This article has been written by Anjali Raut pursuing a Diploma in Corporate Law & Practice: Transactions, Governance and Disputes course from LawSikho.

This article has been edited and published by Shashwat Kaushik.

Introduction 

Effective governance is essential for every organisation to grow well. It functions similarly to a vital organ in the body, ensuring that the body does so in a healthy way. Good governance encompasses the company’s processes, values, and set of rules and regulations. It addresses human resources, accountability, transparency, and sustainable development. The board of directors is mostly responsible for the company’s sound governance.

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However, who sets the corporate governance guidelines? The Securities Exchange Board of India (SEBI) and the Ministry of Corporate Affairs (MCA) comprise the guidelines for corporate organisations in India. However, the issue at hand is how to keep an eye on a company’s expansion or determine whether it is adhering to all applicable regulations and guidelines as stipulated by the MCA and SEBI. To stay on top of the same thing, we need a system in place. We do have corporate governance and various methods for it. The two categories of governance mechanisms are internal and external corporate governance mechanisms. 

What is corporate governance mechanism and its significance

A certain set of authorities and responsibilities that have an influential influence on management decisions and eliminate the managers’ discretionary space is termed a corporate governance mechanism. These mechanisms act as a control between the agent and principals, reducing agent costs and further safeguarding the interests of stakeholders.

The importance of having a corporate governance mechanism is that it creates a system of rules and practices that aligns with the interests of all stakeholders. Good corporate governance fosters ethical business practices, which lead to financial viability. In turn, it can attract investors. Strong and effective corporate governance helps to cultivate a company culture of integrity, leading to positive performance and a sustainable business overall. Essentially, it exists to increase the accountability of all individuals and teams within your company, working to avoid mistakes before they can even occur. When a company has solid corporate governance, it signals to the market that the organisation is well managed and that the interests of the management are aligned with those of external stakeholders. And the growth of the company is ensured.

Basically, two types of mechanisms revolve around the corporate environment, depending on the influence and relative importance of these tools. The two mechanisms are within and outside the firm.

Types of corporate governance mechanisms

Internal corporate governance mechanism 

Internal mechanisms are the ways and methods used by the firms that help the management enhance the value of shareholders. The constituents of internal mechanisms include:

  • The board of director
  • Board committees 
  • Financial statements and auditors
  • Ownership structure 
  • Stock based competition  

External corporate governance mechanism 

Sometimes internal mechanisms lack themselves while performing the best for the company. In such scenarios, external corporate governance plays an important role in tracking the performance of businesses and their growth. External corporate governance mechanisms encompass various structures, processes, and practices that are designed to oversee and guide businesses from outside the organisation. These mechanisms involve the participation of external stakeholders, such as shareholders, creditors, regulators, and other independent bodies, to provide oversight, accountability, and transparency. Here are some key external corporate governance mechanisms:

Shareholders

Shareholders, as the owners of the company, have a vested interest in its success. Through shareholder meetings, proxy voting, and engagement with management, shareholders can exercise their rights and influence corporate decisions. They can hold the board of directors accountable for their actions, ensuring that the company’s best interests are upheld.

Board of directors

The board of directors, comprising both executive and non-executive members, is responsible for overseeing the company’s operations and strategic direction. External directors, who are independent of management, bring objectivity and expertise to the board’s decision-making process. They provide critical oversight, challenge management decisions, and represent the interests of shareholders and other stakeholders.

Auditors and financial reporting

External auditors, appointed by shareholders, play a vital role in ensuring the accuracy and transparency of financial reporting. They independently review the company’s financial statements, providing assurance to stakeholders that the financial information is reliable and free from material misstatements. This helps investors make informed decisions and enhances the credibility of the company.

Regulatory bodies

Government agencies and regulatory bodies play a significant role in corporate governance by setting standards, enforcing rules, and monitoring compliance. They oversee various aspects of business operations, such as environmental sustainability, labour practices, and antitrust laws. Regulatory bodies ensure that companies operate within legal and ethical frameworks, protecting the interests of stakeholders and society at large.

Institutional investors and proxy advisors

Institutional investors, such as pension funds and mutual funds, have significant influence on corporate governance. They often engage with companies to promote good governance practices, such as board diversity, executive compensation, and shareholder rights. Proxy advisory firms provide independent advice and recommendations to shareholders on voting matters, influencing corporate governance decisions.

These external corporate governance mechanisms work together to strengthen the overall governance framework of organisations. They provide checks and balances, ensure transparency, and protect the rights of stakeholders. By effectively monitoring business performance and promoting ethical practices, external corporate governance mechanisms contribute to the long-term success and sustainability of businesses.

What is the nature of business growth and why is it important to monitor the same

Business growth is the phase in which a company reaches the point of expansion and looks for new ways to increase revenue. The business lifecycle, industry growth patterns, and the owner’s goal to create equity value are the factors that determine how a business grows. The company’s ability to grow is essential to its long term existence. It facilitates funding initiatives, attracting fresh personnel, and asset acquisition. It also fuels profit and corporate performance. Additionally , growth can help you expand your supply base , improve stability and profitability, and establish the legitimacy of your company. Growth , though,needs to be deliberate and motivated by the correct factors in order to be successful and long lasting.

In a similar manner, governments also continue to track business growth in order to develop appropriate policies and execute them in accordance with national demand and the needs of the economy. Additionally, external variables include independent investors and financial institutions that monitor the company’s development in order to make informed decisions prior to making any financial investment.

