This article has been written by Mahak Agrawal.
Table of Contents
Introduction
The long term success of an organisation depends not only on its profit-making capacity, efficiency or quality but also on its goodwill with regards to giving something back to the community or the society at large in return of using its resources. This is precisely what corporate governance means. Though there is no universally acknowledged definition of corporate governance, it can be defined as a set of rules, regulations and appropriate control mechanisms through which an organisation is governed. The crux of the entire concept of corporate governance lies in the fact that it creates a fair and transparent corporate culture by ensuring proper disclosure and thereby safeguarding the interests of the various stakeholders involved.
The concept of corporate governance gained momentum in India in the early 1990s with the liberalisation of trade and commerce, i.e., to say, in the era of LPG (liberalisation, privatisation and globalisation). Traditionally, the provisions of good governance were not as mandatory and strict as they are in the modern age of rapid developments.
However, owing to the large-scale economic crisis and the mushrooming of high profile scandals and corporate collapses because of the unregulated use of authority and power and the unethical corporate practices, the issue of good governance found the topmost place in the priority list of most countries throughout the world.
The Cadbury Committee Report (1992) of the United Kingdom and the Sarbanes Oxley Act (SOX) (2002) of the United States are often looked upon as the two important sources in the development of the concept of corporate governance throughout the world. When we look particularly at India, it was the constitution of the Shri Kumar Mangalam Birla Committee in 1999 that led to the rise in the standards of corporate governance to meet the benchmark already set by developed nations such as the US and the UK.
The Satyam Consumer Service Limited scandal has raised several questions on the entire purpose of corporate governance and has brought about a radical shift in the paradigm of corporate governance. It was at this stage that the need was felt by the Indian government and the SEBI (Securities and Exchange Board of India) to revisit the corporate governance framework existing at that time. These high profile fiascos such as the 2G Spectrum scam, the hawala scam, the coalgate scam, the Satyam scandal, to name a few, have shook the foundations of the corporate law framework in India and have lead to various reforms being introduced in the existing framework, some of the important ones being the changes in the whistleblower policies, the terms and conditions of appointment, remuneration and evaluation of directors, the audit committee and the independence of directors.
Though corporate governance in India has travelled great distances in terms of stricter norms, the extent of its implementation is still a question that is open for deliberations.
The need and importance of corporate governance
In today’s globalised world, the existence of any company depends on its profit-making model and the quantum of money it generates depends on the satisfaction of various stakeholders, two of the most important of whom are the shareholders and the investors. To keep them in confidence is the imperative of the board of directors in order to ensure that the money and capital from every nook and corner of the world keep pouring in. Research in this field has shown that good corporate governance which keeps the workings of the company transparent, is an effective tool in keeping up the confidence of the shareholders and the investors. Studies have shown that good corporate governance is, directly or indirectly, linked with improved share price performance.
A company comprises various stakeholders, namely, employees, customers, partners, investors, managers, directors, society and the government. It goes without saying that investors would be more inclined towards investing in companies with high rates of return. This is where corporate governance comes to aid. It builds trust and confidence of investors in the company by assuring higher degrees of transparency, accountability, independence and fairness. Corporate governance plays a significant role in this era of cutthroat competition. In today’s globalised world it is imperative for any corporation to claim global recognition. It needs to attract human resources from every nook and cranny of the globe and identify profitable collaborations and ventures. Unless the corporation recognises and puts in place a well defined ethical code, it cannot succeed.
What can be inferred from this is that in such a time of quick capital flows, a corporation that does not appreciate a trend of strong and unbiased supervision, risks its very existence and sustainability. Thus, the connection between a company’s management, directors and its disclosure mechanism has been of utmost importance. The job of a steward played by the directors contributes significantly towards the efficient working of the company. Furthermore, corporate governance is more about leadership qualities influenced by moral and ethical duties. Great leaders have more cosmopolitan thinking and work towards creating a progressive economy rather than applying the conservative thinking of earning short term profits by hook or by crook.
We have certain legislation in places, such as the Companies Act, 2013, the SEBI guidelines, the standard listing agreements, the Accounting Standards issued by the Institute of Chartered Accountants of India (ICAI), and the Secretarial Standards issued by the Institute of Company Secretaries of India (ICSI). However, the real responsibility of ensuring the desired standard of ethical conduct lies with the management. What matters the most is the mindset of those who run the company. Corporate governance is something that is beyond the domain of law and cannot be achieved solely by external factors such as legislation.
Corporate governance and firm performance
As a common notion, corporate governance is believed to have a significant impact on the performance of the firm with regards to its growth prospects. The various factors of corporate governance such as the board structure, the disclosure norms, the compliance mechanism etc have a notable impression on the firm’s performance in terms of financial security, growth, firm valuation, shareholder satisfaction etc.
