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Corporate Governance: An Overview

• Capitalism at Crossroads
• Increasing Awareness
• Global Concerns
• What is Corporate Governance?
• Governance Is More Than Just Board Processes and Procedures
• A Historical Perspective of Corporate Governance
• Issues in Corporate Governance

Capitalism at Crossroads

The beginning of the twenty-first century was marked by the emergence of corporate governance, as a solution to the collapse of several high-profile corporations, both in the USA and elsewhere. The business world was shocked beyond belief with both the scale and degree of illegal and unethical corporate practices. As a result, “the need for the adoption of good corporate governance principles has been reinforced, and inevitably and inextricably, efforts to this end have gathered momentum every time a new corporate scandal came to light.”¹

Corporates in the very citadel of capitalism, the United States of America, were mired in problems and were going through a grave crisis of credibility during the very early years of the new millennium. Companies that were held out till then as role-models in corporate governance were being threatened with widespread exposures of accounting irregularities and fraudulent practices. The Securities and Exchange Commission (SEC) set up under the New Deal to combat the Great Depression, appeared to be inadequately equipped to deal with gigantic business conglomerates such as Xerox, WorldCom and Enron that committed deliberate frauds with a view to boosting their sales revenues and for showing highly inflated profits. If company managements want the market value of their equity shares to climb new peaks year after year, the temptation to fudge accounts and thereby take credit for unearned profits seem to be difficult to resist. Investors, on their part, can neither equate high profits shown by their companies as a sure index of corporate efficiency nor treat a company’s failure to maintain a consistent high profit a failure of corporate governance.

 

The problems of corporate America, as indeed of several developed and more so of developing economies such as India, have a lot to do with the failure of the auditing profession to safeguard consciously the interests of shareholders. There is a growing apprehension among users of audited accounts such as shareholders, financial institutions and banks, government, industry and the public at large, that all is not well with the profession of auditing. The collapse of US corporate giants has only heightened this perception.

In the past few years, the reported corporate lootings have become so frequent, so spectacular that the term “business ethics” seems to sound like a cruel oxymoron. The swashbuckling CEO, the archetypal corporate hero in prosperous times, is now villified as a crook, gambling away the retirement savings of hapless workers and other unwary investors.

America’s Hall of Shame—2002

Corporate America’s Hall of Shame was littered with failed mega corporations and transnational companies that sound like a virtual “who is who” of international business glitterati.

 

WorldCom improperly booked $3.8 billion in expenses, thus inflating profits. The founder, Bernie Ebbers, borrowed $408 million from the phone company to cover personal debts. Energy firm, Enron, created outside partnerships that helped hide its poor financial condition. Executives earned millions of dollars selling company stocks. The company had to go to bankruptcy court. The accounting firm, Andersen, was accused of shredding Enron documents and was convicted for obstruction of justice. Energy company, Dynegy, was under investigation for accounting and trading malpractices, in part related to California power crisis. Securities and Exchange Commission sued executives of garbage company Waste Management for massive accounting fraud from 1992 to 1997 that resulted in a $17 billion restatement of earnings. Its auditor was Arthur Andersen. Adelphia Communications made illegal loans to founder Rigas’ family members and was under investigation for accounting malpractices. Amid questions about its accounting malpractices, Tyco Chief Executive, L. Dennis Kozlowiski, was charged with deliberately dodging sales tax on purchase of artwork for his New York residence. Chief Executive, Samuel Waksal, of Imclone Systems was charged with insider trading after company’s drug application got rejected. Southern California software company Peregrine Systems said it might have overstated revenue by $100 million over three years. Three former executives of the drugstore chain Rite Aid were indicted for charges of securities and accounting fraud relating to irregularities in the 1990s.

The Bush Federal Administration was prompt to slap punitive measures on erring corporates and preventive steps to avoid future corporate frauds. The new law that has come into force, known as the Sarbanes-Oxley Act, stipulates that chief executive officers (CEOs) and chief financial officers (CFOs) of big companies should swear in front of a notary that their annual and quarterly reports contain no untrue statement and have not omitted any material fact. Over the past few years, more and more companies have made a beeline to make the certification of the truthfulness of their accounting statements. It is now mandatory for both the CEO and the CFO to certify the annual report and also give an assurance that they meet internal controls relating to the circulation of material information regarding the company. This certification means that these officials will be liable for criminal or civil suits for any omissions, false statements and restatements.

Corporate Misgovernance in India

Industrial growth in India along with the development of corporate culture started only after the country became free in 1947. However, with the characteristic of the country’s governance continuing to be feudalistic, and its political system degenerating to be pseudo-democratic, the governance of most of the country’s industrial and business organisations thrived on unethical practices at the market place while showing scant regard for the timeless human and organisational values in dealing with their employees, shareholders and customers. The increasing corruption in the government and its various services had kept the managements of country’s industrial and business organisations above accountability for their misdeeds, encouraging them to indulge in more unethical practices. The state-owned organisations occupying a dominant position in the country’s economy and being monopolistic, passed on the costs of their corporate misgovernance to the helpless consumers of their products and services. Organisations in the private sector, barring a few, indulged in all possible unethical practices to fleece their customers on the one hand and denied the state its due on the other. In India, one could see a large number of privately owned business organisations too indulging in rampant corporate misgovernance. The difference is that while in state-owned organisations employees at all levels are seen to indulge in, or contribute to, corporate misgovernance, in privately owned business organisations only employees at top levels are seen to be indulging in corporate misgovernance, indicating that in privately owned business organisations employees at the lower levels of the corporation are better controlled. The scams committed in a number of large privately owned corporations during the last one decade clearly indicate the nature and extent of corporate misgovernance that exists in privately owned business organisations.

 

Series of Scams That Shook Investor Confidence

The vital need for corporate governance was first realised in the country with the “Big Bull,” Harshad Mehta’s securities scam that was uncovered in April 1992 involving a large number of banks and resulting in the stock market nosediving for the first time since the advent of reforms in 1991. This was followed by a sudden growth of cases in 1993 when transnational companies started consolidating their ownership by issuing equity allotments to their respective controlling groups at steep discounts to their market price. In this preferential allotment scam alone investors lost roughly Rs. 5,000 crore. The third scandal of the decade was the disappearance of the companies during 1993–94. Between July 1993 and September 1994, the stock market index shot up by 120 per cent. During this boom, 3,911 companies that raised over Rs. 25,000 crore vanished or did not set up their projects. Due to the vanishing companies scam, gullible investors lost a lot of money because during the artificial boom hundreds of obscure companies were allowed to make public issues at large share premia through high sales pitch of questionable investment banks and misleading prospectuses.

Another scam took place in 1995–96. Plantation companies scam saw Rs. 50,000 crore mopped up from gullible investors who were prompted to believe plantation schemes would yield huge returns. The so-called non-banking finance companies scam that took place in 1995–97 also saw more than Rs. 50,000 crore mopped up from the public promising them high returns but vanished. The mutual fund scam saw public sector banks raising between 1995–98 nearly Rs. 15,000 crore by promising huge fixed returns, but all of them flopped. Yet another scandal was the one in which BPL, Sterlite and Videocon price rigging happened with the help of Harshad Mehta. The IT scam between 1999–2000 saw firms change their names to include ‘infotech’, and investors saw their stocks run away overnight. The year 2001 witnessed yet another scam in which Ketan Parekh resorted to price rigging in association with a bear cartel. One of the most recent and scandalous scams that was said to be the worst compared to all the previous ones here and elsewhere was the Satyam scandal. The promoter of the country’s fourth largest IT company systematically siphoned off billions of rupees of shareholders’ wealth.

Illegal Tactics of Indian Corporates

Several illegal tactics used by corporates in India over the years are as follows:

• Cornering of industrial licenses mainly with a view to pre-empting competitors to enter into their well-entrenched industry.
• Using import licenses to make a quick profit in the market.
• Illegally holding money abroad to meet business expenses and investments for which government would not allow enough funds.
• Trying to gain special advantages for the business through bribery of concerned officials, generating unaccounted money in the business so as to compensate for penal levels of taxation other “business” expenses and political donations.

The extraordinarily high income tax levels of the 1960s led many companies to devise tax evasion tactics in the form of compensation packages for their senior and middle level employees. These elements grew in value over the years, often crossing the lines of legality. Overseas holidays for families shown as business trips, expensive residences shown as in office use, cars for personal use but shown as being used for work, furniture and furnishings, clothing, food and most household expenses being met by the company for employees became relatively common practices for the companies which promised to be honest otherwise. The economy lost tax revenues and the organisations fostered an acceptance of ignoring and violating of laws that were regarded as unacceptable by the company. The net result of such dishonest practices and scams was that the regulators started tightening up especially in the last few years, also public patience ebbed and intolerance to such issues rose. This fuelled a change in the Indian corporate mindset. These scandals led to the realisation that “corporate governance” was essential and was advocated by financial press, some financial institutions, more enlightened business associations, the regulatory agencies and government.

It is strange but true that early initiative for better corporate governance in India came from the more enlightened listed companies and an industry association. This was quite different from the US or Great Britain, where the drivers of corporate governance were shareholders’ groups, activist funds and self-regulatory bodies within capital markets, or Southeast and East Asia, where it was the result of conditions imposed by the IMF and the World Bank in the wake of the financial collapse of 1997–98. When India embarked on its corporate governance movement in 1996–97, the country faced no financial or balance of payments crisis. There were no major internal or external pressures that could have created urgency for better corporate governance.

Reasons for Corporate Misgovernance

For too long, Indian corporates have insulated themselves from wholesome developments evolving elsewhere. A closed economy, a sheltered market, limited need and access to global business/trade, lack of competitive spirit and a regulatory framework that enjoined mere observance of rules and regulations rather than realisation of broader corporate objectives marked the contours of corporate management for well over 40 years, ever since we adopted a socialistic pattern of society.

Apart from forces militating against healthy and transparent governance is the fact that a vast majority of Indian corporates is controlled by promoter families which while owning a negligible proportion of share capital in their companies, rule them as if they are their personal fiefdoms. According to a survey conducted some years ago, family shareholdings in big business groups averaged a mere 3.3 per cent of the aggregate paid-up capital. Under the new economic policy, the fear of hostile raids has made several business houses enhance their stakes but the units still remain captive for a meagre stake. These so-called “owners” view with disdain any suggestion of professional management, which, after all, is the core and essence of corporate governance. In such an unhealthy scenario, corporate democracy, professionalisation of management and transparency of operations were mere rhetoric used to drum up support or elicit a degree of acceptability from gullible investors.

 

The perpetrators of misgovernance, however, have to face the winds of change in the form of market-driven reforms that are shaking their feeble foundations. Economic liberalisation, a steady dismantling of the control and quota regime, delicensing and deregulation of industries, changes in export-import and overall commercial policies, globalisation of the economy within and outside the ambit of the World Trade Organisation (WTO), the entry of transnational corporations and the take-over bids in an open and competitive environment, have all ripped open the cocoons within which Indian corporates had laid out their cosy existence. These dramatic changes have exposed them to the merciless forces of international competition and forced them to shed their old ways if not switch over to newer norms of corporate governance.

Increasing Awareness

Thus, in the aftermath of economic liberalisation, corporate heavyweights have started mulling over the buzz phrase of corporate governance in hastily convened conclaves and conferences. Apart from the Department of Company Affairs and the Institute of Company Secretaries, the Federation of Indian Chambers of Commerce and Industry (FICCI), the Confederation of Indian Industry (CII), which has worked out a code of corporate governance, the Securities and Exchange Board of India (SEBI) and the Association of Mutual Funds in India (AMFI) just to name a few apex bodies, have discussed it with all the seriousness it deserved. The Industrial Credit and Investment Corporation of India (ICICI) has implemented an internal corporate governance code about ten years ago.

 

The corporate governance movement in India began in 1997 with a voluntary code framed by the Confederation of Indian Industry (CII). In the next three years, almost 30 large listed companies accounting for over 25 per cent of India’s market capitalisation voluntarily adopted the CII code. By 1999, the Securities and Exchange Board of India (SEBI)—India’s capital market regulator—got into the act and set up a committee headed by Kumar Mangalam Birla to mandate international standards of corporate governance for listed companies. From 1 April 2001, over 140 listed companies accounting for almost 80 per cent of market capitalisation started following a mandatory code which was in line with some of the best international practices. By April 2003, each and every listed company joined the SEBI code.

