6

Corporate Governance and Other Stakeholders

• Introduction
• Corporate Governance and Employees
• Corporate Governance and Customers
• Corporate Governance and Institutional Investors
• Corporate Governance and Creditors
• Corporate Governance and the Community
• Corporate Governance and the Government

Introduction

It is a well-accepted principle nowadays that corporations exist not only for the benefi t of its part-owners called shareholders, but also to serve the interests of other stakeholders in society. It is fallacious to argue anymore that the immediate concern of a company is exclusively towards shareholders, while other stakeholders are only of a peripheral importance to it. A corporate does not exist by itself and it does not operate in a vacuum. Its work is organised and facilitated with the help and co-operation of all constituents of the society in which it functions. Therefore, it is only natural that corporates are expected to reciprocate and contribute in a fair measure to the well-being of all stakeholders. Besides, if a corporate is interested in establishing long term shareholder value itself, it is vitally necessary to earn the goodwill of other stakeholders such as employees, customers, institutional investors, creditors, community at large, and the government, by serving their interests and being useful to them as much as possible.

 

Corporate Governance and Employees

As we have seen earlier, better and ethically acceptable corporate governance has been critically important ever since the start of modern corporations, in which owners and managers of companies are separated. When owners directly manage their own company, governance issues may not be that important. The recent downfall of Enron, WorldCom, and other large corporations, partly due to the failure of their boards of directors, has resurrected governance as a significant corporate need. Employees are also one of the stakeholders of the organisation; by increasing their participation in the organisation, one could ensure better corporate governance.

Wealth Creation Requires Capital and Labour

An organisation needs capital and labour to create wealth. Earlier, the most important need for an organisation to be a success was capital; as long as they had capital, the organisation was able to be successful. But today, the need has extended beyond capital and includes labour. The conventional model was the “shareholder primacy” model, which left out the role of the employees in the creation of wealth. The Western reform advocates have promoted the concept of “shareholder capitalism” where the sole emphasis is on strengthening the rights of, and the protection for, financial investors. Today, the growing recognition that human capital is a source of competitive advantage has led to the understanding that labour is, if not, more important or at least as important as, capital. Today, corporate leaders in developed countries increasingly understand that people and the knowledge they create are often the most valuable assets in a corporation. This is what they call knowledge capital, which is considered as an invaluable asset of an organisation. In fact when a company acquires another company they value human capital more than the plant and machinery the latter has. There are a variety of ways by which the interest of employees can be represented in an organisation. The growing representation proves that employee participation does create wealth. There is a need to realise that shareholders’ long-run interests are probably well-served by including employees in corporate governance.

 

The interests of employees can be protected through

• Trade unions
• Co-determination: employee representation on boards of directors.
• Profit-sharing
• Equity-sharing
• “Team production” solution.

Trade unions: Trade unions’ role is to represent the collective voice of employees and as such they provide a muscle in collective bargaining; this role cannot be underestimated. Labour with a perishable commodity to offer will not be able to withstand the financial might of employer otherwise. Trade unions alone could represent the collective interests of employees and fight for what is rightly due to them from the organisation. Though the approach of such unions are often more confrontational than cooperative, it is a body that represents the collective interests of employees. They could use this as a platform to negotiate agreements between the organisation and labour. These could sometimes reduce the flexibility of such agreements in the light of changing market conditions.

Co-determination: It is a situation where there is employee representation on the board of directors of the organisation. This worked well in Germany in the post-world War II decades when the situation brought about labour peace, reduced the level of unemployment, and added to the robust growth of the economy. But in recent decades of the fast growing economy, it has led to economic rigidity and sluggish growth.

Profit-sharing: The concept of profit-sharing with employees in order to protect the interests of employees in the organisation became much more widely used in Europe in 1990s. Most profit-sharing plans are broad-based, i.e. all or most employees were included in the scheme of profit-sharing rather than just executives only. This practice has been followed in firms facing intense competition and in firms with highly qualified workforce. Profit-sharing motivates the individual worker to put in his best as his efforts are directly related to the profits of the organisation, in which he gets a share. Profit-sharing could be done in many ways, such as

1. cash-based sharing of annual profits where the annual cash profits of the organisation are shared among the employees,
2. deferred profit-sharing where the deferred profits of the organisation are shared among the employees.

The objective of such profit-sharing is to encourage employee involvement in the organisation and improve their motivation and distribution of wealth among all the factors of production. Wage flexibility can improve a firm’s performance where one’s wage depends on the profit made by the organisation.

Equity-sharing: Under equity-sharing, employees are given an option to buy the company’ s shares, identify themselves with, and thus become the owners of the organisation. This leads to improved employee commitment to management’s goals, which motivates the employees to perform better. As a result, there is an alignment of interest between employees and shareholders. This may help make firms more adaptable to the changing environment and support the emergence of more transparent and effective corporate governance. This may foster more social responsibility of firms.

There are various ways in which equity sharing could be done: employees share (i) ownership plans, (ii) stock bonus plans, (iii) stock option plans, (iv) employee buyout and (v) worker cooperatives. This method of equity sharing to increase employee participation is followed in larger companies, with highly qualified workforce, and high level of worker empowerment, such as software companies.

Team production solution: Team production solution is a situation where the boards of directors must balance competing interests of various stakeholders and then arrive at decisions that are in the best interest of the organisation. Though they are employed by shareholders to safeguard their interests in the organisation, they have to work for the common benefit of all the stakeholders of the company.

As a result of increasing participation of employees in the organisation, a company can reap the benefits of increase in productivity, which in turn, increases the profit of the organisation. This is the new perspective of wealth creation which in turn leads to the increase in wealth distribution. The grant of shares though should not be at the expense of the benefits and wages due to the employees. The provision of employee share alone is not enough, but it must be accompanied by the increased employee participation in decision-making. It should be understood that employee share plans are not a substitute for diversified retirement savings. The Enron fiasco reminds us that employees can lose everything if the business is not diversified, and the management has plans other than the long-term interest of the organisation and the workforce. There are some guidelines that could be used here while deciding on employee representation in an organisation.

1. Voluntary participation: There should be voluntary participation on the part of the employees and they should not be forced to do anything out of compulsion. If compulsion is exercised either by unions or employers, it may boomerang, instead of being beneficial.
2. Extend benefits to all employees: The benefits should be extended to all employees; factory workers, clerical staff and the executives of the organisation indiscriminately. Extension of benefits to selective groups of employees will create more problems than it will solve and will create dissension among workers and distrust towards employers.
3. Clarity and transparency: The process by which the allocation of shares is done should be clear and transparent, and not too complicated. Workers should clearly understand and appreciate the benefits they will get under the arrangement.
4. Predetermined formula: There should be a predetermined formula to work out the number of shares that could be offered, and it should not be left to the discretion of any party.
5. Regularity: There should be some regularity when such offers are made; they cannot be made as and when the organisation feels like making such offers.
6. Avoiding unreasonable risk for employees: The organisation should take into consideration the interests of the employees when they make any decisions, and they should see to it that there is no undue risk taken.
7. Clear distinction: There should be a clear distinction between the participation schemes that are offered to the employees and the regular wages and the benefits that are offered by the organisation. Those participatory shemes should in no way affect regular wages and related benefits paid to employees.
8. Compatibility with worker mobility: The participation schemes offered should be compatible with the worker mobility. The worker should not be penalised by accepting the schemes offered to him.

By increasing the role of the employees in the organisation, the company can ensure better corporate governance.

Corporate Governance and Customers

Though economics regards the consumer as the king and sovereign who decides through the market forces the quality and quantity of goods produced, and though leaders like Mahatma Gandhi consider him the sole purpose for which an enterprise exists and therefore should be treated with respect in reality, he is given a raw deal—sub-standard products, increased prices through market manipulation, failed warranties, poor after-sale services, and a host of other unfair trade practices befalls his lot. Good corporate governance should place the customer as one of the important stakeholders and should give him his due share.

In India, the importance of good governance has, in recent years, come to be accepted by corporates as elsewhere partly because the scrips of companies associated with sound and transparent management practices tend to attract higher premia in stock exchanges than those entities that, to all intents and purposes, behave like private limited or partnership firms.

However, while good corporate governance is, undoubtedly, of considerable value to those who have invested their money in firms that adhere to its tenets, there is no justification to conclude that it is sufficient in itself. The fact is that companies that practise good governance are of interest to investors because investors believe these companies will perform well, resulting eventually in an increase in their share prices apart from paying handsome dividends. In other words, good corporate governance is valued only inasmuch as it is linked directly to the long-term enhanced potential of a company.