Corporate governance essentially focuses on having an independent board of directors composed of members who are not involved or have no material interests in the firm other than their job. Now, critically analysing, the outsider structure of the board, in a way, has a significant impact on the performance of the firm. Most of the research and studies indicate that boards with a considerable percentage of independent directors can reduce agency costs to a significant extent.
In a company, the shareholders or the investors are the principals and they appoint the board of directors who act as their agents and work on behalf of the shareholders. So, the investors pay the management for undertaking the affairs of the company acting as their agent. This payment that is made to the management by the investors is called agency cost.
An agency cost is a type of internal company expense which comes from the actions of an agent acting on behalf of a principal. Agency costs typically arise in the wake of gross inefficiencies and dissatisfactions such as conflict of interest between shareholders and management, in the sense that the shareholders usually claim higher returns in the form of dividends, whereas, the directors might want to run the company in a way that suits their personal motive and maximises their own personal wealth, even at the cost of the company’s market value.
The good governance code requires the composition of the board to be balanced and consist of a combination of executive and non-executive directors. Independent directors tend to work for the shareholder’s interests, in order to make their reputation stand out. Also, the influence of non-executive directors reduces the extent of inside discretion. Therefore, having independent directors on the board will reduce the agency costs as there will be less conflict of interest between the shareholders and the management since the acting agent in this case would be the independent director.
It is a well-appreciated contention that an independent board facilitates unbiased decision making. It follows that an outsider board can bring with it the requisite skills for effective decision making, thereby fostering specialisation which may not be the case with an insider structure of the board of directors.
It goes without saying, this enhances the financial performance of the firm by improving the firm valuation. Financial performance is basically the firm’s overall financial health over a stipulated time frame measured by its profitability and stability. However, to the contrary, there are findings suggesting a topsy-turvy relationship between the board structure and the financial performance of the corporation. It follows that an outsider board has little or no proper information about the operations and activities of the firm which is important for the effective supervision of the firm, so the resultant ineffectiveness of oversight can significantly reduce the efficiency of the firm.
Companies are starting to realise that publicising their good governance practices has actually led to a noteworthy rise in foreign direct investment and financial stability. The statistics have shown that the Indian corporate world has hinted at a positive response to clause 49 of the listing agreements, which is the backbone of corporate governance in India, since its announcement back then in 2005. Average to large sized firms have gained approximately 4.5% for three days from the date of implementation of clause 49. Moreover, they are of the increasing opinion that the changes to clause 49 have had a markable impact on the stock market culture resulting in positive reliance sentiments and less dependency on loans.
However, there are always differing and contravening opinions on any matter open for deliberation. The relationship between corporate governance and firm performance is no exception. While some suggest that corporate governance has an immediate positive outcome in the form of financial growth, some others stick to the school of thought which holds that good governance has no direct significant impact on performance. The literature available on the matter reveals varied results. Thus, further review and scrutiny by experts in the field is necessary to arrive at any concrete and absolute conclusion.
Closing thoughts
Corporate governance is not the job of a single person. It requires compliance and cooperation from each and every stakeholder right from an employee to the CEO of the company to help the transformation of the Indian corporate sector into a more reliable service provider. Some of the top Indian high tech giants such as Reliance, Tata, Infosys, Wipro, to name a few, can be said to be the flag bearers of good governance practices. With the opening up of trade and commerce across the globe, the application of internationally recognised principles of corporate governance is of much importance for Indian Companies seeking international presence. Corporate governance is much more than just a legal requirement. It is more of a social and an environmental responsibility having a holistic approach based on the basics of values and ethics.
No matter how far we reach, reforms are always needed to meet the changing needs of the society, to keep pace with the global situations and to compete with the roaring economies of the world. Reforms can be seen as a way of updating the existing system of laws. The present corporate legal framework in India is not free from loopholes. Had it been flawless, business tycoons and big wheels like Ramalingam Raju, the mastermind behind the Satyam fiasco, would not have had the chance to play around with the economy.
Compliance and implementation is still an area of concern. Owing to the strong red tapism and bureaucratic and political interference, corporate regulators must be given a free rein to some extent to cater to the issue pertaining to the burgeoning number of frauds in India. Incentives and rewards can act as a motivating factor for ensuring greater adherence to good governance practices. It follows that the compliance measures still need reforms in the larger domain of legal and political sentiments across the nation. Ultimately, corporate governance should be understood to be a path to achieve corporate excellence because it is only through good corporate governance that the Indian corporate bodies can outshine the shining economies across the globe!
Bibliography
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