How did this sea change occur without the presence of sufficient internal or external pressures? The answer has to do a lot with the change in corporate mindset brought about by economic liberalisation and competition of the 1990s. It is useful to emphasise here the great churning that has been unleashed by a decade of liberalisation. Consider the top 100 companies ranked according to market capitalisation as on 1 April 1991. How has the market treated these companies a couple of years after liberalisation? Very poorly! that is what the market statistics of the time tell us. Simply, yesterday’s giants—those who lived off protection and cared precious little for generating greater shareholder value—have been dwarfed by market forces. Compare this with the new players in the corporate sector. They have been doing well. This evidence shows how economic liberalisation, competitiveness and dismantling of controls have reduced entry barriers, and permitted new entrepreneurs to race to the top.

This change has augured well for corporate governance. The new breed of managers is not wedded to the mechanics of yesterday’s regime. Instead, they believe in professionalism and the credo of running business transparently to increase corporate value. Thus, the need for good corporate governance is being appreciated as a sound business strategy, and as an important facilitator to tap domestic as well as international capital.

Global Concerns

There are fewer concerns more central to international business and developmental agendas than that of corporate governance. A series of events over the last two decades have placed corporate governance issues at the centre stage both for the international business community and for international financial institutions. Apart from colossal business failures and serious frauds in the USA, several high-profile scandals in Russia and the Asian crisis have brought corporate governance issues to the forefront in developing countries and transition economies. The virtual collapse of the Russian economy in 1998 resulted in large measure from the weakness of governance mechanisms. The abysmal inefficiency of business operations under state control led to the earlier collapse of the Soviet system. But privatisation of industries resulted in a substantial diversion of assets by managers. These managers are said to have robbed share holders, creditors, consumers, the government, workers, in sum all possible stake holders, an estimated $100 billion and this colossal sum was moved out of the country by these predators. The consequent distrust predictably resulted in the virtual collapse of external capital to firms, illustrating vividly the fact that corporate misgovernance can shake the very foundations of a society, affecting every member therefrom. Likewise, the Asian financial crisis also demonstrated that even strong economies lacking transparent control, responsible corporate boards and share holder rights can collapse quickly as investors’ confidence erodes.

Further, national business communities are gradually realising the fact that there is no substitute for getting the basic business and management systems in place in order to be competitive in the global market and to attract foreign investment.

What is Corporate Governance?

Corporate governance is typically perceived by academic literature as dealing with “problems that result from the separation of ownership and control.” From this perspective, corporate governance would focus on: The internal structure and rules of the board of directors; the creation of independent audit committees; rules for disclosure of information to shareholders and creditors; and, control of the management. Figure 1.1 explains how a corporation is structured.

 

Figure 1.1 Separation of ownership and management

Definitions of Corporate Governance

The concept of corporate governance sounds simple and unambiguous, but when one attempts to define it and scan available literature to look for precedence, one comes across a bewildering variety of perceptions behind available definitions. The definition varies according to the sensitivity of the analyst, the context of varying degrees of development and from the standpoint of academics versus corporate managements. However, there is an underlying uniformity in the thinking of all analysts that there is a definite need to eradicate corporate misgovernance and promote corporate governance at all costs. It is not only the stakeholders who are keenly interested in ensuring adoption of best governance practices by corporates, but all societies and countries worldwide.

From the Academic Point of View

From the academic standpoint, corporate governance is seen as one that addresses “the problems that result from the separation of ownership and control.”² Viewed from this perspective, corporate governance focusses on some structures and mechanisms that would ensure the proper internal structure and rules of the board of directors; creation of independent committees; rules for disclosure of information to shareholders and creditors; transparency of operations and an impeccable process of decision-making; and control of management.

A recent academic survey of corporate governance defined it as follows: “Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment. How do the suppliers of finance get managers to return some of the profits to them? How do they make sure that managers do not steal the capital they supply or invest it in bad projects? How do suppliers of finance control managers?”³

From this point of view, corporate governance tends to focus on a simple model:

1. Shareholders elect directors who represent them.
2. Directors vote on key matters and adopt the majority decision.
3. Decisions are made in a transparent manner so that shareholders and others can hold directors accountable.
4. The company adopts accounting standards to generate the information necessary for directors, investors and other stakeholders to make decisions.
5. The company’s policies and practices adhere to applicable national, state and local laws.⁴

A McKinsey & Company Report published in 2001 under the title “Giving New Life to the Corporate Governance Reform Agenda for Emerging Markets” suggests that by using a two-version “governance” chain model, we can illustrate the governance practices throughout the world.

Model 1

In the first version of McKinsey’s model called “The Market Model” governance chain, there are efficient, well-developed equity markets and dispersed ownership, something common in the developed industrial nations such as the US, UK, Canada and Australia. Corporate governance is basically how companies deal fairly with problems that arise from “separation of ownership and effective control.” This model illustrates conditions and governance practices that are better understood and appreciated and as such highly valued by sophisticated global investors.

 

Figure 1.2 The “market model” governance chain (more common in the US, the UK, Canada and Australia)

Model 2

In the second version of McKinsey’s model called “The Control Model,” governance chain is represented by underdeveloped equity markets, concentrated (family) ownership, less shareholder transparency and inadequate protection of minority and foreign shareholders, a paradigm more familiar in Asia, Latin America and some east European nations. In such transitional and developing economies there is a need to build, nurture and grow supporting institutions such as a strong and efficient capital market regulator and judiciary to enforce contracts or protect property rights.

From the Angle of Developed Versus Developing Countries

The concept of corporate governance can also be viewed from the context of economic development achieved by countries. While the principles underlying the concept are the same and there is no question of the norms governing it being different, the evolution of the systems and procedures that are required to implement it are at varying degrees of maturity. The earlier definitions quoted assume that in all societies an efficient and functioning legal system is in place, which is unfortunately, not so.

 

Figure 1.3 The “control model” governance chain (more common in Asia, Latin America, parts of Europe)

 

The Anglo-American, German, Japanese and other mature and developed economies have all well-functioning market systems and highly developed legal institutions, although there are considerable differences between them as there are in other features of democracy. In fact, it is these well-developed and mature institutions that have played a significant role in ushering in faster economic development of these countries. Therefore, in such economies, proper checks and balances exist to ensure good corporate behaviour. Even if any aberration occurs and corporate misdemeanour is noticed, quick remedial action can be taken to arrest the spread of such virus throughout the system, as was promptly done in the US by the Bush administration through the enactment of the Sarbanes-Oxley Act in the wake of corporate failures in 2002.

In the context of developed societies, the essence of corporate governance as expressed in the words of Patricia A. Nodoushani and Omid Nodoushani is as follows: “It is a relationship among various participants in determining the direction and performance of a corporation. However, corporate governance goes beyond the simple concept of who is in charge and who has the power. Chief among its goals are improving shareholder value and supporting a continuing commitment to growth.”

Providing the foundation to this more “traditional” view of corporate governance are three basic assumptions: Primacy of the shareholder; diversity of the shareholder group; and the maximisation of shareholder wealth as a fundamental raison d’être of a company.⁵ This view is consistent with both the Anglo-American system and the Continental European or German systems. Yet another crisp definition was from the former President of World Bank, J. Wolfensohn, who expressed the view that “corporate governance is about promoting corporate fairness, transparency and accountability.”⁶

In such a scenario, in the absence of mature supporting institutions, governance practices tend to be designed as more ad hoc to suit the needs of controlling or influencing the shareholders. According to McKinsey, “the Market Model is a natural goal or target for any reform process of developing or transition economies which will however require fundamental institutional reform” to usher in material changes in the functioning of corporates.

According to some other experts: “Corporate governance means doing everything better to improve relations between companies and their shareholders; to improve the quality of outside directors; to encourage people to think of long-term relations; information needs of all stakeholders are met and to ensure that executive management is monitored properly in the interest of shareholders.”

Sir Adrian Cadbury, chairman of the Cadbury Committee, defined the concept thus: “Corporate governance is defined as holding the balance between economic and social goals and also between individual and communal goals. The governance framework is there to encourage the efficient use of resources and equally to require accountability for the stewardship of those resources. The aim is to align as nearly as possible the interest of individuals, corporations and society. The incentive to corporations is to achieve their corporate aims and to attract investment. The incentive for states is to strengthen their economies and discourage fraud and mismanagement.”⁷

 

Experts at the Organisation of Economic Co-operation and Development (OECD) have defined corporate governance as “the system by which business corporations are directed and controlled.” According to them, “the corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as, the Board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs” (OECD, April 1999). By doing this, it provides the structure through which the company objectives are set, and also provides the means of attaining those objectives and monitoring performance. OECD’s definition, incidentally is consistent with the one presented by Cadbury Committee.

All these definitions which are shareholder-centric capture some of the most important concerns of governments in particular and the society in general. These are: (i) management accountability, (ii) providing adequate investments to management, (iii) disciplining and replacement of bad management, (iv) enhancing corporate performance, (v) transparency, (vi) shareholder activism, (vii) investor protection, (viii) improving access to capital markets, (ix) promoting long-term investment, and (x) encouraging innovation.

All these traditional views reflect the necessity of corporate governance for improved performance of corporates themselves. However, there is a growing school of thought that maintains that this traditional theory does not go far enough. Good governance is critical not only for the success or failure of companies, but also for industries and economies as well. Besides, there is a need to extend the concept of governance to corporates of developing and transitional economies and standardise it to accommodate “well-entrenched” local and regional customs, traditions and business practices, which may be very different from what are obtained in advanced societies.

Of late, corporate governance has become the cynosure of all issues connected with corporations. National business communities are gradually realising the fact that there is no substitute for getting the basic business and management systems in place in order to be competitive in the global market and to attract investment.

From the standpoint of developing economies and transition societies, ensuring corporate governance becomes difficult in the absence of a well-developed corporate culture, capital market, money market, regulatory systems, well-defined and suitable public policies, proactive governments, well-informed stakeholders and presence of corruption, bribery, discrimination and a culture of accepting misgovernance, fraud and corporate misdemenour as part of human frailities. This has been amply demonstrated in the manner in which corporates have been run in developing countries by all-pervasive family-owned concerns. Shareholders, on the other hand, have remained scattered, mute and often oblige managements and pass resolutions without a murmur for the meagre dividends and petty gifts. In such a scenario, developing strong and powerful regulatory institutions, legal structures and evolving healthy precedence is of great importance.

Corporate governance systems depend upon a set of institutions (laws, regulations, contracts, and norms) that create self-governing firms as the central element of a competitive market economy. These institutions ensure that the internal corporate governance procedures adopted by firms are enforced and that management is responsible to owners (shareholders) and other stakeholders.⁸ As John D. Sullivan asserts: “In developing economies one must look to supporting institutions—for example, shoring up weak judicial and legal systems in order to enforce contracts and protect property rights in a better way.”⁹ This need for an institutional arrangement being the sine qua non for adopting better corporate governance practices is underlined in the following definition: “Corporate governance is not just corporate management; it is something much broader to include a fair, efficient and transparent administration to meet certain well-defined objectives. It is a system of structuring, operating and controlling a company with a view to achieving long-term strategic goals to satisfy shareholders, creditors, employees, customers and suppliers and to comply with the legal and regulatory requirements, apart from meeting environmental and local community needs. When it is practised under a well-laid out system, it leads to the building of a legal, commercial and institutional framework and demarcate the boundaries within which these functions are performed.”¹⁰

 

A critical factor in corporate governance is the inherent need to accept it, and to get acclimatised to, change with its fast phase and unpredictability in a market-driven global economy, even while getting even with cut-throat competition at all levels. Every country wants its corporates to flourish and grow, provide wealth and welfare to its people, enhance standards of living and ensure social cohesion to the extent feasible.