World over, progressive opinion now recognises the need for broader accounting by corporates, encompassing social performance of significance to stakeholders as against mere bottomline accounting that is of interest only to stockholders. Thus, the oil major Shell, has institutionalised stakeholder consultations as part of its corporate strategy, and its statement of business principles now includes its responsibilities towards customers and employees—in addition to shareholders. Interestingly enough, Shell says that its responsibility to shareholders is to provide “acceptable” returns as against maximised returns. And then again, IBM’ s current corporate social responsibility strategy refers to enhancing stakeholder value and to the delivery of measurable results to society at large. Similarly, Dow Chemicals includes service to stakeholders in its vision statement which says: “To be successful, we have to provide a balance to the needs of all four of these groups (customers, employees, shareholders and society). If we maximise the return to any one or two of these stakeholder groups at the expense of the others, we won’ t survive very long.”

The general public perception is that stockholders are part-owners of the companies they have invested in, and that their interests need not necessarily be congruent with those of the society in which these firms function. While there is undoubted validity to this proposition in the manner it is framed, it rests upon a differentiation that may not be as watertight as it appears. After all, both stockholders and stakeholders are investors in any given company. An investor, by definition, is anyone who commits something of value to risk in the expectation of a return. The term “something of value” can obviously cover time, effort and other values which may not have anything to do directly with money. Take an employee, he or she “invests” his or her life (or, at least, a part of it) in the employer. As such, an employee can be legitimately said to hold equity in the company. Thus, stockholders and stakeholders are both investors in a company.

The Society Bears The Hidden Taxation

With regard to what economists refer to as “external diseconomies” or “social costs”, these terms merit examination in some detail. In the mid-1990s, Dr. Ralph Estes, Professor of Business Administration at American University, published a paper, “The Public Cost of Private Corporations” in the journal “Advances in Public Interest Accounting”. Dr. Estes’ basic contention was simple: Corporations pay the internal costs of doing business—but they do not pay, or even calculate, the costs that their operations impose on society at large. In other words, Dr. Estes’ contention was that the profit and loss statements revealed only the costs companies had internalised and not the uncompensated costs to society, namely the external diseconomies. For the persons affected, these represented “coerced assessments”, a form of hidden taxation. To him: “While difficult to measure, these costs are unquestionably real to those on whom they are imposed. They are, however, never reckoned in corporate accounting’ s narrow calculus. When policy issues such as corporate regulation, taxation, defence contracting, and the system of subsidies, incentives, tax credits, bail-outs, price supports and below market-price fees for grazing, mining and timber rights on public lands that is sometimes referred to as ‘corporate welfare’ are debated, these social costs should be matched against the social benefits obtained.” He adds further: “To improve public policymaking, we should also re-evaluate how we assess the performance of corporations. A scorecard that ignores social costs presents a distorted picture of performance that can influence policymakers to be excessively generous with taxpayer-funded corporate benefits, and overly lax in enforcing corporate regulations.” While these ideas were bad enough (as far as the corporates were concerned), what really caught people on the backfoot was Dr. Estes’ computation that these social costs or external dis-economies added up to $2.6 trillions (1994), almost twice the entire US federal budget and more than ten times the annual federal deficit. Even worse, as annual corporate profits in the US, on an average, worked out only to about $1 trillion or thereabouts, it was obvious that they were coming from the pockets of stakeholders.

 

The Stakeholder Alliance

It is in this context that a North American advocacy group, “The Stakeholder Alliance”, is attempting to promote “more responsible capitalism by pressing corporations to become fully accountable to their stakeholders”. The Alliance has come out with what it calls the Sunshine Standards to provide direction for corporates reporting to stakeholders—employees, customers, communities, suppliers, as well as financial investors—who contribute significantly to the success of corporations or are affected significantly by their actions. According to the Alliance, these standards are intended to supersede the Generally Accepted Accounting Principles (GAAP) issued by the Financial Accounting Standards Board (FASB) and its predecessors that currently govern corporate reporting to stockholders. The fundamental principle underlying the Sunshine Standards has been enunciated as follows: “All information should be provided that stakeholders may need to make rational, informed decisions in the marketplace, and to protect themselves from negative consequences of corporate actions; the disclosure must be complete, accurate, timely, objective, understandable and public.”

 

Customer’s Information Needs

Thus, the advocacy group, dealing with customer information needs, stresses the need for corporates to disclose actions on the matters brought by customers and regulatory authorities regarding products, services and market practices: comprehensive legal record relating to products and services, including product liability, injury and wrongful death claims, covering all jurisdictions for five years; and indictments and citations for regulatory violations, giving details of each incident and resulting penalty, settlement, or other disposition. The information needs of customers further include the following:

• Risks of injury from normal usage of products or services.
• Noise, odours and other nuisances or problems associated with their use.
• Design for recycling of products.
• Biodegradability of products and packaging.
• Unusual life cycle costs, including repairs, energy consumption and disposal that will be borne by parties other than the producer or seller.
• Warnings, with appropriate details, regarding unusual contamination and adulteration, exposure and risks during production, shipping, marketing and storage.
• Contents, additives and treatments of food and medicines, sufficient to allow reasonably informed consumers to make rational market decisions and to protect themselves and their families—appropriate descriptions may include pesticides used in fruits and vegetables, hormones and chemicals used in breeding and processing meat, and chemicals used in cosmetics and personal grooming products to which some consumers may be allergic.
• “Well hidden characteristics” or those product qualities which, regardless of expense or purchase frequency, remain hidden even after use—such as the amount of toxic chemicals and nicotine in cigarettes.

The Alliance has also pointed out that customers, in choosing from competing producers and vendors, may legitimately consider standards of social responsibility. These might include such issues as the working conditions under which products are manufactured, sustainability of production and business methods and so on. Decisions that may appear to be “merely” economic are, to many customers, reflections of personal—and possibly intense—religious, moral, political and social convictions. Elaborating on its contention that the Sunshine Standards should supersede GAAP, The Stakeholders Alliance has argued that the scorecard widely used today, accounting’s profit and loss statement, is not sufficient.

As stakeholders contribute significantly to the success of the enterprise or are considerably affected by its actions, corporations owe them an accounting. Quite simply, they require a better scorecard.

With a broader scorecard, one that reports effects on all stakeholders, managers will make different decisions. When managers are held directly accountable for injuries that result from their decisions, when the costs of those injuries to employees and customers are reported publicly, and when managers’ compensation is affected directly, different decisions will be made. Instead of only being penalised for the expenditures, if the managers are credited for benefits to the community from pollution reduction, they will be better able to weigh effects on all stakeholders.

The Alliance has stated in this regard: “When corporations are fully accountable to stakeholders, when stakeholders are properly viewed as investors in the enterprise instead of merely resources to be consumed, and when managers are held personally responsible for the effects of their actions on stakeholders, corporate managers will behave differently. Their decisions will be directed towards nurturing and developing (instead of merely using or exploiting) the resources the corporation needs for long-term health. Stakeholders will give more to the corporation in return.”

Thus a customer who is also a stakeholder of a company contributes towards the success of the enterprise as much as he is affected by the actions of the company.

Consumer Protection Acts

On 15 March 1962, President John F. Kennedy declared before the US Congress the four rights of consumers—right to satisfaction of basic needs, right to safety, right to be informed, and right to choose. We celeberate this day as World Consumer Rights Day. In 1983, the United Nations Secretary General submitted draft guidelines for consumer protection to the Economic and Social Council. Based on it, the Council recommended that the world governments develop, strengthen and implement a coherent consumer protection policy, taking into consideration the guidelines set out therein. In India the Consumer Protection Act 1986 was passed and the country embarked on an expedition of strengthening our consumer protection regime.¹

 

Consumer Protection Act 1986

The word “consumer” is used to describe a customer who buys goods and services from a seller for personal use and not for business purposes. Although the study of consumer is comparatively new, its roots are old. The explosion of interest in consumer matters emerged mostly during the second half of the twentieth century. The reason for this tremendous upsurge of activity is twofold—a combination of new business methods and changing attitudes. The key factors on business methods are to be found in the complexity of the goods themselves and in the changing forms of advertising and distribution.