Let us be specific, as we are only going to be discussing external corporate governance mechanisms in this essay. They are as follows:

Financial market

Any place or framework that enables buyers and sellers to exchange financial instruments, such as derivatives, bonds, stocks, and different foreign currencies, is referred to as a financial market. The exchange of capital between investors and people in need of capital is facilitated by the financial market. Here, the stock market plays a significant role in a firm’s ups and downs. There is a direct relationship between the market value of a firm and the efficiency of its managers.

Therefore, a company that is losing market value could be acquired with the assistance of another large corporation. The management of the company may take negative measures in response to the takeover threat, such as implementing an agency expenses policy or using any other tactic to protect their business. This is how the financial market can analyse the growth of any business. 

The market for good and services

A further element that propels the company’s enterprise is competition. A company’s business will naturally begin to decline if the public is  dissatisfied with the goods and services it provides; this could also result in a decline in the company’s profit margin. Therefore , in order to access resources in accordance with market demands, the corporation must promptly implement research and surveys. These corporate surveys make sure the business is headed in the proper direction, which promotes growth and they are also a terrific way to keep an eye on how the business is growing.

The labour market for managers

Human capital is a term that can and cannot be occasionally controlled. In order to satisfy their needs, the labour market may compete with the business and perhaps damage the company’s resources if managers exhibit extreme conservatism and strictness towards their staff. To establish a healthy balance of coordination between manager and employees, this process requires the correct selection of a competent manager who oversees the lower class employees. Human resources are essential to the expansion of any business. If the workers are content and happy with their employer, it indicates that the business will thrive in future.

Regulatory role of the state

In order to determine periods of economic expansion or contraction, assess the state of the economy overall, and formulate wise policy decisions, the government monitors business cycles. Government laws apply to every industry, and institutions are required to adhere to these regulations. Penalties are levied on the institutions for breaking these regulations. Government rules are therefore a necessary reality for industries. A collection of guidelines or procedures designed to assist citizens in making informed economic decisions that are advantageous to the country as a whole is known  as government policy for business growth.

For instance, the expansion of the corporate sector in India has been significantly aided by policies such as  liberalisation, privatisation, globalisation, foreign direct investment (FDI), outward foreign direct investment (OFDI), etc.

  • Liberalisation: The liberalisation of the Indian economy began in the early 1990s and involved a number of measures to reduce government control over the economy and open it up to private sector participation. This included the removal of industrial licensing requirements, the reduction of tariffs, and the opening up of the banking and insurance sectors to foreign investment.
  • Privatisation: The liberalisation of the economy was accompanied by a wave of privatisation, as the government sold off many of its loss-making enterprises to private companies. This included the sale of major public sector banks, telecommunications companies, and airlines. Privatisation was seen as a way to improve the efficiency and profitability of these companies and to reduce the government’s fiscal deficit.
  • Globalisation: The globalisation of the Indian economy has been driven by a number of factors, including the growth of international trade, the rise of multinational corporations, and the spread of information technology. Globalisation has led to increased competition in the Indian market, which has forced companies to improve their efficiency and innovation. It has also led to increased foreign direct investment (FDI) in India, which has helped to finance the country’s economic growth.
  • Foreign direct investment (FDI): FDI has played a major role in the expansion of the corporate sector in India. FDI inflows have increased significantly in recent years, as foreign companies have been attracted by India’s large and growing market, its relatively low labour costs, and its improving business environment. FDI has helped to finance the growth of new businesses, create jobs, and transfer technology and skills to India.
  • Outward foreign direct investment (OFDI): In recent years, Indian companies have also begun to invest overseas, in a process known as outward foreign direct investment (OFDI). This has been driven by a number of factors, including the desire to access new markets, acquire resources, and spread risk. OFDI has helped to internationalise Indian companies and raise their global profile.

Conclusion

Corporate governance mechanisms are a specific set of powers and duties that have the ability to significantly impact management decisions and limit managers’ latitude in making decisions. These methods further guarantee the protection of stakeholder interests by serving as controlling tools to establish a balance between principal and agent costs. We have spoken about the corporate governance mechanisms in this article and how crucial they are for businesses to grow. These days, corporate governance is a subject that all businesses must discuss. But there is still one question: why do we need these internal and external corporate governance mechanisms? The primary cause of the inadequate corporate governance practices prevalent in the Indian corporate sector is the family structure of the majority of the companies. The majority of the so-called shareholders are relatives who do not have to know anything about the company’s governance. Therefore, in order to establish proper governance, these kinds of businesses require appropriate monitoring and controlling mechanisms. Good governance is advantageous for the expansion of business as well as the country’s economy. We also talked about the two different kinds of corporate governance mechanisms:Internal and external. Since the external mechanism was the focus of our paper, we went into great length about it. As  an investor, being aware of such important factors is crucial. Investors are more conscious of the impact of governance on a company’s performance. Stakeholder confidence is bolstered and their interests are protected by sound company governance. It keeps investors informed about the company’s numerous initiatives, policies, guidelines, and rules. Overall, we came to the conclusion that corporate governance is essential for implementing transparency, accountability and flexibility in decision making as well as other business practices that not only support the protection of stakeholder interests but also present a favourable image of the company’s financial performance. 

References

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