But these concerns are not limited to developing countries and transition societies alone. There is a global trend towards strengthening corporate governance. For example, in recent years, the Cadbury Committee in the United Kingdom, the Vienot Commission in France, and the Organisation for Economic Co-operation and Development (OECD) have all issued new guidelines. In the United States, there is mounting concern over the “independence” of independent audits as witnessed in the recent publicity surrounding violations of rules prohibiting auditors to invest in companies that they audit. In all of these cases, the underlying concerns centre around ways to accomplish the core values of corporate governance including transparency, accountability and building values.¹¹

In this context, it is refreshing as well as interesting to note another definition of corporate governance: “Some commentators take too narrow a view, and say it (corporate governance) is the fancy term for the way in which directors and auditors handle their responsibilities towards shareholders. Others use the expression as if it is synonymous with shareholders’ democracy. Corporate governance is a topic recently conceived, as yet ill-defined, consequently blurred at the edges… Corporate governance as a subject, as an objective, or as a regime to be followed for the good of shareholders, employees, customers, bankers, and indeed for the reputation and standing of our nation and its economy.”

Narrow Versus Broad Perceptions of Corporate Governance

Corporate governance can also be defined from a very narrow perception to a broad manner. According to an article that appeared in Financial Times in 1997: “Corporate governance… is defined narrowly as the relationship of a company to its shareholders or, more broadly, as its relationship to society.”

 

The earliest definition of corporate governance in its narrow sense is from the Economist and Nobel Laureate, Milton Friedman. According to him, “corporate governance is to conduct the business in accordance with the owner’s or shareholders’ desires, which generally will be to make as much money as possible, while conforming to the basic rules of the society embodied in law and local customs.” This definition is based on the economic concept of market value maximisation that underpins shareholder capitalism. In the present day context, Friedman’s definition appears narrow in scope. In this narrow sense, corporate governance can be viewed as a set of arrangements internal to the corporation that define the relationship between the owners and managers of the corporation. For instance, Monks and Minow¹² define corporate governance as “the relationship among various participants in determining the direction and performance of corporations. The primary participants are: (1) the shareholders, (2) the management, and (3) the board of directors.”¹³

The World Bank defines corporate governance from two different perspectives. From the standpoint of a corporation, the emphasis is placed on the relations between the owners, management, board and other stakeholders (the employees, customers, suppliers, investors and communities). Major significance in corporate governance in this narrow perspective is given to the board of directors and its ability to attain long-term, sustained value by balancing these interests. From a public policy perspective, corporate governance refers to providing for the survival, growth and development of the company, and at the same time, its accountability in the exercise of power and control over companies. The role of public policy is to discipline companies and, at the same time, to stimulate them to minimise differences between private and social interests.¹⁴ The OECD also offers a broader definition: “…Corporate governance refers to the private and public institutions, including laws, regulations and accepted business practices, which together govern the relationship in a market economy, between corporate managers and entrepreneurs (corporate insiders) on one hand, and those who invest resources in corporations, on the other.”¹⁵

From all the above definitions, any discerning reader can understand that good corporate governance is a desideratum to the growth and development of enterprises worldwide. To attain sustainable economic growth, the economy should boast of a growing enterprise sector which is, inter alia responsible, accountable, transparent and fair not only to its shareholders, but also to the entire groups of stakeholders. These characteristics of good corporate governance are now recognised as a sine qua non for access to, and development of, financial markets, and are being increasingly demanded by both international and domestic investors.

In the case of transition economies which are eager to convert their command economies to market-driven economies, it is improved corporate performance that will justify and accelerate their efforts to reach their goal. In the case of India too, the government found implementation of delicensing, deregulation and liberalisation relatively “easy going” because of the improved performance of the corporate sector in the wake of the new economic policy initiated in and after 1991, which in turn, boosted the growth of the country’s national income, in the aftermath of the changed strategies in economic policy.

Ensuring better corporate governance practices in the country’s mega corporations will result in boosting investors’ confidence so that they can confidently commit their funds to them. Having a transparent and fair system to govern markets, equitable treatment of all stakeholders and an opportunity to enterprises to prove their worth in competitive markets are all very important to the successful development of an economy. And in this scenario, corporate democracy should go hand-in-hand with political democracy.

Perceptional Differences in Definitions

We have seen several definitions of corporate governance and any intelligent reader would not have failed to note the fact that even while all of them emphasise the importance of ensuring good corporate governance practices for the good of the economy and the nation, there is a perceptible difference in the emphasis they lay in terms of objectives, goals and the means and tools to achieve and realise it. In this context, it will be appropriate to recall the contention of many writers of the history of economic thought. Having gone through the chequered history and development of economic thought with their profound impact on the policy formulations and functioning of economies world-wide, they come to the inevitable conclusion that economic doctrines—though they appear to be permanent and inexorable—reflect the conditions of the times in which they are enunciated; so also the contexts and the situations in which they are to be tested or to be put into practice. Lest one is tempted to jump to the conclusion that such economic doctrines have no scientific relevance, one should be clear in one’s mind that economics being a social science studying human behaviour that can not be put into one strait-jacket, can hardly have inflexible and exact doctrines like physics or mathematics.

 

Therefore, corporate governance which reflects a practical field of economics too has definitions that lay varying degree of emphasis on time, context and the dimensions of corporate governance issues. According to some economists: “Corporate governance is a field in economics that investigates how to secure/motivate efficient management of corporations by the use of incentive mechanisms, such as contracts, organisational designs and legislation. This is often limited to the question of improving finance performance, for example, how the corporate owners can secure/motivate that the corporate managers will deliver a competitive rate of return.”¹⁶

Thus, in today’s world different governance practices exist in different markets reflecting the business reality. But there is a common view that the “natural goal” for all markets, be they developed or developing, should be essentially the same. But even though there is common goal, writers on the topic also come to the conclusion that “One Size Does Not Fit All.” For example, Mayer is of the view that “governance is more than shareholder/management alignment; it is about who is in control, for how long and over what critical important corporate activities.” Other commentators argue that new economy companies’ governance structures should adopt themselves rapidly to the fast-moving changes in control, while this adoption may be slow in old economy companies. It is, therefore, important that governance structures and practices should be tailored to meet appropriate requirements and needs.

There are many writers who hold the view, as Mayer does, that governance is moving in a direction that encompasses corporate strategy as a key element. To Mayer, “corporate governance is not… solely concerned with the efficiency with which companies are operated in the interests of shareholders. It is also intimately related to company strategy and life cycle development.”

There are writers who would want corporate governance to include management discipline (including financial discipline), business ethics, corporate social responsibility, and stakeholder participation in the decision-making processes. It is also being presumed that corporates have a responsibility to promote sustainable economic development of the countries in which they operate. In this era of globalisation, it is being increasingly realised that instituting corporate governance is not only a means to survive in today’s competitive world, but a good strategy to prosper.

Governance Is More Than Just Board Processes and Procedures

To most of us, corporate governance is just a set of codes and guidelines to be practised diligently by companies. We have the Cadbury Code and the CII Code of Desirable Corporate Governance. These codes generally enjoin corporations to ensure changes in their Board structures and procedures with a view to making the company more accountable to shareholders. To achieve such an objective, they would recommend increasing the number of independent directors on boards and not to have one person acting both as the chairman and CEO, and to introduce committees for specific purposes such as the audit committee and remuneration committee.

 

However, “governance is more than just Board processes and procedures. It involves the full set of relationships between a company’s management, its Board, its shareholders and its other stakeholders, such as its employees and the community in which it is located. The quality of governance is directly linked to the policy framework. In the 21st Century, stability and prosperity will depend on the strengthening of capital markets and the creation of strong corporate governance systems.”¹⁷ In such a scheme of things, therefore, governments play a crucial role in making the legal, institutional and regulatory framework within which governance systems are kept in place. The efficiency or otherwise of the governance system will directly depend on the framework conditions, which would include legal rights of shareholders and how these are protected when violated by managements.

Writers on the theme of quality of governance link it to the efficiency or otherwise of the economies. Poor governance, for instance, can wreck havoc on the performance of national economies, which in turn, will upset global financial stability. The financial crises in Russia and Asia had created ripples that affected not only the countries in their regions, but the entire world’s economy. Poor governance undermines investor confidence in the markets and holds the whole financial system hostage. This is the reason why even in advanced countries like the US, UK, France, Germany, Sweden and Australia, important long-term efforts have been initiated in the sphere of company law, mergers and acquisitions by companies.

All these broader visions of corporate governance and the consequent improvements that have been effected in the systems, procedures and the frameworks are the direct outcome of the increasing public awareness about the necessity to have better governance practices. In this effort, not only governments are involved, but also world-level organisations such as the World Bank, OECD, and Asia Pacific Economic Co-operation (APEC). The OECD, for instance, had elaborated the corporate governance system which had been adopted by its member governments.

The OECD has emphasised the following requirements of corporate governance:

1. Rights of shareholders: The rights of shareholders which have been stressed as important for ensuring better corporate governance by all writers and organisations including the World Bank and APEC, include secure ownership of their shares, voting rights, the right to full disclosure of information, participation in decisions on sale or any change in corporate assets (including mergers) and new share issues. Shareholders have the right to know the capital structures of their corporation and arrangements that enable certain shareholders to obtain control disproportionate to their holding. All transactions should be at transparent prices and under fair conditions. Anti-takeover devices should not be used to shield management from accountability. Institutional shareholders should consider the costs and benefits of exercising their voting rights.
2. Equitable treatment of shareholders: The OECD and other organisations such as APEC have stressed the point that all shareholders including minority and foreign shareholders should get equitable treatment. All shareholders should have equal opportunity for redressal of their grievances and violation of their rights. Shareholders should not face undue difficulties in exercising their voting rights. Any change in their voting rights should be subject to a vote by shareholders. Insider trading and abusive self-dealing that are repugnant to the principle of equitable treatment of shareholders should be prohibited. Directors should disclose any material interests regarding transactions. They should avoid situations involving conflict of interest while making decisions. Interested directors should not participate in deliberations leading to decisions that concern them.
3. Role of stakeholders in corporate governance: The OECD guidelines as also others on the subject of corporate governance recognise the fact that there are other stakeholders in corporations apart from shareholders. Apart from dealers, consumers and the government who constitute the stakeholders’ group, there are others too who ought to be considered. Banks, bondholders and workers, for example, are important stakeholders in the way in which companies perform and make decisions. Corporate governance framework should, apart from recognising the rights of shareholders, allow employee representation on board of directors, profit sharing, creditors’ involvement in insolvency proceedings etc. For an active stakeholder participation, it should be ensured that they have access to relevant information.
4. Disclosure and transparency: The OECD lays down a number of provisions for the disclosure and dissemination of key information about the company to all those entitled for such information. These may range from company objective to financial details, operating results, governance structure and policies, the board of directors, their remuneration, significant foreseeable risk factors and material issues regarding employees and other stakeholders. The OECD guidelines also spell out that annual audits should be performed by independent auditors in accordance with high quality standards. Like the OECD, the APEC also provides guidelines on the establishment of effective and enforceable accountability standards and timely and accurate disclosure of financial and non-financial information regarding company performance. Moreover, in the administration and management of a company, there may be several grey areas that baffle managers as to which course of action must be pursued to be on the right side of law. In such a piquant situation, they are expected to disclose their options to stakeholders. “When in doubt, disclose” is the ideal guideline one must follow.
5. Responsibilities of the board: The OECD guidelines explain in detail the functions of the Board in protecting the company, its shareholders and its other stakeholders. These functions would include concerns about corporate strategy, risk, executive compensation and performance, accounting and reporting systems, monitoring effectiveness and changing them, if needed. APEC guidelines include establishment of rights and responsibilities of managers and directors.

The OECD guidelines focus only on those governance issues which arise due to separation between ownership and control of capital. Though these have limited focus, they are comprehensive, especially with reference to voting rights of institutional shareholders and obligations of the Board to stakeholders. Though the APEC principles too reiterate them, they give foremost importance to disclosures. Again, instead of rights of shareholders, they reiterate the rights and also of the responsibilities of shareholders, managers and directors. To them, establishment of accountability standards is a separate principle by itself.