The second half of the twentieth century has seen a growing tendency for manufacturers to appeal directly to the public by forceful national advertising campaigns and other promotional methods—further influence during the same period has been the development of a huge market, for extremely complex mechanical and electrical goods in many parts of the world. The need for what is called consumer protection has become far greater because the consumer is no longer in a position to rely on his own judgement when buying a complex product say, a computer. The second motivating force is the general move from individualism to collectivism.

 

The judiciary of the United States has been a long way ahead of many countries in recognising and dealing with consumer problems. In particular, the American courts have increased through their proactive judicial pronouncements the manufacturer’s liability in two respects: (i) by moving from negligence liability to strict liability and (ii) by breaking the shackles of the private contract rule. The subject of consumer protection is very much alive in other western countries too.

It is desirable for consumers to be aware of their rights, and to exercise those rights responsibly and intelligently. In these days of audlo-visual publicity on the private and public media, it is indeed very difficult, if not impossible, to verify the exaggerated or false claims made by producers, manufacturers, distributors and dealers of various goods and services. The all-pervasive, exaggerated and often false claims, made for services and goods, emphasise the imperative need for Consumer Protection Legislation and creation of an awareness about it among the general public.

In this connection, there are a number of enactments in India such as the Prevention of Food Adulteration Act 1954, the Essential Commodities Act 1955, the Trade and Merchandise Marks Act 1958, the Drugs and Magic (Objectional Advertisement) Act 1964, the Monopolies and Restrictive Trade Practices Act 1969, the Hire Purchase Act 1972, the Standards Weight and Measures Act 1976, etc. However, the remedies prescribed thereunder are time-consuming, inadequate and expensive. As in other areas of judicial processes, the offenders are hardly caught, proceeded against and rarely, if ever, get convicted. When violators go scot-free, the victims have no remedy but to get frustrated.

Though all these and a number of other statues were proclaimed to be consumer welfare-oriented, none of these conferred a legal right upon an aggrieved individual consumer to seek legal redress and recover costs and damages for injury or loans suffered by him as a result of faulty and defective goods and services, bought or secured for valuable consideration.

The Consumer Protection Act 1906 (COPRA) meets this essential social need to a great extent. A vigilant consumer owes it to himself and his family members to know and understand the relevant provisions of this significant statue, which is a piece of socio-economic legislation.

The Act (COPRA) is applicable to all defective goods and deficiency in service. “Goods”, under the act mean every kind of moveable property, including stocks and shares, growing crops attached to or farming part of the land. And “Service” means service of any description which is made available to potential users including facilities in connection with banking, financing, insurance, transport, processing, supply of electricity or other form of energy, boarding or lodging or both, entertainment, amusement or the purveying of news or other information.

“Consumer” means any person who buys or hires any services for some consideration, paid or promised, and includes any other user of goods or services using them with the approval of the buyer. It does not, however, include a person who obtains goods for any commercial purpose or for resale.

The consumer in India, far from being alive to his rights (as is the case in the US and Britain) is generally at the mercy of the manufacturer of goods, the wholesaler and the retailer, all of whom exploit him. The six rights of the consumer as enunciated under Section 6 of the COPRA are as follows:

1. The right to safety: The rights to be protected against the marketing of goods and services which are hazardous to life and property.
2. The right to be informed: The consumer has the right to be informed about the quality, quantity, potency, purity, standard and price of goods or services, as the case may be, so as to protect the consumer against unfair trade practices.
3. The right to choose: The right to be assured, wherever possible, access to a variety of goods and services at competitive prices.
4. The right to be heard: The right to be heard and assured that consumer’s interests will receive due consideration at appropriate forums.
5. The right to seek redressal: The right against unfair trade practices or restrictive trade practices or unscrupulous exploitation of consumers.
6. The right to consumer education: If a consumer wants to know on what basis the bus fare is fixed or whether a product contains ingredients that are vegetarian or not and on what basis a builder determines the area of the flat including the ratio between the super built up area and the carpet area, then this information can be had through the Consumer Protection Councils.

The Consumer Protection Act also makes provision for the establishment of the other authorities for the settlement of consumer disputes through the consumer disputes redressal agencies which include the following:

• A Consumer Disputes Redressal Forum known as the District Forum established by the state government in each district of the state by notification.
• A Consumer Disputes Redressal Commission known as the State Commission established in each state by the state government by notification.
• A National Consumer Disputes Redressal Commission known as the National Commission established by the centre by notification.

Two of the salient features of the Act are that it is applicable even to enterprises in the government sector, financial institutions and co-operative societies and that its provisions are in addition to, and not in derogation of the provisions of other laws, relating to consumer.

 

Corporate Governance and Institutional Investors

Most of the reports on corporate governance have emphasised the role which institutional investors play in corporate governance. The Cadbury Committee (1992),² for example, states: “Because of their collective stake, we look to the institutions in particular, with the backing of the Institutional Shareholders’ Committee, to use their influence as owners to ensure that the companies in which they have invested comply with the code.” The Kumar Mangalam Birla Committee similarly states: “Given the weight of their votes, the institutional shareholders can effectively use their powers to influence the standards of corporate governance.”³

Contrary to this, some argue that the investment objectives and the compensation system in the institutional investing companies often discourage their active participation in corporate governance. Peter Drucker (1976) has once commented that “…It is their job to invest the beneficiaries’ money in the most profitable investment. They have no business trying to manage. If they do not like a company or its management, their duty is to sell the stock…”.

Types of Institutional Investors in India

In India, there are broadly four types of institutional investors:

• The development oriented financial institutions, such as IFCI, ICICI, IDBI, the State Financial Corporations, etc. form the first category.
• The second category covers all the insurance companies such as the Life Insurance Corporation of India (LIC), General Insurance Corporation (GIC) and their subsidiaries.
• The third category includes all banks.
• Finally, in the last category, all mutual funds (MFs), including the UTI, are placed.

 

Factors Influencing Investment Decisions

While an investment decision is under consideration, the following are the key factors in the order of their importance, that are taken into consideration:

• Financial results and solvency
• Financial statements and annual reports
• Investor communications
• Composition and quality of the board
• Corporate governance practices
• Corporate image
• Share price.

1. Financial results and solvency: This is the most important factor among factors such as an upward trend in earnings per share and profits, a healthy cash flow, and a reasonable level of dividend payment. All these are considered major indicators of a company’s financial health and are indicated in the financial results. However, a consistent dividend policy is less significant.
2. Financial statements and annual reports: There are two important desiderata under this head. These are:
   1. Extent of disclosure: The quality of the financial statements is the next most influential factor when it comes to investment decisions. Institutional investors consider the level of disclosure of the company’s strategies, initiatives and quality of management’s discussion and analysis of the year’s results. Financial position in the annual report is equally important. This is a strong indication of the investing public’s emphasis and preference for clear disclosures in a company’s annual report, in excess of regulatory requirements.
   2. Comparability with international GAAP: A significant proportion of institutional investors do not invest in a company if the financial statements are non-comparable to International Generally Accepted Accounting Principles (GAAP). Implicitly, this could mean that comparability of financial statements of companies with International GAAP is important in the eyes of the investor.
3. Investor communications: Institutional investors value the willingness of companies to provide additional information to investors, analysts and other commentators, their prompt release of information about transactions affecting minority shareholders and the existence of other transparency mechanisms that help ensure fair treatment to all shareholders.
4. Composition and quality of the board: The most important aspect within this factor is the quality and experience of the executive directors on the board. In stark contrast, investors would consider investing even though they are dissatisfied with the quality, qualification and experience of independent non-executive directors and their role in board meetings. In addition, many investors are not too concerned if there are insufficient independent non-executive directors on the board.
5. Corporate governance practices: Investors consider corporate governance practices when they make investment decisions. The company should follow the principles for corporate governance being—auditing and compliance, disclosure and transparency and board processes.
6. Corporate image: The image of the company in the community is also considered when an institutional investor is called on to take an investment decision. The image of the organisation should not be bad.
7. Share price: This is the last factor that is considered by an institutional investor when an investment decision is made. If the shares of the company enjoy continuously rising prices in the bourses, investors could be encouraged to invest in them.

The above analysis shows how much importance institutional investors give to the above-mentioned factors when they consider making an investment decision. It is important to understand that corporate misgovernance is not the fault of the institutional investors who have invested in companies. However, in view of their large stake in these companies, it is expected that they play an important role in the corporate governance system of the company. Some even argue that institutional investors are answerable to their investors in the very same manner as companies are answerable to their investors. Therefore, it is their view that the primary objective of institutional investors should be to maximise the wealth of their own shareholders rather than looking at the corporate governance practices of companies in which they have invested.

