases of corporate governance
The Enron Scandal
The Enron scandal is an example of bad corporate governance. Enron Corporation declared bankruptcy in 2001. It was one of the largest companies in the U.S. This company falsely reported its revenue by a high margin and committed fraud in relation to hiding debts from investors and regulators to escape accountability. This scandal had a lasting effect on Wall Street and led the government to pass new corporate accountability and governance regulations.
The Worldcom Scandal
Another major scandal that occurred in 2002 was WorldCom, in which the founder and CEO planned a scheme to increase the incomes in the accounting records to maintain high share prices on the stock exchange. Internal auditors discovered fraudulent entries in records where assets were overstated by making false balance sheet entries.
PepsiCo.
PepsiCo. is one of the good examples of corporate governance; in its 2020 proxy statement, the company sought input from investors on following areas as under
- Long term plans and business sustainability issues;
- Human capital management;
- Leadership structure and Board composition;
- Compensation; and
- Good governance and corporate ethics.
Some important requirements enacted
Sarbanes –Oxley Act: It is popularly known as SOX and was passed to control unlawful and fraudulent activities committed by chief executives of big companies to gain public and investor confidence again. Its emphasis is that top management must certify the accuracy of the yearly financial information presented, and severe penalties were imposed for indulging in fraudulent financial activity.
Basel II: Basel II provides guidelines for minimum capital requirements, regulatory supervision, and market discipline. Banks are required to maintain certain ratios of capital to their risk-weighted assets. This requirement reduces the financial effect of risky operational decisions, which form part of corporate governance.
Corporate governance scenario in India and changes in Companies Act, 2013
Different committees were formed, such as the Confederation of Indian Industry (CII), the Securities Exchange Board of India (SEBI), and the Narayana Murthy Committee, and they identified major features: accountability, transparency, and treating all shareholders equally. To improve the chief affairs of the company, the Ministry of Corporate Affairs (MCA) issued a new set of Corporate Governance Voluntary Guidelines in 2009.
The Companies Act, 2013 was introduced on August 29, 2013 and replaced the Companies Act, 1956. Afterwards, MCA issued rules for management and administration, the appointment and qualification of directors, meetings of the Board of Directors, and its powers and accounts, known as the Companies (Management and Administration) Rules These two amendments provided a robust framework for corporate governance.
Conclusion
The concept of corporate governance is becoming very prominent due to the occurrence of many eye opening scandals in the past that adversely affected economies all over the world. Governments are taking various measures in their respective countries to enact rules and provisions in the laws that should be strictly followed by companies and protect shareholders and others from both financial and non-financial loss. But ultimately, good corporate governance is the responsibility of those who are managing affairs and taking crucial decisions for the company to achieve its goals and objectives by complying with its basic principles.
References
- Corporate Governance Definition: How It Works, Principles, and Examples (investopedia.com)
- What is Corporate Governance? – Definition from WhatIs.com (techtarget.com)
- Microsoft Word – Report No 18 of 2018_(27-6-2018) (cag.gov.in)
- Corporate Governance under Companies Act, 2013 – LawBhoomi
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