To conclude, most of the earlier definitions of corporate governance centre around issues and problems arising out of the separation between ownership and control of capital, such as rights of shareholders, equitable treatment of all shareholders including minorities, foreigners and other stakeholders, disclosure and transparency, and the responsibilities of the board of directors. Later day commentators on the topic stress the importance of corporate governance covering a wider spectrum of policies and procedures encompassing management disciplines, stakeholder participation in decision making processes, social responsibility and corporation’s contribution to sustainable development. There is now a definite emphasis on the quality of governance which is imperative and vital to achieve and realise all these policies. Moreover, it is necessary that we have to have different hats to fit different heads. One Size Does Not Fit All. The Broad objectives and principles of corporate governance may be the same to all societies, but when it comes to applying them to individual countries we have to reckon the peculiar features, socio-cultural characteristics, the history of its people, their value systems, economic system, political set-up, stage and maturity of development and even literacy rates. All these factors have an impact on both political and corporate governance systems. Superimposing the governance systems and procedures that are effective in mature Western democracies on transition economies will be inappropriate, ineffective and may even be inimical to the interests of the people these are intended to serve.

A comparative study of corporate governance guidelines issued by three international organisations, namely, the Organisation for Economic Co-operation and Development, International Corporate Governance Network and the Asia-Pacific Economic Co-operation which fairly represent the thinking and perceptions of people on several governance issues of corporates is given on the next page.

A Historical Perspective of Corporate Governance

From a Narrow to a Broader Vision

As we have observed earlier, corporate governance has focussed traditionally on the problem of the separation of ownership by shareholders and control by management. But with the passage of time, experiences gained from historical developments of corporate misdemeanour and with the impact of a growing visions of society, we have come to recognise increasingly a broader framework of corporate governance. It is now accepted that firms should respond to the expectations of more categories of stakeholders which include employees, consumers, large institutional investors, government and the society as a whole. These diverse interests are to be harmonised and accommodated. Firms can achieve long-run value maximisation only if they respond to the expectations of these increasingly large number of stakeholders. In recent years, externalities such as product safety, job safety, and environmental impacts have increased the importance and significance of better governance of corporations to achieve these ends. Still more additions to the wide range of corporate governance practices include as indicated earlier business ethics, social responsibility, management discipline, corporate strategy, life-cycle development, stakeholder participation in the decision-making processes, and promotion of sustainable economic development. Nowadays commentators on the issue emphasise the importance of the quality of governance. All this growth in the perception of corporate governance from the very narrow definition of Milton Friedman (to conduct the business purely in accordance with shareholders’ desires) to the very broad to include the entire society, has not been achieved in a short period. The evolution and development of corporate governance as an all-encompassing system of corporate behaviour with a great stake in sustainable development has an interesting and chequered history.

 

 

TABLE 1.1 Corporate governance guidelines—a comparative study

The Growth of Modern Ideas of Corporate Governance from the USA

The seeds of modern ideas of corporate governance were sown by the Watergate scandal during the Nixon presidency in the US. Subsequent investigations on the scandal revealed that the regulators and legislative bodies failed to control and stop several major corporations from making illegal political contributions and bribing government officials. The need to arrest such unhealthy trend was translated into the legislation of the Foreign and Corrupt Practices Act of 1977 in America that provides for the maintenance and review of systems of internal control in an establishment. In the same year, the Securities and Exchange Commission (SEC) proposed mandatory reporting on internal financial controls. In 1985, a series of high profile business failures rocked the US which included the collapse of Savings and Loan. With a view to identifying the main causes of misrepresentation in financial reports and to recommend ways of reducing such incidences, the government appointed the Treadway Commission. Its report published in 1987 highlighted the need for a proper control environment, independent audit committees and an objective Internal Audit System. The Treadway Report underlined the need for published reports on the effectiveness of internal control and advised the sponsoring organisations to develop an integrated set of internal control criteria to enable corporations improve their control mechanisms. As a result of this recommendation, the Committee of Sponsoring Organisations (COSO) came into being. COSO’s Report in 1992 stipulated a control framework for the orderly functioning of corporations.

 

England Catches Up

Even while these developments in the US stirred a healthy debate in the UK, a series of corporate scams and collapses in that country took place in the late 1980s and early 1990s which worried banks and investors about their investments and led the government in the UK to realise the inefficacy of the existing legislation and self-regulation. Famous corporations such as Polly Peck, Bank of Credit and Commerce International (BCCI), British & Commonwealth and Robert Maxwell’s Mirror Group International collapsed like a pack of cards. Illustrious business enterprises, which witnessed spectacular growth in boom time became disastrous failures later due to poor management and lack of effective control.

The Cadbury Committee

When it was realised in England that the existing rules and regulations were not adequate to curb unlawful and unfair practices of corporates so as to protect the unwary investors, it was thought necessary to look at the issues involved afresh and look for remedial measures. It was with this view a committee under the chairmanship of Sir Adrian Cadbury was appointed by the London Stock Exchange in 1991. This Cadbury Committee, consisting of representatives drawn from the echelons of British industry was assigned the task of drafting a code of practices to assist corporations in England in defining and applying internal controls to limit their exposure to financial loss, from whatever cause it arose.

The objective of the committee was “to help raise the standards of corporate governance and the level of confidence in financial reporting and auditing by setting out clearly what it sees as the respective responsibilities of those involved and what it believes is expected of them.” The Cadbury Committee, in a commendable pioneering effort, investigated extensively the accountability of the board of directors to shareholders and to the society. The committee submitted its report along with the “Code of Best Practices” in December 1992. In its globally well received report, the committee elaborated the methods of governance needed to achieve a balance between the essential powers of the board of directors and their proper accountability. Though the recommendations of the committee were not mandatory in character, the companies listed on the London Stock Exchange were enjoined to state explicitly in their accounts, whether or not the code has been followed by them, and if not complied with, were advised to explain the reasons for non-compliance.

The Cadbury Code of Best Practices had recommendations which were in the nature of guidelines relating to the board of directors, non-executive directors and those on reporting and control. These recommendations are given in Chapter 3: “Landmarks in the Emergence of Corporate Governance.”

 

The Aftermath of the Cadbury Report

The Cadbury Committee’ s Report, especially its recommendations concealed in the Code of Best Practices, shocked the corporate world in Britain and elsewhere. Its most revolutionary recommendations reverberated several transformatory changes that were to be incorporated in the corporate sector everywhere and its ramifications vibrated not only in the advanced countries of the West, but also could be heard in emerging and transition economies like those of Russia, India and those in South East Asia. The most controversial of the Cadbury’s recommendations was the one that required that the “directors should report on the effectiveness of a company’s system of internal control.” It was the extension of control beyond the financial matters that caused the controversy.

After five years of the publication of the Cadbury Report, public confidence in corporates in England was again shaken by further scandals. To deal with the situation, a “Committee on Corporate Governance” headed by Ron Hampel was constituted with a brief to keep up the momentum by assessing the impact of Cadbury Report and developing further guidelines. The final report of the Hampel Committee submitted in 1998 contained some important and progressive guidelines, especially the extension of directors’ responsibilities to “all relevant control objectives including business risk assessment and minimising the risk of fraud.” Earlier, another Committee headed by Greenbury to address the issue of directors’ remuneration submitted its Report in 1995. An amalgam of all these codes known as the Combined Code was subsequently derived. This Combined Code is appended to the listing rules of the London Stock Exchange and its compliance was made mandatory for all listed companies in the United Kingdom.

The Combined Code stipulated, inter alia, that the boards should maintain a sound system of internal control to safeguard shareholders’ investment and the company’s assets. Further, the directors should, conduct a review of the effectiveness of the group’s system of internal control and report to shareholders at least once a year that they have done so. The review should cover all controls, including financial, operational and compliance and risk management.

The developments with regard to corporate governance led to the publication of Turnbull Guidance in September 1999, which required the board of directors to confirm that there was an ongoing process for identifying, evaluating and managing key business risks. Shareholders, after all, are entitled to ask if all the significant risks had been reviewed (and presumably appropriate actions taken to mitigate them) and why was a wealth-destroying event not anticipated and acted upon?

It was also found that the one common factor behind past failures of corporates was the lack of effective Risk Management. Risk Management subsequently grew in importance and is now seen as highly crucial to the achievement of business objectives by corporates.

It was clear, therefore, that boards of directors are not only responsible but also needed guidance not just for reviewing the effectiveness of internal controls but also for providing assurance that all the significant risks have been reviewed. Furthermore, assurance was also required that the risks had been managed and an embedded risk management process was in place. In many companies, this challenge was being passed on to the Internal Audit function.

Corporate Governance in the Banking Sector

Around this time, some bank failures in the West underlined the necessity of close monitoring of the banking system. Weakness in the banking system of a country can threaten the financial stability, both within the country and globally. The need to improve the strength of financial systems has attracted growing international concern. A communication issued at the close of the Lyon G-7 Summit in June 1996 called for action in this vital area. Several official bodies including the Basel Committee on Banking Supervision established by the Central Bank Governors of the Group of Ten Countries in 1975, the Bank for International Settlements, the International Monetary Fund and the World Bank have recently been examining ways and means to strengthen financial stability throughout the world.

 

The Basel Committee on Banking Supervision has been working in this field for many years, both directly and through its many contacts with banking supervisors in every part of the world.

Revival of Corporate Governance Issues in the New Millennium

As the stock market began to decline in the United States in early 2000, a number of thus far highly regarded companies began to collapse. Most dramatic was the demise of Enron. Serious problems were also reported at WorldCom, Adelphia, Global Crossing, Dynegy, Sunbeam, and Tyco. The revelations gave rise to anguished complaints of corruption, fraud, deception, insider trading and self-dealing at major corporations, which only months ago, looked invincible and almost infallible. Further research revealed that these examples of types of corporate fraud represented only a small sample of the murky goings on in hundreds of corporations. Between the period 2000 and 2002, the revelations of corporate fraud in the US were of such magnitude and inflicted such damage on investors’ that company reputations were irreparably destroyed and investors confidence dipped to a new low. Declining stock prices and erosion of billions of dollars of investors had severe and widespread impacts. The fraud and self-dealing revelations resulted in investigations by the US Congress. the Securities and Exchange Commission (SEC), and the State Attorney General in New York. All these enquiries and the conclusions put their teeth in a comprehensive Act. The Sarbanes-Oxley Act (SOA) was enacted into a law on 30 July 2002.

It is said that eternal vigilance is the price of freedom. Such is also the price investors have to pay for ensuring corporate governance. Complacence and undue faith and trust in corporate managements have resulted in huge and unbearable losses of investors’ hard-earned money. The history of corporate governance gives us an unforgettable lesson that vigilance and a continuing effort at building and strengthening it alone will give the investors the safety net they require.

Issues in Corporate Governance

Corporate governance has been defined in different ways by different writers and organisations. Some define it in a narrow perspective to include in it only the shareholders, while others want it to address the concerns of all stakeholders. Some talk about corporate governance being an important instrument for a country to achieve sustainable economic development, while some others consider it as a corporate strategy to achieve a long tenure and a healthy image. To people in developing societies and transitional economies, it is a necessary incentive to usher in more powerful and vibrant institutions of control. To some, it provides another dimension to corporate ethics and social responsibility of business. Thus corporate governance has different meaning to different people. But to all, corporate governance is a means to an end, the end being long term shareholder, and more importantly, stakeholder value. Thus, all authorities on the subject are one in recognising the need for good corporate governance practices to achieve the end for which corporates are formed. They identify some governance issues being crucial and critical to achieve these objectives. These are:

 

1.  Distinguishing the roles of board and management: Constitutions of more and more companies stress and underline that the business is to be managed “by or under the direction of” the board. In such a practice, the responsibility for managing the business is delegated by the board to the CEO, who in turn delegates the responsibility to other senior executives. Thus, the board occupies a key position between the shareholders (owners) and the company’s management (day-to-day managers of the company’s resources). As per this arrangement, the board of a listed company has the following functions:

1. Select, decide the remuneration and evaluate on a regular basis, and when necessary, change the CEO.
2. Oversee (not directly, but indirectly) the conduct of the company’s business to evaluate whether or not it is being correctly managed.
3. Review and, where necessary, approve the company’s financial objectives and major corporate plans and objectives.
4. Render advice and counsel top management including the Board of directors.
5. Identify and recommend candidates to shareholders for electing them to the board of directors.
6. Review the adequacy of systems to comply with all applicable laws and regulations.
7. All other functions required by law to be performed.