 

It can be seen that companies with good corporate governance records have actually performed better compared to companies with poor governance records. This, therefore, strengthens the argument put forth by most corporate governance reports that institutional investors must be more active while monitoring the performance of companies in which they have invested. This helps them not only in meeting their investment objectives (in increasing shareholders’ wealth), but also in doing something socially useful. Also it is noticed that institutional investors have extended loans to companies with good governance records.

Findings of the Study Conducted by Pitabas Mohanty

However, we find that there is no effect of the investment of the institutional investors on the corporate governance records of companies.

 

According to a study conducted by Pitabas Mohanty on institutional investors and corporate governance in India, the following relationships were seen:

• There is a positive relationship between the stake of mutual funds and corporate governance index. But there is a negative relationship between the stake of Unit Trust of India and corporate governance index.
• There is also a positive relationship between the debt holding of the Direct Foreign Invesments and corporate governance index.
• There is a negative relationship between the stake by the banks (both debt and equity) and corporate governance index.

When the study considered institutional investors and financial performance, the following results were noticed:

• There is a positive relationship between the stake of mutual funds and financial performance. However, this relationship is one-way only, in the sense that it is financial performance that is determining the stake of the MFs in companies and not the other way round.
• There is a positive relationship between the debt extended by the development financial institutions and the financial performance of companies. This shows that the development financial institutions have lent money to companies with better corporate governance index. It also implies that the development financial institutions’ lending money has improved the performance of companies.

However, it should be stressed that in this study, corporate governance was redefined using a narrow perspective by looking only at the shareholders.

Kumar Mangalam Birla Committee and Institutional Investors

Institutional shareholders have acquired large stakes in the equity share capital of the listed Indian companies. They have or are in the process of becoming majority shareholders in many such companies and own shares largely on behalf of retail investors. They thus have a special responsibility given the weightage of their votes and have a bigger role to play in corporate governance as retail investors look upon them for positive use of their voting rights.

 

The Kumar Mangalam Birla Committee⁴ recommends that institutional investors maintain an arm’s length relationship with managements and should not seek participation at the board level, which may make them privy to unpublished price sensitive information. Given the weight of their votes, the institutional shareholders can effectively use their powers to influence standards of corporate governance. Practices elsewhere in the world have indicated that they can sufficiently influence policies of a company. This is because of their collective stake which ensures that the company they have invested in complies with the corporate governance code in order to maximise shareholder value. What is important in view of the committee is that institutional shareholders put to good use their voting power.

The committee, therefore, recommends that the institutional shareholders should reflect the following characteristics:

• Take active interest in the composition of the board of directors.
• Be vigilant.
• Maintain regular and systematic contact at senior level for exchange of views on management, strategy, performance and the quality of management.
• Ensure that voting intentions are translated into practice.
• Evaluate the corporate governance performance of the company.

Shareholders are the owners of the company and as such they have certain rights and responsibilities. But in reality, companies cannot be managed by shareholder referendum. Shareholders are not expected to assume responsibility for the management of corporate affairs.

A company’s management must be able to take business decisions quickly. Shareholders have to, therefore, necessarily delegate many of their responsibilities as owners of the company to the directors who then become responsible for corporate strategy and operations. A management team carries out implementation of this strategy. This relationship, therefore, brings in the accountability of the boards and the management to the shareholders of the company. A good corporate framework is one that provides adequate avenues to shareholders for effective contribution in the governance of the company, while insisting on a high standard of corporate behaviour without getting involved in the day-to-day functioning of the company.

The McKinsey Survey on Corporate Governance

A recent, well-published survey by McKinsey & Co. in this regard is illuminating. In the survey, around one-fifth of the institutional investors expressed preference towards corporate governance over financials while deciding their emerging market portfolios. Further, around a significant two-third felt corporate governance is almost as important as the balance sheet. In fact, respondents to the survey were ready to pay a premium of 28 per cent for well-governed companies in emerging markets. The survey, which covered a sample of 188 companies in six emerging markets to test the link between market valuation and corporate governance, established that companies with better corporate governance command a higher price-to-book ratio. McKinsey conducted this survey in Malaysia, Mexico, South Korea, Taiwan, India and Turkey, to determine the correlation between good corporate governance and the market valuation of the company. The survey found that in India, good corporate governance increases market valuation by:

 

• Increasing financial performance;
• Transparency of dealings, thereby reducing the risk that boards will serve their own self-interests;
• Increasing investor confidence.

McKinsey rated the performance on corporate governance of each company based on the following components:

1. Accountability: Transparent ownership, board size, board accountability, ownership neutrality.
2. Disclosure and transparency: Broad, timely and accurate disclosure, International Accounting Standards.
3. Independence: Dispersed ownership, independent audits and oversight, independent directors.
4. Shareholder equality: One share, one vote.

Through the survey, McKinsey found that companies with good corporate governance practices, have high price-to-book values indicating that investors are willing to pay a premium for the shares of a well-managed and governed company.

Companies in emerging markets often claim that Western corporate governance standards do not apply to them. However, results from the survey show that investors from all over the world are looking for high standards of good governance. Additionally, they are even willing to pay a high premium for shares in companies that meet their requirements of good corporate governance.

Corporate Governance and Creditors

Both financial sector reform and private sector development have received considerable attention in developing and transitional economies in recent years. But the critical nexus between banks and firms—not only for financing but also for efficiency and ultimate survival has been underemphasised. Banks and other creditors have an extremely important role to play in fostering efficiency in medium and large private or state-owned firms. Creditors, in turn, rely for their survival on debt repayment by their borrowers. Without dependable debt collection, no amount of supervision or competition can make banks run efficiently.

Debt appears to be slowly emerging as a device for exerting control over medium and large enterprises in some transitional economies. The powers and incentives of creditors in these countries are still weak, however, compared to their counterparts in more mature market economies. Strong creditors are as critical to the efficient functioning of enterprises as are strong owners. External financing for private firms comes essentially from two sources: debt and equity. While control by equity holders is appropriate in profitable times (when entrepreneurial risk taking is needed), creditor monitoring and control become binding in times of financial distress, particularly when tight controls on spending and investment are needed. Indeed, foreclosure and bankruptcy laws typically shift control of firms to creditors at such times. Thus, the development of effective creditor controls is a crucial element in successful economic transition.

 

The legal and institutional requirements for effective debt monitoring have not been as thoroughly analysed as required, but are no less important. Like equity holders, creditors can monitor firms either actively or passively. The active mode involves hands-on evaluation of a firm’s operations, investment decisions, and capacity and willingness to repay. The passive mode depends on collateral for security. To the extent analysis is carried out before a lending decision is made, the value of the firm’s collateral is what is analysed rather than the operations of the firm.

Creditor Monitoring and Control

There are three crucial elements in creditor monitoring and control in market economies: adequate information, market-oriented creditor incentives, and an appropriate legal framework for debt collection. The experiences of emerging economies of Eastern Europe in the first half of the 1990s provide fascinating lessons about how—and how not—to strengthen creditors as agents of governance and restructuring for medium and large enterprises. Based on these lessons one can arrive at guidelines that could be used by creditors in ensuring that the organisation they lend to is not lacking in corporate governance.

Adequate Information

The first requirement is information. Lenders need information on the creditworthiness or otherwise of potential borrowers, and depositors and bank supervisors need information on bank portfolios. While this may seem obvious, constraints imposed by the poor quality and asymmetric distribution of information in developing and transitional economies should not be underestimated. Inadequate financial and cost accounting can hide the true value of firms’ assets, and dramatic changes in the structure of input prices, demand, competition, and distribution channels reduce the value of prior information. Reputation, the basis for much lending in stable market economies, is less binding, owing to the phenomenal pace of change.

Even if information on firms is available from potential borrowers, bank employees are often not trained in techniques of market analysis and loan appraisal, and thus have difficulty using that information. Similarly, bank supervisors often lack not only the technical ability but also the political will to carry out tough supervision. Furthermore, the “watchdog” professions, including accounting, law, securities, and credit rating services, are still in their infancy, making it difficult for outside investors to monitor firms and prevent fraud or misuse of their investments.

When information asymmetries are significant, adverse selection may make it costly, if not impossible, for outside investors to fund the growth of a firm with either debt or equity. If formal lending occurs, it will typically be based on collateral (or perhaps reputation) rather than on active monitoring of the firm’s operations.

Creditor Incentives

The second requirement for debt to serve a control function is the existence of appropriate market-based incentives for creditors, be they banks, trade creditors, or government. These incentives may be in the form of higher margin of profit, high interest charges from customers and sometimes even reduction in the quantum of Non-Performing Assets (NPAs). A high growth achieved after consolidating the current business in an intensely competitive environment may by itself act as an incentive.

Debt Collection

The third requirement for creditor monitoring and control in a market economy is an appropriate legal framework and effective procedures for debt collection. Without an effective system of debt collection, debtors lose repayment discipline, the flow of credit is constrained, and creditors may be forced to come to the state to cover their losses if they are to survive. In informal credit markets, the effectiveness of debt collection depends on non-legal or extra-legal sanctions, such as the threat of a debtor’s ostracism by the business community or, in extreme cases, self-help on the part of creditors or their agents. Formal credit markets depend more on legal procedures involving collateral, workouts (creditor-mandated reorganisation of the debtor firm), and bankruptcy. Well-designed and implemented rules facilitate rapid and low-cost debt recovery in cases of default, thereby lowering the risks of lending and increasing the availability of credit (particularly bank credit) to potential borrowers. Poorly designed and implemented rules make lending more costly and stifle the flow of credit.

Kinds of Debts Provided to Corporates

There are two kinds of debts with regard to an organisation and each of them has a different role to play with regard to corporate governance namely, (i) diffused debt and (ii) concentrated debt.

Diffused Debt

Debt purchasers provide finance in return for a promised stream of payments and a variety of other covenants pertaining to corporate behaviour, such as the value and risk of corporate assets. If the corporation violates these covenants or defaults on the payments, then debt holders typically obtain the rights to repossess collateral, throw the corporation into bankruptcy proceedings, vote in the decision to reorganise, and vote on removing managers. Since the legal obligation of the corporation is to each debt holder, creditors do not need to coordinate to take action against a delinquent firm. This will tend to make debt re-negotiation much more difficult, so that corporate governance may be more severe with diffuse debt holdings than with concentrated debt. Clearly, the effective exertion of corporate control with diffuse debt depends on the efficiency of the legal and bankruptcy systems.

The ability of diffuse debt holders to exert corporate governance effectively, however, is not without its own problems. The legal system in many countries gives companies the right of an automatic stay on assets and managers frequently remain in place pending a decision by the bankruptcy court. This makes repossession of assets difficult even for secured creditors and reduces the governance power of debt holders. Furthermore, inefficient bankruptcy proceedings frequently take years to complete even in the most developed economies, which further erodes the corporate governance role of diffuse debt. Even where banks or other creditors take over assets of defaulted borrowers, they may not have the expertise to make use of the assets repossessed or even to dispose them off profitably.

Thus, around the world, legal protection of diffuse debt holders seems insufficient to protect the rights of investors and limit managerial discretion.

Concentrated Debt

As with large equity holders, concentrated debt can ameliorate some of the problems with diffuse debt. For many companies, banks typically are the large creditors. A bank’s corporate governance power derives from the following:

1. Its legal rights in case the firms default or violate covenants.
2. The short maturity of its loans, so that corporations must return regularly.
3. Its frequent dual role as the voter of substantial equity shares (either its own shares or those of other investors).

Concentrated debt holders can also renegotiate the terms of the loan, which may avoid inefficient bankruptcies. Thus, large creditors can frequently exert substantial control rights over firms as well as exercising important cash flow power.

Nevertheless, large creditors face important constraints to exerting sound corporate governance in many countries. First, the effectiveness of large creditors relies mostly on the legal and bankruptcy systems. It is by using and by threatening to use legal means that creditors exert influence over management. If the legal system does not efficiently identify the violation of covenants and payments and provide the means to bankrupt and reorganise firms, then creditors lose a crucial mechanism for bringing in corporate governance. Besides, except in a small number of countries, legal systems around the world are demonstrably inefficient at protecting outside investors. Also, with poor legal and bankruptcy systems, the flexibility to renegotiate debt arrangements with large creditors may lead to inefficient renegotiation, the continuation of unprofitable enterprises, and impediments to corporate finance since the balance of power in those renegotiations shifts markedly towards debtors. Second, large creditors like large shareholders may attempt to shift the activities of the corporation to reflect their own preferences. Large creditors, for example, may induce the company to forego good investments and take on too little risk because the creditor bears some of the cost but will not share the benefits. More generally, large creditors may seek to manipulate the corporation’s activities for their own gain rather than maximise the profits of the firm. These features suggest that large creditors do not resolve the problem of aligning managers’ incentives to maximise profits. Third, large creditors may not be independent to the extent that a single family controls both a bank and a non-financial firm, it would be surprising to see much discipline by the former on the latter. Where relatively few families control a large portion of an economy, only foreign creditors may be independent, and this group may suffer from a greater information problem.

Moreover, creditors, be it bankers, trade creditors or even governments, have a control over the corporate practices of the organisation and they need to steer it in the right direction.

Corporate Governance and the Community

The corporation has grown up with industrialisation, modernisation and now globalisation. The corporation is the work-horse of modern civilisation. Without corporations, there might not be the modern material civilisation with high living standards, longer life spans and great personal comforts. Modernisation and globalisation also remain the world’s most viable mechanisms to enable poor nations and peoples to share in the growing global prosperity.

Only the corporation has been able to combine for economic value creation, financial capital, new technologies, and human resources. Sole proprietorships and partnerships were too small to achieve the scale of research and production that corporations could. Corporations will continue to create much of the wealth of society in future and open up new possibilities for humanity.

 

However, a corporation is a set of relationships among different stakeholders. Each stakeholder plays some role in the success of the corporation. Without capital and stockholders, there can be no corporate entity. Without banks and other debt investors, the corporation cannot maximise its ability to earn a return on its equity capital.

But without customers, there will be no business for the corporation to do. Without employees, the corporation will be unable to do its business. Quality and cost efficient suppliers are necessary for the success of any business. And, if the community turns against a company, losing confidence in its good faith, then that corporation will lose its business legitimacy, sometimes very rapidly as we have seen in several cases around the globe. The corporation must also have concern for the physical and social environments in which it does business and must take care not to take unfair advantage of its competitors.

By aligning and attending to the needs of these stakeholders, the corporation fulfils its duty to society to promote modernisation and a better life for all in a sustainable way.

A modern corporation is under fire from many directions. It has duties and obligations to different stakeholders when these duties and obligations often seem to conflict with one another.

How is a corporation to decide what to do? That is the role of governance. Corporate governance is the mechanism by which the values, principles, management policies and procedures of a corporation are made manifest in the real world.

The fundamental basis of corporate governance and responsibility in the value system of the corporation includes the following:

• Its human resource principles—respect and dignity for all.
• Its dedication to accurate and transparent accounting and financial standards.
• Its concern for the environment, for good business ethics and conduct, for social advancement.
• Its over-riding passion to serve customers and to guarantee its products and services.
• Its insistence on fair treatment of suppliers—and competitors.
• Its uncompromising commitment to comply with government laws and regulations in all countries in which it operates.
• Its desire to work with others to lead society to a better economic standard and quality of life.

The managerial skill lies in accomplishing all these things at the same time. In the famous business book, Built To Last, the authors describe the ability of good corporations to sustain themselves over generations accomplishing potentially conflicting objectives at the same time.⁵

A good structure of corporate governance satisfies these needs and interests of different stakeholders in a way that provides for long-term growth in the value of the company and its contribution to society. Its reputation and goodwill are enhanced, it commands success in the market for its products or services, its employees are productive and loyal, its equity owners are rewarded with good dividends and a rising price for their stock, and its growth is not impeded by external forces.

Corporate governance divides responsibilities for policy-making, business decisions, and implementation among a board of directors, executive management, all management and all employees. This is the general pattern for corporations around the world, with differences in detail arising in different countries. For example, in the United Kingdom the positions of chairman of the board and the chief executive officer are usually given to different individuals while, in the United States, they are combined in one person. In Germany, employee representatives have a right to sit on a supervisory board. In Japan, few corporations have so-called “outside” directors on the board, though recent legislation proposes to change that.

 

No matter the structure, good governance requires checks and balances and responsible oversight to ensure that many factors and points of view are considered. For example, a board should have the power, and spend the time, to probe into, and give informed opinions about, the plans of management.