2.  Composition of the board and related issues: A board of directors is a “committee elected by the shareholders of a limited company to be responsible for the policy of the company. Sometimes, full-time functional directors are appointed, each being responsible for some particular branch of the firm’s work.”¹⁸

The composition of board of directors refers to the number of directors of different kinds that participate in the work of the board. Over a period of time there has been a change as to the number and proportion of different types of directors in the board of a limited company. Figure 1.4 illustrates the usual composition of the board in recent times in most of the countries.

The SEBI-appointed Kumar Mangalam Birla Committee’s Report defined the composition of the Board thus: “The Board of Directors of a company shall have an optimum combination of executive and non-executive directors with not less than 50 per cent of the board of directors to be non-executive directors. The number of independent directors would depend whether the chairman is executive or non-executive. In case of a non-executive chairman, at least one-third of the board should comprise independent directors and in case of executive chairman, at least half of the board should be independent directors.”¹⁹

 

Figure 1.4 Types of Directors

 

As shown in Figure 1.4, an executive director is one who is an executive of the company and also a member of the board of directors, while a non-executive director has no separate employment relationship with the company. Independent non-executive directors are those directors on the board who are free from any business or other relationship which could materially interfere with the exercise of their independent judgement in the process of decision-making as a member of the board. An affiliated director or a nominee director is a non executive director who has some kind of independence, impairing relationship with the company or the company’s management. For example, the director may have links with a major supplier or customer of the company, or may be a partner in a professional firm that supplies services to the company, or may be a retired top management professional of the company.²⁰

3.  Separation of the roles of the CEO and chairperson: The composition of the board is a major issue in corporate governance as the board acts as a link between the shareholders and the management and its decisions affect the performance of the company. Professionalisation of family companies should commence with the composition of the board. All committees that studied governance practices all over the world, starting with the Cadbury Committee, have suggested various improvements in the composition of boards of companies.

It is now increasingly being realised that the practice of combining the role of the chairperson with that of the CEO as is done in countries like the US and India leads to conflicts in decision-making and too much concentration of power in one person resulting in unhealthy consequences. In the United Kingdom and Australia, the CEO is prohibited from being the chairperson of the company. The role of the CEO is to lead the senior management team in managing the enterprise, while the role of the chairperson is to lead the board, one important responsibility of the Board being to evaluate the performance of senior executives including the CEO. Combining the role of both the CEO and chairperson removes an important check on senior management’s activities. Besides, in large corporations, the job of the CEO as well as that of the chairman may be heavy and onerous and one person, however much business acumen and astuteness he might possess, may not be able to deliver what he is expected to, competently, efficiently and objectively. That is the reason why many authorities on corporate governance recommend strongly that the chairman of the board should be an independent director in order to “provide the appropriate counterbalance and check to the power of the CEO” (IFSA).²¹

4.  Should the board have committees?: Many committees on corporate governance have recommended in one voice the appointment of special committees for (i) nomination, (ii) remuneration and for (iii) auditing. These committees would lessen the burden of the board and enhance its effectiveness. According to the Bosch Report, committees, apart from having written terms of reference outlining their authority and duties, “should also have clear procedures for reporting back to the board, and agreed arrangements for staffing including access to relevant company executives and the ability to obtain external advice at the company’s expense.”²² When these committees are peopled with independent directors selected for their competence, professional expertise in their chosen fields and long years of work experience would help the respective committees decide issues objectively and in a manner that would promote the long term interests of the organisation.

 

5.  Appointments to the board and directors’ re-election: As per the Indian Company Law, shareholders elect directors to the board. However, shareholders are a legion in large companies and also scattered and to have them together to elect the directors will be expensive and time-consuming. Therefore, in actual practice, in most cases, the board or its specially constituted committee selects and appoints the prospective director and gets the person formally “elected” by the shareholders at the ensuing Annual General Body Meeting. In the Indian context, almost ninety percent of appointments to the board is done at the behest of the promoters who also double as CEOs or MDs. Although this is not an ideal situation, the practice continues because of loopholes and laxity in implementation of the spirit of law.

Shareholders in fact only endorse the board’s nominees and it is only in rarest of rare cases that shareholders refuse to ratify the board’s nominees for directorship. There are other issues of corporate governance in relation to the Board’s appointments such as: appointment of a nomination committee, terms of office, duties, remuneration and re-election of directors and composition of the board on which several committees have made their own recommendations.

6.  Directors’ and executives’ remuneration: This is one of the mixed and vexed issues of corporate governance that came to the centrestage during the massive corporate failures in the US between 2000 and 2002. Executive compensation has also in recent time become the most visible and politically sensitive issue relating to corporate governance.

According to the Cadbury Report: “The over-riding principle in respect of Board remuneration is that shareholders are entitled to a full and clear statement of Directors’ present and future benefits, and how they have been determined.” Other committees on corproate governance have also laid emphasis on other related issues such as “pay-for performance,” severance payments, pension for non-executive directors, appointment of remuneration committee and so on. “However, while controversy often surrounds the size or quantum of remuneration, this is not necessarily an issue of corporate governance—a payment that may be excessive in one context may be reasonable in another. The key corporate governance issues are: (i) transparency; (ii) pay for performance (whether the payment is justified); (iii) process for determination; (iv) severance payments; and (v) pensions for non-executive directors.”²³

7.  Disclosure and audit: The OECD lays down a number of provisions for the disclosure and communication of “key facts” about the company to its shareholders. The Cadbury Report termed the annual audit as “one of the cornerstones of corporate governance.” Audit also provides a basis for reassurance for everyone who has a financial stake in the company. Both the Cadbury Report and the Bosch Report stressed that the board of directors has a bounden responsibility to present the shareholders a lucid and balanced assessment of the company’s financial position through audited financial statements. There are several issues and questions relating to auditing which have an impact on corporate governance. There are, for instance, questions such as: (1) Should boards establish an audit committee? (ii) If yes, how should it be composed? (iii) How to ensure the independence of the auditor? (iv) What precautions are to be taken or what are the positions of the state and regulators with regard to provision of non-audit services rendered by auditors? (v) Should individual directors have access to independent resource? and (vi) Should boards formalise performance standards? These questions are being answered with different perceptions and with different degrees of emphasis by various committees and organisations that have gone into and analysed these issues in depth.

8.  Protection of shareholder rights and their expectations: This is an important governance issue which has considerable impact on the rights and expectations of shareholders. Corporate practices and policies vary from country to country. There are a number of questions relating to this issue such as: (i) Should companies always adhere to one-share-one-vote principle? (ii) Should companies retain voting by a show of hands or by poll? (iii) Can shareholder’s resolutions be “bundled”? i.e. to place together before shareholders for approval a resolution that contains more than one discrete issue and (iv) Should shareholder approval be required for all major transactions? These questions have elicited answers with different emphasis from various committees and organisations that have addressed these issues.

9.  Dialogue with institutional shareholders: The Cadbury Committee recommends that institutional investors should maintain regular and systematic contact with companies, apart from their participation in general meetings of shareholders, use their voting rights positively, take a positive interest in the composition of the board of directors of companies in which they invest, and above all, recognise their rights and responsibilities as “owners” who should act in the best interests of those whose money they have invested by influencing the standards of corporate governance and by bringing about changes in companies when necessary, rather than by selling their shares, and quitting the companies.

If institutional investors have to exercise their rights and carry out their responsibilities, companies have to provide them the required information and facilities.

10.  Should investors have a say in making a company socially responsible corporate citizen?: This is an issue that highlights a conflict between two schools of thought. One school based on past experiences contends that institutional investors should act in the best financial interests of the beneficiaries. This is based on the assumption that socially responsible behaviour of corporations such as ecological preservation, anti-pollution measures and producing quality and environment-friendly products which mostly enhance costs and thus reduce profits. But there is another school of thought which asserts environment friendliness and economic gains are not contradicting goals, but on the other hand, they benefit corporations in the long run and cite the examples of Ford Motors, Johnson & Johnson, Pfizer and Dow Chemicals to prove their point. Much can be, and are being said, on both sides and though the last word is yet to be said on the issue, present thinking worldwide across continents and divergent societies prefer strongly, corporates that are committed to the overall welfare of people in whose midst they work and make their gains.

Relevance of Corporate Governance

Internationally, over the past few years, much emphasis has been placed on the importance of corporate governance. Different economies have systems of corporate governance that differ in the relative strength of influence exercised by the stakeholders and how they influence the management.

 

Corporate governance is all about governing corporations. By their nature large modern enterprises are usually owned by one group of people (the owners or shareholders) whilst being run by another group of people (the management or the directors). This separation of ownership from management creates an issue of trust. The management has to be trusted to run the company in the interest of the shareholders and other stakeholders. If information were available to all stakeholders in the same form at the same time, corporate governance would not have been an issue at all. Armed with the same information as managers, shareholders and creditors would not worry about the former wasting their money on useless projects; suppliers would not worry about the customer not fulfilling his part of a supply agreement; and customers would not worry about a supplier from not delivering the goods/services agreed upon. In the real world of imperfect information, each agent will use whatever information advantage he may have.

Looking at conventional firms, management will usually have an information advantage over other stakeholders and hence the need for corporate governance. Good corporate governance means governing the corporation in such a way that the interests of the shareholders are protected whilst ensuring that the other stakeholders’ requirements are fulfilled as far as possible. It means that the directors will ensure that the company obeys the law of the land while carrying out its business.

In recent years, some high profile business frauds and questionable business practices in the United Kingdom, the United States and other countries including India have led to doubts being cast on the integrity of business managers. This has led to the scrutiny of corporate governance and a desire for governments to tighten the regulation around corporate governance further.

When something goes wrong, government response the world over tends to be to set up an investigative committee. There have been a number of these committees set-up in various countries to look at what needs to be done following corporate governance problems.

Need for and Importance of Corporate Governance

Many large corporations are multinational and/or transnational in nature. This means that these corporations have impact on citizens of several countries across the globe. If things go wrong, they will affect many countries, albeit some more severely than others. It is, therefore, necessary to look at the international scene and examine possible international solutions to corporate governance difficulties.

Corporate governance is needed to create a corporate culture of consciousness, transparency and openness. It refers to a combination of laws, rules, regulations, procedures and voluntary practices to enable companies to maximise shareholders’ long-term value. It should lead to increasing customer satisfaction, shareholder value and wealth. With increasing government awareness, the focus is shifted from economic to the social sphere and an environment is being created to ensure greater transparency and accountability. It is integral to the very existence of a company.

 

Governance and Corporate Performance

Several studies in the US have found a positive relationship between corporate governance and corporate performance. That is, improved corporate governance is linked with improved corporate performance—either in terms of rise in share price or profitability. However, it would be overstating the case to say that these studies are conclusive, because other research has either failed to find a link or found it otherwise.

One difficulty in looking for statistical evidence of the value of good corporate governance is that governance is multi-dimensional. There are several different corporate governance mechanisms, which can interrelate with and, sometimes, substitute for one another.

There are strong signs that the world’s business-ethical standards are becoming more stringent, and what constitutes good business practice is becoming clearer. Fifteen years ago, Korn/Ferry International and the Columbia University Business School conducted a 20-country poll on 1,500 business executives. They were asked to look ahead and identify a list of the most important characteristics of the ideal corporate CEO for the year 2000. It was found that “ethics” was right at the top of the list. Not anywhere else, but right at the top. The Conference Board in New York, together with the Institute of Business Ethics in London, did similar studies in 1992, and found 84 per cent of responding US firms had a corporate ethics code, followed by 71 per cent of UK firms, and 58 per cent for the rest. The figure for UK grew particularly fast; 4 years earlier, it had been just 55 per cent. It seems that the business stress on ethics is a very Anglo-American phenomenon. As these two countries are arguably the trendsetters in the global economy, their way of doing business would eventually affect the rest of the world and, with innovations and modifications to suit different countries and markets, could even become the global norm.