When employees, managers, executive management, or board members look too much towards their own power, prestige or financial reward, they act less and less as good stewards for the interests of stakeholders. Corporate governance is there to counteract the tendency to be selfish and short-sighted. Corporate governance is there to ensure that managers act as agents and fiduciaries, guiding their corporations to successful accomplishment of their corporate and societal responsibilities.

Thus it is obvious that good corporate governance aligns with the interests of management, shareholders and other stakeholders.

The management and board of a corporation must define the values and principles for the company. To be effective and relevant to an individual company’s specific circumstances, business principles must be developed and implemented by companies themselves, not mandated by outsiders.

A company must develop its own understanding of how its principles or behaviour relate to external expectations or to external codes or guidelines, like the Caux Round Table Principles for Business.⁶ Internal monitoring of compliance, external reporting of performance and independent assurance are matters that should be decided by companies themselves.

Of course, only when companies are profitable can they contribute effectively to the improvement of social conditions by creating jobs and economic growth. Prosperous companies are a precondition for corporate social responsibility.

Practical Steps to Corporate Social Responsibility

Following sound principles of corporate governance and social responsibility may help a company in many ways—all elements of long-term sustainability. They may help build customer loyalty, increase morale and trust within the workforce, enhance productivity, attract new business and long-term investors, find efficient solutions to business problems, improve supply management, build up reputation, and a host of other issues.

 

The International Chamber of Commerce recommends the following nine steps to attain corporate social responsibility:

1. Confirm CEO/Board commitment that priority to responsible business conduct comes first.
2. State company purpose and agree on company values.
3. Identify key stakeholders.
4. Define business principles and policies.
5. Establish implementation procedures and management systems.
6. Benchmark against selected external codes and standards.
7. Set up internal monitoring.
8. Use language that everyone can understand
9. Set pragmatic and realistic objectives.

In conclusion, corporations exist because they, in a sustainable fashion, enable people to constructively practise their craft and create jobs, economic value, and wealth for the society and the enterprise, especially in free societies. Always everywhere, governments that reflect and represent diverse interests of the society tend to look favourably at the growth of corporations because of the benefits they provide—generation of wealth through production of goods and services, employment, income and the wherewithal of growing economies. Corporations, in turn, have a moral and social responsibility to live upto such expectations and justify their continued patronage.

Corporate Governance and the Government

Government plays a key role in corporate governance by defining the legal environment and sometimes by directly influencing managerial decisions. As the efficiency of the bankruptcy system and the degree to which managers maintain control through the bankruptcy process help determine whether or not the threat of bankruptcy influences managerial decisions. Similarly, the ability to write and then enforce contracts, to oblige management to provide accurate and comprehensive information before shareholders, votes on important issues, to enforce the obligations of the boards of directors, to specify and have managerial incentive contracts enforced, and to have confidence in the full range of contractual arrangements that define the firm in modern corporations—all determine the extent to which equity and bond holders can exert corporate governance.

 

Moreover, political economy forces that produce the laws, enforcement mechanisms, bankruptcy processes, and the ability of powerful managers to influence legislation will profoundly shape corporate governance. Beyond defining the rules of the game, the government may directly influence corporate governance. At one extreme, the government owns the firm, so that the government is charged with monitoring managerial decisions and limiting the ability of managers to maximise private benefits at the cost of society. At a less extreme level, governments regulate corporations. Specifically, governments regulate the activities and asset allocations of corporations and may even insure corporate liabilities in favoured industries, even in countries that traditionally tend to disavow such support. In theory, governments regulate to maximise social welfare, limit adverse externalities and exploit positive ones, deal with monopoly power, and directly prohibit managers from undertaking socially adverse actions.

Some authors argue that governments will tend to use regulations instead of the threat of legal sanctions when the legal system does not effectively dissuade managers from taking socially costly actions. Thus, regulations that work ex ante may be optimal in situations where the use of ex post-legal penalties is ineffective. The problem with using state ownership and regulation of corporate activities to resolve the corporate governance problem is that this places the control rights in the hands of government bureaucrats that almost certainly do not have the same incentives as a private owner. Thus, these government bureaucrats are unlikely to induce managers to maximise firm value. Rather, politicians frequently use state enterprises for personal gains either by placing cronies in position of corporate power, catering to special interest groups, or supporting politically influential unions that help politicians to retain power. Indeed, the evidence suggests that public enterprises are extremely inefficient producers and they frequently disregard social objectives, as evidenced by the finding that state enterprises are worse polluters than private firms.

Thus the government in every country exercises a certain amount of control over operations of the organisation and the government could use this to steer the organisation towards the path of good corporate governance.

A detailed analysis of the role of government in ensuring corporate governance is given in the chapter on ‘Role of Government in Ensuring Corporate Governance’.

• Adequate information
• Co-determination
• Concentrated debt
• Corporate social responsibility
• Creditor incentives
• Creditor monitoring and control
• Diffused debt
• Equity-sharing
• Institutional investors
• Investment decisions
• Profit-sharing
• Team Production Solution
• Hidden taxation
• The Stakeholder Alliance
• Trade unions
• Wealth creation

1. Who are the stakeholders involved in instituting corporate governance? Discuss briefly what they are expected to contribute to the process.
2. Today labour is considered as one of the most important factors of production. Discuss the ways in which its interests can be protected.
3. What are the information needs of customers? How can they access their needs?
4. Discuss the salient features of the Consumer Protection Act 1986.
5. Critically examine the role of institutional investors in promoting corporate governance.
6. Discuss briefly:
   1. Corporate governance and creditors and
   2. Corporate governance and the government.

• A Cadbury Report of the Committee on the Financial Aspects of Corporate Governance (1992) London.
• CII (1998) Desirable Code of Corporate Governance, Confederation of Indian Industry.
• Fernando, A. C. (9 July 1997), “Corporate Governance Time for a Metamorphosis”, The Hindu Business Review.
• Governance (1999) World Bank, www.worldbank.org
• ‘Principles of Corporate Governance’ The Organisation for Economic Co-operation and Development www.oecd.in
• Rajagopalan, R. Directors and Corporate Governance, Chennai: Company Law Institute of India Pvt. Ltd.
• The Kumar Mangalam Birla Committee on Corproate Governance, SEBI, (7 May 1999).

 

 

Case Study

The Tylenol Crisis: How Ethical Practices Saved Johnson & Johnson from Collapse

(This case is developed from published reports, and is purely meant for class room discussion. It is not intended to serve as endorsement of sources of primary data or illustrations of effective or ineffective management.)

Company Background

Robert Wood Johnson along with his two brothers, James Wood and Edward Mead Johnson, formed a partnership in 1885 to make commercial use of the discoveries of Sir Joseph Lister, a reputed English surgeon, who identified airborne germs as the invisible assassins that caused infection in the operating room. This partnership firm was incorporated as Johnson & Johnson in 1887 and began its operations in New Brunswick, New Jersey. It developed Listers’ methods of manufacturing antiseptics, and supplied to hospitals in the United States the first ready-made, sterile, ready-to-use, wrapped and sealed surgical dressings. The company’s first products were improved medicinal plasters containing medicinal compounds mixed in an adhesive. Johnson & Johnson introduced a slew of products in course of time that included antiseptic surgical dress materials, adhesive plasters and even a book on antiseptic practices titled Modern Methods of Antiseptic Wound Treatment, which for many years remained the standard text on antiseptic practices. Johnson & Johnson’s international growth, which commenced in 1919 with the establishment of an affiliate in Canada, spread rapidly. New subsidiaries were created in more than 50 countries including Australia (1931), Sweden (1956), Japan (1961), Greece (1973), Korea (1981) and Egypt (1985). One of the landmarks in the extensive growth of Johnson & Johnson was the writing of credo by General Johnson that codifies the company’s ethical and socially responsible approach to conducting business. The credo epitomises the company’s responsibility to the people who use its products and services—to its employees to the community and environment and to its shareholders.

The Tylenol Crisis

Johnson & Johnson’s subsidiary, McNeil Consumer Products has an analgesic called Tylenol which became a market leader in the $1.36 million US analgesics market with 37 per cent share. Tylenol also accounted for 17–18 per cent of Johnson & Johnson’s net earnings and 7.4 per cent of the company’s worldwide revenues for the period 1981–82. Tylenol was the absolute leader in the market for pain-killers outselling the next four leading pain-killers including Anacin, Bayer, Bufferin and Excedrin.