In India too, there are several examples to illustrate the positive relationship between corporate governance and corporate performance, though this is the case with fewer companies and there is a long road to traverse for the entire Indian corporate sector as such. Among companies that have shown commendable success after introducing internationally acclaimed corporate governance practices are: Infosys Technologies Ltd that has consistently enhanced its performance and is a forerunner in espousing global governance standards; Tata Steel which is recognised and rewarded not only in India but also globally for its excellent corporate performance and/equally commendable social commitment and activism; Dr. Reddy’s Lab which has excelled in all the important dimensions of corporate governance. There are several other group of companies belonging to the Tatas, Birlas, Murugappa’s etc. in the private sector and the oil companies in the public sector that have done India proud in the sphere of corporate governance.

Investors’ Preference for Good Governance

A recent large-scale survey of institutional investors found that a majority of investors consider governance practices to be at least as important as financial performance when they are evaluating companies for potential investment. Indeed, they would be prepared to pay a premium for shares in a well-governed company compared to a poorly governed company exhibiting similar financial performance. In the US and UK, the premium was 18 per cent while it was 27 per cent for Italian and 27 per cent for Indonesian companies.²⁴ Likewise, a survey by Pitabas Mohanty (Institutional Investors and Corporate Governance in India) has revealed that companies with good corporate governance records have actually performed better as compared to companies with poor governance records “and institutional investors have extended loans to them easily. Another similar survey of institutional investors, globally, has also revealed governance to be an important factor in investment decision-making.”

 

Benefits to society

According to John D. Sullivan, Corporate Governance brings to the society innumerable benefits. These benefits are as follows:

• A strong and vibrant system of corporate governance can be a major benefit to society. Even in developing countries where shares of most firms are not actively traded on stock markets, adopting standards for transparency in dealing with investors and creditors will bring benefit to all and also it helps to prevent systemic banking crises.
• Research has proved that countries with stronger corporate governance protections for minority shareholders have much larger and more liquid capital markets. Studies of countries that have their laws on different legal traditions show that those with weak systems tend to result in most companies being controlled by dominant investors while those with strong systems tend to have a widely dispersed ownership structure. Hence, for countries that try to attract investors—corporate governance matters a great deal in getting the hard currency out of potential investors.
• Many economists and management experts point out that competition in product markets and for capital, act as constraints on corporate behaviour, in effect promoting good corporate governance. In many developing countries, competition in product or goods markets is quite limited, especially where significant regulatory barriers exist. These ground realities emphasise the importance of adopting the best possible corporate governance systems in countries where the market system is weak or yet to take proper shape.
• Corporate governance is also inter-related to another area that has emerged worldwide to a position of great prominence. In many societies, combating corruption is not a subject that is easy to deal with, both because of political sensitivities and potential yet often undependable and long-drawn legal action. When companies try to be transparent, have systems that provide full disclosure of accounting and auditing procedures, allow transparency in all business transactions, corruption will not have a big role to play.
• Better corporate governance procedures can also improve the management of the firm and help a great deal in working out business strategy, ensuring that mergers and acquisitions are undertaken for sound business reasons and that compensation system reflect performance. It needs to be stressed that good corporate governance system also has to include improvements in management system. In many developing countries, there has been a tradition of very centralised management usually involving family’s owned business. In many developing countries including India, for example, family business groups have tended to dominate the business landscape. This is changing for the better as a result of financial globalisation, observing the World Trade Organisation’s liberalisation rules, and the increasing integration of regional markets. Now, firms in these countries are increasingly adopting modern management techniques, financial accounting systems, and business strategies. These changes require delegation of authority, paying increased attention to developing highly trained staff, and use of management information systems instead of the older centralised decision-making structures. It is highly likely that these trends will force similar changes throughout the emerging economies of the world.

Benefits of Good Corporate Governance to a Corporation

Good corporate governance secures an effective and efficient operation of a company in the interest of all stakeholders. It provides assurance that management is acting in the best interest of the corporation, thereby contributing to business prosperity through openness in disclosures and accountability. While there is only limited evidence to link business success to good corporate governance, good governance enhances the prospect for profitability. The key contributions of good corporate governance to a corporation include:

 

1.  Creation and enhancement of a corporation’s competitive advantage: Competitive advantage grows naturally when a corporation or its services facilitate the creation of value for its buyers. Creating competitive advantage requires both the vision to innovate and the strategy to manage the process of delivering value. An effective board should be one that is able to craft strategies that fit the business environment of the corporation and are flexible to accommodate opportunities and threats, and to compete for the future. Corporations which develop their strategies by involving all levels of employees create widespread commitment to make the strategies succeed. Practical examples of strategies that create value to corporations are sales and marketing strategies, customer base and branding strategies. Coca Cola projects American values to its customers worldwide. Sony is reputed for the invention of new products. Johnson & Johnson and Procter & Gamble, are world renowned as the largest manufacturers of quality personal hygiene products.

2.  Enabling a corporation perform efficiently by preventing fraud and malpractices: The Code of Best Conduct—policies and procedures governing the behaviour of individuals of a corporation—form part of corporate governance. This enables a corporation to compete more efficiently in the business environment and prevents fraud and malpractices that destroy business from inside. Failure in management of best practice within a corporation has led to crises in many instances. The Japanese banks that made loans to property developers that created the bubble economy in the early 1990s, the foreign banks which granted loans to State-owned enterprises that became insolvent after the Asian financial crisis in 1997, and the demise of Barings are examples of managements not governing the behaviour of individuals in the corporation leading to their downfall.

3.  Providing protection to shareholders’ interest: Corporate governance is a set of rules that focusses on transparency of information and management accountability. It imposes fiduciary duty on management to act in the best interests of all shareholders and properly disclose operations of the corporation. This is particularly important when ownership and management of an enterprise are in different hands, as these are in corporates.

4.  Enhancing the valuation of an enterprise: Improved management accountability and operational transparency fulfill investors’ expectations and confidence on management and corporations, and in return, increase the value of corporations. As indicated earlier, companies that have adopted corporate governance standards have invariably enhanced their market valuations.

5.  Ensuring compliance of laws and regulations: With the development of capital markets and the increasing investment by institutional shareholders and individuals in corporations that are not controlled by particular shareholders, jurisdictions around the world have been developing comprehensive regulatory frameworks to protect investors. More rules and regulations addressing corporate governance and compliance have been and will be released. Compliance has become a key agenda in establishing good corporate governance. After all, corporate governance ensures the long-term survival of a corporation and thereby enables its shareholders long-term benefits.

 

• Board procedures
• Board processes
• Broad perceptions
• Broader vision
• Developing countries
• Dialogue
• Disclosure
• Enabling corporations
• Enhancing valuations
• Global concerns
• Historical perspective
• Investor confidence
• Investors’ preference
• Laws and regulations
• Misgovernance
• Modern ideas
• New millennium
• Perceptional differences
• Related issues
• Strategies and techniques
• Transparency

1. Discuss the factors that were responsible for the emergence of corporate governance both in the USA and India.
2. What do you understand by the term “Corporate Governance?” While explaining the concept, discuss both the “market model” and the “control model.”
3. Explain the historical model of corporate governance.
4. Discuss some of the most prominent issues of corporate governance. Discuss the relevance of these issues with particular reference to the Indian corporate sector.
5. Justify the need and relevance of corporate governance to developing countries with particular reference to India.
6. How is corporate governance related to corporate performance? Illustrate your answer with suitable examples from the Indian corporate sector.

• Prabhudev Konana, “Anarchic Capitalism vs. Sensible Capitalism,” The Hindu (4 December 2008).
• Cadbury, Sir Adrian, “Report of the Committee on the Financial Aspects of Corporate Governance” (December 1992).
• “Corporate Governance and Business Ethics,” All India Management Association (1997), Ed. M. R. Gera, New Delhi: Excel Books.
• Corporate Governance, Ed. Devi Singh and Subhash Garg (2001), New Delhi: Excel Books.
• “Directors’ Remuneration—Report of a Study Group” (Referred to as “Greenbury Report”), Gee Publishing (July 1995).
• Fernando, A. C., “Corporate Governance—The Time for a Metamorphosis,” The Hindu (9 July 1997).
• “Leadership Summit/Building Trust Among Stakeholders,” The Hindu (19 September 2002).
• Quinn, Michelle “Business Leadership is Taking a Beating,” San Jose Mercury News (30 June 2002).
• Rangarajan, C., “Corporate Governance—Some Issues,” Indian Management (February 2000).
• Ramachandran, Sushma, “Corporate Fraud,” The Hindu (26 August 2002).
• Rajawat, K. Yatish, “Indian Companies Ready for Life after Sarbanes-Oxley,” Economic Times (26 August 2002).

 

 

Case Study

Infosys Technologies: The Best Among Indian Corporates

(This case is based on reports in the print and electronic media. The case is meant for academic discussion only. The author has no intention to tarnish the reputations of corporates or executives involved.)

Humble Beginning and Spectacular Growth of Infosys

Infosys Technologies is India’s most popular and best managed IT company with its global headquarters at Bangalore. It was founded in 1981 by Narayana Murthy and six of his colleagues in Bombay in a single room of Murthy’s house with a paltry sum of Rs. 10,000 as capital. It has, today, a global presence of 32 sales offices in 16 countries, 33 global software development centres and one business continuity centre. It employed 35,229 people as on 31 December 2004.

Vision and Message of Infosys

The vision of Infosys is “to be a globally respected corporation that provides best-of-breed business solutions, leveraging technology, delivered by best-in-class people”. Its mission is “to achieve our objectives in an environment of fairness, honesty and courtesy towards our clients, employees vendors and society at large”. Infosys has set standards in every business activity— best campus, best working environment, best employer, most transparent dealings, highest quality standards—as well as the highest ethical standards, never seeking any deviant benefits from the government.

The most telling message that Infosys gives out to any discerning observer is its motto: Powered by Intellect and Driven by Values. These two phrases put together stand for everything that Infosys is and wants to be. It is a combination of the business acumen and the deep commitment to ethical values.

Powered by Intellect: Infosys plans to take a lead in leveraging the global delivery model (GDM), pioneered and perfected by it, to help clients derive maximum strategic advantage. In the next growth phase, Infosys would focus on customer-centricity, meeting shareholder expectations and building a multicultural workforce—a seamlessly integrated team of talented, global professionals.

Driven by values: Infosys is an ethical organisation whose value system ensures fairness, honesty, transparency and courtesy to all its constituents and society at large.

Infosys Technologies strives to be the best company both commercially and ethically not only in India but also globally. To realise this objective, the company has developed C-Life Principle of core values that it puts into practice in all aspects of its business activities.

• Customer delight: A commitment to surpassing customer expectations.
• Leadership by example: A commitment to set standards in the business and transactions, and be an exemplar for the industry and their own teams.
• Integrity and transparency: A commitment to be ethical, sincere and open in their dealings.
• Fairness: A commitment to be objective and transaction-oriented, thereby earning trust and respect.
• Pursuit of excellence: A commitment to strive relentlessly, to constantly improve themselves, their teams, services and products so as to become the best.

Infosys also has developed a strong management system to guarantee at all times to all its stakeholders a set of procedures that would serve them. For example, there was a much publicised sexual harassment case against one of its top managers in the USA that was settled out of court. But this unsavoury situation has led the company to review and improve its staff training to create an awareness of such problems and to introduce a code of conduct for employees with a view to guiding them follow a certain work ethics in their places of work.

Even while Infosys is committed to long-term shareholder value, its business activities are anchored in three pillars of corporate behaviour, namely, Business Ethics, Corporate Governance and Corporate Social Responsibility. The Infosys fraternity recognises, understands and appreciates these principles. As a result, Infosys demonstrates an exceptional work ethic.

India’s Most Admired Company

Infosys Technologies is widely known for its best practices in terms of business ethics and corporate governance. In 2000, the company was conferred the National Award for Excellence in Corporate Governance by the Government of India. The Business World—IMRB Survey ranked Infosys number one among the most respected companies in India, in 2001. It was voted as India’s best managed company for 6 years in a row, between 1996 and 2001 by the Asia Money Poll. In the year 2000, in the survey of Far Eastern Economic Review, Infosys was selected as one of Asia’s leading corporations and was ranked first as “The Company that Others Try to Emulate”. The company was voted “India’s Most Admired Company” in Economic Times in 2000. In 2003, Infosys Technologies co-founder and chairman, N. R. Narayana Murthy, won the Ernst & Young World Entrepreneur of the Year award; judges of the award praised his “intellectually, philosophically, ethically and spiritually-driven entrepreneurship” and his company’s “outstanding financial performance and global impact in a dynamic and volatile industry”. Infosys Technologies has won the prestigious “Global Most-Admired Knowledge Enterprises (MAKE)” Award, for 2004. Infosys won the award for the second time in a row, and remains the only Indian company to have ever been named a prestigious global most-admired knowledge enterprise.