On 30 September 1982, the CEO of McNeil Consumer Products received a shocking news that seven persons had died mysteriously after taking cyanide laced capsules of Extra-Strength Tylenol in Chicago’s West Side. The deaths that were broadly reported in the media spread like wildfire and became the cause of a massive, nationwide panic.

The company’s immediately initiated investigations revealed that a malevolent person or a group of such persons, for reasons known to him/them, presumably replaced Tylenol Extra-Strength capsules with cyanide-laced capsules, resealed the packages, and deposited them on the shelves of at least half-a-dozen or so pharmacies and food stores in the Chicago area. The Extra-Strength Tylenol capsules were each found to contain 65 milligrams of cyanide, 10,000 times more cyanide to kill a human being. The poisoned capsules were bought and used, by seven unsuspecting persons who died a horrible and instantaneous death. Johnson & Johnson, the parent company of McNeil Consumer Products Company which made the concerned Tylenol had to suddenly explain to the world why its trusted and premium product was killing unsuspecting people.

McNeil Consumer Products Company officials asserted that the cyanide-laced capsules had not emanated from either of its plants. A spokesman of the parent company, Johnson & Johnson, informed the media of the strict quality control at the plants or in the company’s premises. Since the cyanide-laced Tylenol had been discovered in shipments from both the company’s plants and had been found only in the Chicago vicinity, officials came to the conclusion that the tamperings could have taken place only after the product had reached Illinois. It was also found that the poisoned capsules were from four manufacturing lots and that they were taken from different pharmacies/stores over a period of weeks or even months. It was also observed that the person or persons whose vicious act caused the seven deaths should have spent a few hours in tampering with and resealing the bottles with five or less cyanide capsules and one with ten and then placing them back on the shelves of five different stores in the Chicago area. Four different individuals who died had consumed the deadly cyanide coated pain-killer from four different bottles, while a family of three died after consuming it from the fifth.

The publicity about the cyanide laced capsules created a nationwide panic immediately and with the expansion of 24 hour electronic media, people were bombarded with more and more news on the subject. Aroused by such sensational news through the media, people started calling hospitals to enquire about Tylenol. A Chicago hospital was reported to have received 700 telephone calls just on a single day. People in cities across the United States were admitted to hospitals on suspected cyanide poisoning. It was reported that within the first 10 days of the crisis, Johnson & Johnson received 1411 telephone calls on its most controversial product of the time.

Another interesting offshoot of the incident was that there were a number of copycats who attempted to stimulate the tamperings in Chicago. In the first month after the seven deaths that occurred due to the poisoned capsules, the Food and Drug Administration (FDA) counted 270 incidents of suspected product tampering. In the considered perception of the FDA, this large number of product manipulations might have been due to the mass hysteria created by the media frenzy that led to blame any type of headache or nausea on food and medicine they thought that they might have been poisoned. The FDA estimated that only about 36 of the cases were “genuine” cases of tamperings.

Johnson & Johnson’s Crisis Communication Strategies

James Burke, chairman of Johnson & Johnson, reacted in a matured manner to the adverse media reports by forming a seven-member strategy team forthwith. There were two questions that had to be addressed urgently without any loss of time. The first and foremost question was “How do we protect the people?” and the second, “How do we save this product?” Even against the advice of some worried insiders, the company initiated its first action by cautioning the users of the medicine. Through the use of the media, the company immediately alerted consumers across the country not to consume any type of Tylenol product. They advised the consumers not to resume using the product until the extent of tampering was determined and necessary corrective action initiated. Johnson & Johnson withdrew all forms of Tylenol capsules from the store shelves in Chicago and the surrounding area, after stopping the production and advertising of the drug. Further, after realising the vulnerability of the product with the discovery of two more contaminated bottles of the now much-maligned product, the company ordered the withdrawal of all Tylenol capsules from the width and breadth of the United States of America.

Even though the company was convinced that there was little chance of discovering any more cyanide coated tablets, Johnson & Johnson made it known that they would not like to take any risk with the safety and health of the Tylenol-consuming public, even if it cost the company its reputation and millions of dollars. A day later, the Food and Drug Administration also advised consumers to avoid taking Tylenol capsules. It was estimated that the recall included approximately 31 million bottles of Tylenol, with a retail value of more than $100 million. The normally media-shy company also used the media extensively, both for public relations and paid advertising, to inform the public on their strategy during the crisis. The company established a 1800 hotline for consumers to call to enable the company executives to respond to enquiries from them concerning the safety or otherwise of Tylenol. It is worth repetition here that within the first 10 days of the crisis, Johnson & Johnson received 1411 telephone calls enquiring the company on the various aspects of the Tylenol crisis.

The Impact of the Strategy

It is now well known that the recall of the Tylenol capsules was not an easy decision to make for the company. Many well-informed analysts were of the opinion that recalling all Tylenon-related products could adversely affect the business prospects of the company. There was a great deal of discussion on the recall of the pain-killer at the national level. Some company executives were really concerned about the panic that could be caused to the industry over such a widespread recalling of the company’s premium product. There were others too who felt that the nation-wide recall of Tylenol would effectively bury any chance for the product to survive in future.

What Johnson & Johnson faced was an unusual situation for a large corporation of its size and reach in facing a crisis of such dimensions. Johnson & Johnson’s handling of the Tylenol tampering crisis was considered to be one of the best in the history of public relations by experts in the field. Moreover, in many such instances companies in crisis had put themselves first and ended up doing more damage to their reputations than if they had immediately taken responsibility for the crisis. According to many commentators, the way Johnson & Johnson handled the crisis became the model and lesson for crisis management. It was the considered opinion of many that the company’s response to the crisis demonstrated clearly its commitment to customer safety and quality of its product. Besides, the candidness with which the company approached the issue and the open and transparent communication with public helped the company maintain a high level of credibility and customer trust. In the case of many other companies, the top brass would have thought of the huge financial loss the company would have to incur and also its reputation once it decided to recall its own product at a national level. But in this case, the then chairman and CEO of Johnson & Johnson, James E. Burke, said, “It will take time, it will take money, and it will be very difficult; but we consider it a moral imperative, as well as good business, to restore Tylenol to its preeminent position.” Burke and his executives rather than thinking about the huge financial implications, followed both the letter and spirit of the company’s credo which said that the company’s primary responsibility “is to the doctors, nurses and patients, to mothers and fathers and all others who use our products and services. In meeting their needs, everything we do must be of high quality.”

In the wake of Tylenol tampering, Burke sent immediately a team of scientists to find the source of tampering. The former commissioner for the US Consumer Product Safety Commission, R. David Pittle, commented: “They did the right thing and they did it promptly. Putting consumer safety above all else can help develop a loyalty from the consumer.” All these public relations work paid off ultimately. The public at large were led to believe that Johnson & Johnson was the victim of a conspiracy by one or more malevolent persons to sully the company’s reputation and to destroy a premium product that was its major profit earner. In this connection, it is worth recalling an article that appeared in the Washington Post on 11 October 1982. It said: “Johnson & Johnson has effectively demonstrated how a major business ought to handle a disaster. What Johnson & Johnson’s executives have done is to communicate the message that the company is candid, contrite, and compassionate, committed to solving the murders and protecting the public.” The much-respected newspaper also applauded Johnson & Johnson for being honest with the public and stressed the fact that it must have been difficult for the company to withstand the temptation to disclaim any link between Tylenol and the deaths of seven people. It also added that the company never attempted to do anything, other than try to get to the bottom of the deaths. It also mentioned that Johnson & Johnson almost immediately put up a reward of $100,000 for nabbing and nailing the killer.

Johnson & Johnson’s Strategy to Win Back Public Trust

The strategy adopted by Johnson & Johnson to win back the trust of the public both for reinstating its product and restoring its own reputation in the aftermath of Tylenol crisis was implemented in two phases. The first phase was the actual handling of the crisis. The comeback of both Johnson & Johnson and Tylenol was the second phase in the company’s strategy to win back the trust of people on both counts. The planning of phase one started almost immediately as phase one was being implemented.

With regard to phase one the company adopted a public relations campaign almost immediately following the discovery of the deaths in Chicago and linking it to Extra Strength Tylenol capsules. As the plan was being considered, Johnson & Johnson’s top executives put customer safety first before they got worried about their company’s profit and other financial concerns.