Infosys Technologies made a winning sweep in the Business World “Most Respected Companies’ Award” 2004. The company remained “India’s most respected company” since 2001; it topped the special categories of “most ethical and most globally competitive” companies and the “Most Respected Company in the IT Sector” category, topping all 19 parameters of the survey. The latest Business Today—AT Kearney study conducted in March 2005 placed Infosys Technologies as “India’s Best Managed Company”. Such encomiums have been pouring in for Infosys, year after year.

Infosys Technologies featured among the world’s most respected companies, having climbed in the “respect” ranking from last year. It was also recognised in a number of other categories including corporate governance, creation of shareholder value, corporate social responsibility and innovation.

A People-centric Company

Infosys excels in people management. While its employee strength has skyrocketed to over 35,000 from around 5000 at the turn of the century, the intense focus on people and their skills has only increased over the years. Infosys’ focus on people is a natural corollary of its growing business, with customers identifying this as a quality that often distinguishes it from other competitors in the IT services sector. As Infosys seeks to transform itself into a global enterprise, it has learnt that its employees have to be the best, not just in India, but in the globe. While its selection is already stringent (in 2003–04, it recruited 10,000 people from over a million applicants), training will help keep its nose ahead of the increasing competition.

Business Description

The company’s services include business consulting, custom software development, maintenance and re-engineering services, systems integration, IT infrastructure management and business process outsourcing. Infosys is today the second largest publicly traded software services exporter providing specialist IT services to around 350 corporations such as GE, Airbus, Cisco and Nortel, predominently in the US. It was the first Indian company to be listed on the NASDAQ exchange in 1999, when their stock value soared.

Financials of Infosys—Next $1-b Revenue Seen in 18 Months

Infosys’ net profits rose by 53 per cent to Rs. 513 crore, while revenue grew by 47 per cent to Rs. 1,987.32 crore for the quarter-ended 31 March 2005, over corresponding last year. Sequentially, the growth in net profits and revenues was at 3.25 per cent and 5.96 per cent, respectively. Onsite volumes grew by 4.6 per cent while off-shore volumes rose by 6.6 per cent during the March quarter, as compared to double digit-volume growth the company used to post in the last few quarters. The lower growth during the year was attributed to the high cost incurred by the company in complying with the tenets on corporate governance prescribed by The Sarbanes—Oxley Act, the Anti-Money Laundering Act and the Patriots Act in the US wherefrom most of Infosys business comes. The company has forecast a substantial revenue growth in the current fiscal (2005-06) enabling it to cross the $2 billion mark by March 2006.

While it took 23 years for Infosys to go past the $1 billion revenue mark, it may take less than 18 months for it to cross the next billion. The scorching pace at which Infosys is growing gives an indication of the company getting several of its initiatives right. “We are beginning to see the results of various initiatives taken over the last few years,” Mr. Nandan Nilekani, the CEO and Managing Director of the company, observed in April 2005. He said the company’s clients increasingly see it as a strategic long-term partner which can offer a wide range of services and contribute to their business goals. The company also hopes to reap large benefits from its current investments. Infosys is expected to invest Rs. 950–1100 crore mainly in technology infra-structure expansion of seat capacity and China Operations.

Business Strategy of Infosys

As Infosys scorches its way ahead with around 50 per cent growth rates, there are a handful of hurdles it will have to clear to stay on course. The most obvious one is the strong appreciation of the rupee, but there are other, far more significant challenges, such as the shrinking pool of skilled manpower and the creation of a complete solutions provider with global reach and scale; yet another challenge is the increasing cost of adherence to global best practices that would tell upon profit margins in an extremely competitive environment as has been demonstrated in 2004–05 financials of many software services companies. Their profit margins were highly reduced consequent on their complying with Sarbanes-Oxley Act on corporate governance, the Anti-Money Laundering Act and the Patriots Act in the US.

Like its peers in the upper reaches of India’s IT service industry, Infosys faces the challenges of, all at once, inducting and orienting a large number of employees, ensuring that the Infosys way, a process-driven way of working, does not change, and distilling knowledge from all the projects it has completed or from the work in progress. The company, which currently has around 36,000 employees on its rolls, has addressed these challenges through what it terms “PRIDE” (Process Repository @ Infosys for Driving Excellence), an online resource that segues into the company’s fancied knowledge management system termed Kshop (Knowledge Shop) at one end, and the actual development environment at another. As a result of this, “Infosys will reap the benefit of an army of employees that works the same way, gains in process efficiency and productivity, and higher quality”.

Rapid Wealth and Value Creation Through Diversified Business

Building a $1-billion company has not been achieved by just being good to employees. While it was initially just a plain IT services company, Infosys has stepped up its offerings over the past few years at both ends of the spectrum and is increasingly managing to string its various pieces together. Thus, Infosys Consulting, which the company started off in April 2004 with a $20-million investment, will become a 500-employee unit by 2007 and Progeon, its business process management subsidiary, already boasts of over 3400 employees.

The company’s extended capabilities are reflected in growing engagements with customers across industries. In many cases, Infosys began with conventional IT maintenance work in 2000, but rapidly stepped up its partnership to encompass many other areas such as business process consulting, software process consulting, application development and support, enterprise architecture services, and technical training as in the case of Hannaford Brothers, a European retailer. The creation of a US-based consulting company is a major step forward in Infosys’ long-term strategy of presenting itself as a global service provider. Infosys’ $20-million investment in this subsidiary is designed to send a clear signal to the marketplace that it is being totally different from its Indian competitors, and intends to compete for business consulting services with the traditional consultancies.

Infosys relies on its much-touted Global Delivery Model (GDM), which is based on much more than cheap manpower, to push its case as a preferred vendor. Yet, it is apparent that the competition, especially companies like IBM, having recently discovered GDM are pushing ahead with their new-found wisdom. The key to GDM is the focus on getting the best talent, wherever it is located, and using that to address the customer’s needs.

One of Infosys’ key strengths has been its ability to add new business offering and mould itself to suit changing market requirements. It has added services such as independent software testing and enterprise applications to its offerings. It has also reorganised itself along verticals or industrial compared to the geography-specific orientation it conformed to earlier. And most of the company’s growth has been organic, barring the odd buy like its acquisition of Expert Information Systems, which it morphed into Infosys Australia.

Infosys is also looking to diversify its risk and explore emerging markets for its range of services. The American market may offer the largest and deeper IT market to companies; yet, the potential in other countries can not be ignored. The contribution from the US has in fact dipped to just over 65 per cent for the third quarter ended 31 December 2004, compared to over 73 per cent in the corresponding period in the previous fiscal.

Infosys’ Key to Success

Infosys survived the global downturn in IT spending during the years of recession between 2001 and 2004, managing to actually grow by focussing on providing services to companies that desired to update their existing systems, undertaking more work for current clients, launching an aggressive marketing campaign overseas, adding new clients and cutting costs wherever possible.

Infosys’ attributes its success to investing heavily in its employees leading the market by focussing on cutting edge technology, and applying strict ethical business practices. Infosys’ success in the highly competitive IT industry lies in:

• Giving employees a world-class environment to work and learn.
• Giving employees a high quality of life and wealth creation opportunities.
• Looking at potential employees’ ability to learn and assimilate technical knowledge and skills.
• Replacing obsolete technology regularly to remain at the cutting edge.
• Emphasising constantly on quality by benchmarking against the best processes in the world.
• Diversifying income sources to minimise risk of revenue, i.e. setting limit to contributions from one client, one technology, one industry.
• Complying with accounting standards of advanced countries and ensuring strictest adherence to corporate governance.

Business Ethics at Infosys

Infosys Technologies has unveiled a code of ethics for its finance professionals and a whistleblower’s policy to encourage and protect employees willing to share information on frauds, but who choose to remain anonymous. Though the Indian law has not imposed it on companies as yet, the Infosys chose to apply this code because it believes it should raise the bar for compliance.

The code of ethics for its finance professionals states, “We consider honest conduct to be conduct that is free from fraud or deception and marked with integrity. We consider ethical conduct to be conduct conforming to accepted professional standards of conduct. Ethical conduct includes the ethical handling of actual or apparent conflicts of interest between personal and professional relationships. By expecting the highest standards of honesty and ethical conduct, we expect our officers to stay far from the line differentiating honesty from dishonesty and ethical conduct from unethical conduct”.

The Code of Business Conduct and Ethics helps the company ensure compliance with legal requirements and the company’s standards of business conduct. The code deals with aspects of employees’ responsibilities to the company and its stockholders, which includes General Standards of Conduct (covering workplace free of harassment, drug and alcohol abuse, safety in workplace, dress code and other personal standards, expense claims and applicable laws.

The Whistleblower’s policy encourages employees to report questionable accounting matters, any reporting of fraudulent financial information to shareholders, the government or the financial markets or any conduct that results in a violation of law by Infosys to the management even if it is on an anonymous basis. It sets out norms for receiving, retaining and treating complaints and procedures for confidential, anonymous submission by employees of complaints with regard to accounting frauds leading to results in a violation of laws or mismanagement of company resources.

In terms of ethical behaviour, Infosys has an unwavering commitment to best global practices and has been driven by its vision to became a global player. It was one of the first Indian public companies to adopt voluntarily the stringent US GAAP long time back while many other organisations are only toying with the idea of implementing it in their companies. To quote Nandan M. Nilekani, Infosys’ CEO and Managing Director: “Infosys as a company has always believed in commitment to values, ethical conduct of business and making a clear distinction between personal and corporate funds. When we founded the company, we took a decision that we keep this line very clear.”

The culture of ethical behaviour in the organisation emanates from the top and percolates down to the managerial and employees’ level, for the foundations of such systems are made to rest on ethical value system. The founders of the company took only salaries and dividends and had no other benefits from the company unlike founders of other companies. In following these principles of observation and preservation of ethical standards in his company, N. R. Narayana Murthy “has known the way, shown the way, and gone the way”. In order to create an ethical working environment, the initiative must be supported by, or better still, come from, the top management and leaders in the organisation. The steps in doing the same include the following:

• Making the decision to commit to ethics.
• Recognising that they are the role models by definition, by action, and by values.
• Assuming responsibility for instilling ethical behaviour.
• Articulating their values.
• Train the staff.
• Encouraging open communication.
• Being consistent in their approach.

It is only by doing all of the above on a continuous basis, that they can ensure the permeation of their ideals throughout the organisational layers, and deep-rooted understanding and following of these ideals by employees. Narayana Murthy and the other leaders at Infosys have taken this to heart and make it a point to express the company’s ideals at every opportunity, to fellow-Infoscions as well as to the society in general. Explains Nilekani, “When a company has a strong value system, focusses on honesty, transparency and fairness to all stakeholders, the key thing is we have to set the example and be a role model in the way we conduct ourselves. We cannot have a system where we preach corporate governance but in our actions we don’t demonstrate it. Then people will not believe us. I think once we practise that in every aspect of activity, then automatically people get ingrained in that”.

The Phaneesh Murthy Case

For a company so revered by the entire Indian and foreign business community for having set the highest ethical standards, it seemed to be only a matter of time before someone tried to pull it down. But to their credit, the company honourably resolved the issue and came back much stronger and surer of its values than ever before. Infosys became entangled in a scandal, between October 1999 and December 2000, that dented its reputation as a company that had the best corporate governance structure in the country. The Hindu Business Line reported on 7 August 2002, “Since its inception, this is probably the first piece of negative news about Infosys”.

In December 2001, former Infosys employee Reka Maximovitch filed a complaint in the Alameda Superior County Court, Oakland, US, alleging verbal sexual harassment, unwanted sexual advancements and unlawful termination of employment against Phaneesh Murthy, the highest-paid employee of Infosys. It created ripples in business circles and in the eyes of the public when he abruptly resigned from Infosys in June 2002 to “devote time and attention to pursue a successful defence of the suit”.