The initial media reports focussed on the deaths of American citizens from a trusted consumer product. In the beginning, the product tampering was not known, thus the media made a very negative association with the brand name. Before the crisis, Johnson & Johnson had not actively sought press coverage, but as a company in crisis they recognised the advantage of open communication in clearly disseminating warnings to the public as well as a clear enunciation of the company’s stand. The company immediately alerted consumers across the United States, through the media, not to consume any type of Tylenol product. The company advised consumers not to resume using the product until the extent of the tampering could be determined. As mentioned earlier, the company also stopped the production and advertising of Tylenol and ordered the recall of all Tylenol capsules from the market. Along with the nationwide alert and the Tylenol recall, Johnson & Johnson established relations with the Chicago Police, the Federal Bureau of Investigation (FBI) and the Food and Drug Administration. This way the company could have a part in searching for the culprit who laced Tylenol capsules and could help prevent further tampering. Johnson & Johnson also arranged several major press conferences at the company’s corporate headquarters. Within hours, an internal video staff set up a live television feed via satellite to the New York metro area. This allowed all press conferences to go national. Jim Burke got more positive media exposure by going on 60 minutes and the Donahue show and giving the public his command messages.

The media was not only focussed on the deaths, but it was also pervasive. Throughout the crisis over 100,000 separate news stories ran in US. newspapers, and hundreds of hours of national and local television coverage. A post-crisis study by Johnson & Johnson said that over 90 per cent of the American population had heard of the Chicago deaths due to cyanide-laced Tylenol. News clipping services found over 125,000 news clippings on the Tylenol story. One of the services claimed that this story had been given the widest US news coverage since the assassination of President John F. Kennedy. Media reporting continued to focus on Tylenol killing people until more information about what caused the deaths was made available. In most crises media focusses on the sensational aspects of the crisis, and then follow with the cause as they learn more about what really happened.

In phase two Johnson & Johnson concentrated on a comeback plan. Actually this phase was already on by the time the first phase was being implemented. To restore the confidence and trust of the public in Tylenol, and to make the product tamper-free, Johnson & Johnson followed a series of concerted measures: First, the company brought in a new Triple Safety Seal Packaging—a glued box, a plastic seal over the neck of the bottle, and a foil seal over the mouth of the bottle. Tylenol became the first product in the industry to use the new tamper resistant packaging within months after the tampering of the product was reported. The company made the announcement of the new Triple Safety Seal Packaging at a press conference at the manufacturer’s headquarters. Before the crisis, Tylenol was a premium product and had a massive advertising budget and it was number one alternative to aspirin in the country. On the comeback trail Johnson & Johnson unleashed an extensive marketing campaign and promotional programme to bring Tylenol back to its premium position as the number one over-the-counter analgesic in the United States.

Secondly, to promote the use of Tylenol among customers who might have strayed away from the brand as a result of the tampering, the deaths and the adverse media publicility, the manufacturing subsidiary of Johnson & Johnson, McNeil Consumer Products, provided $2.50-off by coupons that could be used towards the purchase of any Tylenol product. The coupons could be obtained by consumers calling a special toll-free number. This offer was also made in November and December through an advertisement blitzkerg in popular newspapers where the $2.50 coupon was printed.

Thirdly, to promote the product, salesmen at McNeil were advised to recover former stock off the shelves and place the new-look Tylenol by putting a new pricing programme into effect. This new programme gave consumers discounts as high as 25 per cent. Also, a totally new advertising campaign was launched in 1983.

Finally, more than 2250 salesmen from Johnson & Johnson and its subsidiaries were instructed by the company to make presentations to doctors, surgeons and the medical fraternity. These presentations were made to promote support for the re-introduction of Tylenol.

The Success of the Comeback Trail

The Tylenol comeback was a great success. Many executives attribute the success of the comeback to the quick actions of the corporation at the onset of the Tylenol crisis. They think that if Johnson & Johnson had not been so direct in protecting the public interest, Tylenol capsules would not have reemerged so easily.

In the wake of Tylenol crisis, the nationwide recall of the product and the media frenzy that followed in the aftermath of the death of seven users, there were a number of people who believed that Tylenol could never be resurrected. Many marketing experts thought that Tylenon was doomed by doubts that the public would have had as whether or not the product was safe. “I don’ t think they can ever sell another product under that name,” advertising genius Jerry Della Femina told the New York Times in the first days following the crisis. “There may be an advertising person who thinks he can solve this and if they find him, I want to hire him, because then I want him to turn our water cooler into a wine cooler.”

But many skeptics including Della Femina were proved quite wrong in assuming that Tylenol could never be brought back to the shelves again. Not only is Tylenol still one of the top selling over-the-counter drugs in the country, but it took very little time for the product to return to the market. Johnson & Johnson’s handling of the Tylenol tampering crisis is considered by public relations experts to be one of the best in the history of public relations. This was possible because of the company’s realistic reading of the crisis situation, its seriousness, a workable strategy and the tremendously sympathetic media reports, which did much to boost the company’s work and played a huge role in Johnson & Johnson’s public relations campaign. If the company had not fully cooperated with the media, they would have, in turn, received much less positive media coverage. Disapproving coverage by the media could have easily destroyed Tylenol’s reputation permanently, and with it Johnson & Johnson’s as well.

Analysts have come to recognise Johnson & Johnson’s handling of the Tylenol crisis as the example for success when confronted with a threat to an organisation’s existence. Berge lauds the case in the following manner, “The Tylenol crisis is without a doubt the most exemplary case ever known in the history of crisis communications. Any business executive, who has ever stumbled into a public relations ambush, ought to appreciate the way Johnson & Johnson responded to the Tylenol poisonings. They have effectively demonstrated how major business has to handle a disaster.” The Tylenol case was the base for many of the crisis communications strategies developed by researchers over the last 20 years.

Reasons for Success of Efforts Taken by Johnson & Johnson in the Tylenol Crisis

We can list a number of favourable factors that have contributed to the success of the efforts initiated by Johnson & Johnson in the aftermath of the Tylenol crisis: (i) by making it known to the consumers in particular, and the public in general, through the use of the media, Johnson & Johnson proved that it was a victim of someone’s criminal behaviour of tampering its product and causing death to innocent victims; (ii) Johnson & Johnson provided the victims’ families counseling and financial assistance even though they were not responsible for the product tampering; (iii) any negative feelings by the public against the company were lessened as the media showed Johnson & Johnson taking positive remedial action to help the victims’ families; (iv) the company’s developing a Triple sealed packaging and tamper-free sealing and the random inspection procedures before the shipment of Tylenon to retailers brought in a sense of trust and confidence on the most–maligned product of the time; (v) by the media portraying the company as the unfair victim of a hostile act of an outsider created a wave of sympathy for the company; (vi) Johnson & Johnson’s willingness to accept losses by pulling the Tylenol product across the country deepened the sympathy with the public; (vii) the Johnson & Johnson Tylenol crisis is an example of how an organisation should communicate with the public during a crisis. The organisation’s leadership especially set the example from the beginning by making public safety the organisation’s number one priority and concern. This is particularity important given the fact that Johnson & Johnson’s main mission with Tylenol is to enhance the public’s well-being or heath; and (viii) more importantly, the leadership of the company rose to the occasion and acted commendably during the crisis, especially in the matter of its relations with the Fourth Estate. Johnson & Johnson did not have a proactive public affairs programme before the crisis. The only media relations the company engaged in was in the advertising and marketing area. During the crisis, the company realised the importance of maintaining a good, if not cordial, relationship with the media if it were to surmount the problem of its life and death. This realisation and their subsequent establishment of excellent rapport with the media quickened the process of the public accepting Tylenol.

1. Trace the genesis and growth of Johnson and Johnson. How did the Tylenol crisis affect the onward growth march of J&J?
2. Explain in your own words the Tylenol crisis. What were the factors that accentuated the crisis?
3. Discuss the impact of the strategy adopted by Johnson & Johnson to recall the Tylenol capsules in the aftermath of the news that seven patients died after using them to cure their headache and illness.
4. What was the strategy adopted by Johnson & Johnson to win back public trust? Did it have the desired impact?
5. Explain in your own words the story of how ethical practices saved Johnson & Johnson from virtual collapse.

• Crisis Communication Strategies. http://www.ov.edu/deptcomm/dodjcc/groups/02C2/Johnson%20%20Johnson.htm
• Kaplan, Tamara “The Tylenol Crisis: How Effective Public Relations Saved Johnson & Johnson”, The Pennsybrania State University.
• Publications of Johnson & Johnson.