Initially, Phaneesh Murthy refused to participate in the settlement initiated by Infosys on the terms specified by it. However, later on, he voluntarily signed the settlement and agreed to every condition that Infosys had set. As the company retained its right to sue Phaneesh for his actions and lack of contributions, it went ahead with the settlement without any contribution from Phaneesh.

The stand taken by Infosys in this case seemed to go against its image of a company considered to be a model of good corporate governance. Media reports blamed Infosys for having kept the issue under wraps for a long time neglecting to put in place a structured policy concerning sexual harassment, and for compromising on moral values. The company’s share price declined by 6.6 per cent soon after Phaneesh left. This news and the issue of sexual harassment at the workplace were debated heatedly in corporate and media circles, in India as well as abroad, as many more shocking events unfolded over the next 1 year.

Infosys Technologies maintained a studied silence on the episode on the ground that the matter was subjudice. On 11 May 2003, Infosys finally announced the amicable settlement with Maximovitch by agreeing to pay $3 million as compensation. The company contributed US$ 1.5 million and the balance US$ 1.5 million was contributed by the insurers under the company’s Directors and Officers Liability Insurance Cover. Infosys refused to give more details about the manner in which the settlement was arrived at, and whether Infosys conducted any internal enquiry before Phaneesh Murthy submitted his resignation.

A crisis brings out the best and worst in any organisation or in any person. It is also true that a crisis provides a learning opportunity for them. Infosys also learnt its lesson and put in place principles of work ethics to be followed by its employees and a whistle blower policy. Infosys chairman and chief mentor, Mr. N. R. Narayana Murthy said later, “The litigation with the plaintiff is behind us. We have taken further steps to strengthen our internal processes and improve the checks and balances to handle similar situations”.

Corporate Governance at Infosys

Infosys, beginning as a modest software consultancy firm in 1981, has become over the years, a large public company that conforms to internationally benchmarked standards of corporate governance. Admiration for Infosys both from within and outside the business community comes from its strong focus on corporate governance. It has been rated highly in several corporate governance reports, including one by rating agency CLSA, which has given it a high CG Star grade.

Infosys has set new and effective standards in communicating with shareholders, stock exchanges, and general public at large. Its annual report is said to be a trend-setter with respect to the disclosure norms evidenced by the sheer length and detail of the report. Its annual report has been commended as an ideal report by the Securities and Exchange Commission of US to be emulated American Companies. Infosys has demonstrated through its practices and procedures its commitment to enhance investor-relations and has amply rewarded its shareholders through its impressive performance by increasing shareholder value. In fact, the company pursues a value-based management methodology wherein it measures the company’s performance on the basis of various tools and techniques such as brand value, economic value added, intangible asset scorecard, balance sheet including intangible assets, current-cost-adjusted financial statements and human resources accounting and value-added statements. It continuously strives to improve itself on all these parameters.

Infosys has started implementing best international governance practices even while the concept was getting crystalised, after the recommendations of the Cadbury Committee and the Confederation of Indian Industry’s Code. The Kumar Mangalam Committee Report on Corporate Governance (1999) summarised the overall objective of the concept thus: “The fundamental objective of corporate governance is the enhancement of long-term shareholder value while, at the same time, protecting the interests of other stakeholders.” Infosys has adopted these ideals as an article of faith, and observes it to the minutest details. While Infosys has complied with most of the recommendations made by the CII and those of the Kumar Managam Birla Committee on Corporate Governance, it was also the pioneer in benchmarking its policies with the best in the world. If best corporate governance practices are to be implemented in an organisation, it has to be done in a manner so as to ensure (i) an independent and proactive board, (ii) independent committees to decide executive compensation and for nomination and audit purposes (iii) an independent audit system. Infosys has put in place all these governance practices and has seen to their yielding the fruitful results for the overall welfare of all stakeholders.

One of the prerequisites of an Independent Board is to have a clear demarcation of responsibilities and authority between the chairman of the board and the senior officers of the management such as the chief executive officer, managing director, president and the chief operating officer. Infosys has achieved this separation between the board and management long back. The CEO is responsible for corporate strategy, brand equity, planning, external contacts, acquisitions by and board matters. The COO is responsible for all day-to-day operational issues and achievement of the annual targets in client satisfaction, sales, profits, quality, productivity, employee empowerment and employee retention. The CEO, COO, executive directors and the other senior management personnel make periodic presentations to the board on their targets, responsibilities and performance.

Another important criterion suggested by various committees to ensure best global practices in Indian companies is to have an appropriate mix of executive and non-executive directors to maintain the independence of the board. To separate the board functions of governance and the management, Infosys has 8 executive directors and 8 non-executive directors, out of the 16 directors on its board. While the executive directors bring to the board their expertise and experience in managing the day-to-day affairs of the company and the problems and issues involved in decision making, the non-executive directors bring in international professionalism to corporate boards. The board members are known to possess expertise in skills, technology, finance, human resources and business strategy, all of which are essential to manage and guide a high profile, high growth, high tech, global software company. The directors at Infosys belong to the productive age group between 40 and 55 years of age so as to serve the board actively. They are not related to any senior manager or board members so as to be bereft of any influence. The board members are expected to attend and participate in all board meetings and also in the meetings of the committees to which they belong. While the executive directors are not allowed to serve on the board of any other company—unless it is an industry association or government body relevant to the software industry or one whose objective is promotion of social welfare—non-executive directors are not expected to serve on boards of competitor companies. Board meetings are regularly held with clear-cut agenda. Apart from routine meetings, the board also meets once in every 3 months to review the quarterly results and other issues.

An effective corporate board is one that delegates the resolution of important issues to specialised committees. Infosys has three committees—the Audit Committee, the Nomination Committee and the Compensation Committee. As suggested by various committees on corporate governance and to ensure independence of the board, the members of these committees are all non-executive directors. The degree of independence vested in these three committees ensures that vital areas such as compensation, audit and nominations are carried out in a just and equitable manner without being influenced by management. According to Nilekani, Infosys’ experience with these committees has been quite beneficial. “These committees have been extremely effective, especially the audit committee. We have used it very effectively to audit the entire business practices of the company. We have internal auditors, external auditors. We present all the issues before the audit committee. The whole process has been very effective.”

An ideal way to ensure better corporate governance is to assess the efficacy of the board of directors through an effective appraisal system. However, this ideal is rarely followed even in developed countries, and universally board performance is hardly monitored or evaluated. Infosys, to some extent, has put in place structures to ensure evaluation of performance of the Board. Says Nilekani: “All the working board members have performance indicators. At the beginning of every year when we present budgets to the board, we also present our individual performance indicators. What jobs we do? What are the goals for the year? We are measured on that. The compensation committee decides our benefits based on the performance.” It is a self-evaluation process, and external directors also measure the performance of the internal board.

Effective and efficient risk management is one aspect of corporate governance that helps a company achieve its goal of maximising shareholder wealth. In today’s competitive environment, companies have to, apart from employing shareholders’ money productively, ensure that they do not expose their businesses to unwarranted risks. Infosys has put in place a risk management system that tracks every conceivable form of risk, arising out of client, geographic or technologies concentrations. The company’s diversified business strategy, especially in terms of risk avoidance, has been effective and has ensured that there is no undue dependence either on a single client, territory or technology.

Corporate Social Responsibility

If wealth creation for the benefit of shareholders is an objective of corporate governance, social concern to protect the interests of all stakeholders and the society at large are also to be given due prominence. Infosys balances wealth and welfare strategically. Infosys has used its wealth and stands to contribute to improvements in the community. A core value of Infosys is a strong sense of social responsibility and commitment to help people and community. It is actively involved in various community development programmes.

Infosys established the Infosys Foundation, a trust founded to further the company’s commitment to social causes, to aid destitutes and the disadvantaged people. One per cent of Infosys’ profit after tax is donated to the Foundation every year. The Foundation focusses on enhancing the living conditions of the rural population, healthcare for the poor, education, and promotion of Indian arts and culture. Last year (2003–04), Infosys initiated three social programmes to improve computer literacy of rural people as well as the teachers in rural areas. Along with Microsoft, infosys launched a programme, computers@ classrooms, as part of which old computers were given away to educational institutions.

The Infosys Foundation

“It is better to light a candle than remain in darkness.” The Infosys Foundation starts with this humble, but thought-provoking philosophy. The foundation came into being with the objective of supporting the underprivileged in society. It began its activities in Karnataka in 1996. Today, the activities have been extended to Tamil Nadu, Andhra Pradesh, Maharashtra, Orissa and Punjab. The Foundation primarily aims at improving the health, education and basic facilities, benefiting a large number of individuals and institutions.

In a short span of time, the Foundation has successfully implemented projects in the the following areas:

• Health care: It has constructed many hospitals, wards in hospitals, donated costly equipment, distributed medicines for free and introduced various schemes to benefit those in need.
• Social rehabilitation and rural upliftment: The foundation has constructed orphanages, girls’ hostels and shelters, and undertaken various initiatives to aid the lesser privileged.
• Learning and education: The Foundation has undertaken “A Library for Every School”, one of the largest rural education programmes in the country. It provides financial support to promising students from economically weaker sections. It has constructed science centres and labs in rural schools, and in some cases, entire schools for the benefit of rural children.
• Arts and culture: The Foundation has coordinated a project to donate cassettes among rural schools in Karnataka to bring back life into the dying arts, puppet shows to enliven the theatre art, and encourages artistes to perform and also benefit financially.

Infosys Technologies contributed Rs. 5 crore to the Prime Minister’s National Relief Fund to assist the victims of the giant Tsunami that ravaged south and south-east Asia in the last week of December 2004. The company also actively supported its employees’ efforts across group companies globally, to make monetary and material contributions towards aid operations.

Infosys also instituted in 1999 the Infosys Fellowship Programme to foster excellence in education and offered funds at the Five IITs and three IIMs for Ph.D. programmes in computer science, management, law and accounting. Under this programme, the company grants Rs. 9 lakhs per fellowship for the entire duration of Ph.D. programme.

1. Trace the history and the spectacular growth of Infosys as one of the best managed IT companies in India, and even of the world at large.
2. Discuss the vision and message of Infosys that have paved the way to its becoming the darling among IT companies in India.
3. Discuss the factors that have made Infosys as the most admired IT company in India.
4. What are the challenges Infosys faces to maintain its primary status amongst the IT companies in India? How has the management of the company worked out a business strategy to achieve that goal?
5. Discuss the role of business ethics in achieving corporate governance at Infosys. Has the Phaneesh Murthy case sullied the reputation of the company? Make a critical assessment of the impact of the scandal on the growth story of Infosys.

• Articles from www.domain-b.com
  1. Infosys, HLL best in corporate governance (November 2, 2001)
  2. Infosys recognised as a “globally most-admired knowledge enterprise for 2004” (December 3, 2004).
  3. Infosys sweeps Businessworld Respected Companies Award (8 November 2004).
  4. Infosys looks beyond the billion (24 April 2004).
  5. That billion-dollar feeling (15 April 2004).
  6. Infosys recognised as a most admired knowledge enterprise (14 August 2003).
  7. Infosys contributes Rs. 5 crore for tsunami relief operations (29 December 2004).
  8. Infosys settles sexual harassment suit against Phaneesh Murthy (12 May 2003).
  9. Meticulous millionaire (8 November 2002).
• Corporate Announcements, Infosys Technologies. www.nseindia.com http://valuebased.rediffblogs.com
• ‘Having a Conscience Is in our DNA’, The Hindu Business Line, Internet Edition (15 Apr 2004).
• Infosys Annual Reports.
• Infosys Makes India Proud, Financial Express, Net Edition (16 April 2004).
• Infy unveils ethics code to check financial frauds, The Hindu Business Line, Internet Edition (14 May 2003).
• Infosys on list of most ethical firms, Economic Times (24 February 2004).
• Morals In Management, Life Positive (June 1999).
• Phaneesh Murthy of Infosys: The Sexual Harassment Saga (8 June 2003). www.suchetadalal.com
• Sachitanand, Rahul, Business Today Special Issue on India’s Best Managed Companies (ABT—AT Kearney Study) (March 2005).
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• www.infy.com
• www.siliconindia.com
• What does it take to be a part of Infosys, Economic Times (18 April 2004).