“There is nothing like a dream to create the future.” —Victor Hugo

Change is ubiquitous in contemporary society, and nowhere more so than in the operations of the large-scale public corporation. Dramatic changes are underway, not only in the structure of corporate activity in areas such as the nature of work and the nature of organisational form, but also in the product and financial markets and the regulatory environment within which corporations operate.

The depth and rapidity of these changes compel a reassessment of the ability of various governance structures to cope and adapt. Understanding this process will require not only an understanding of the nature of the changes that are underway, but also a reassessment of the paradigms of corporate governance and their ability to inform, respond to, and even shape such change.

Traditionally, the phrase “corporate governance” invokes a narrow consideration of the relationships between the firm’s capital providers and top managers, as mediated by its Board of Directors. Corporate governance is more than simply the relationship between the firm and its capital providers. Corporate governance also implicates how the various constituencies that define the business enterprise serve, and are served by, the corporation. Implicit and explicit relationships between the corporation and its employees, creditors, suppliers, customers, host communities—and relationships among these constituencies themselves—fall within the ambit of a relevant definition of corporate governance. As such, the phrase calls into scrutiny not only the definition of the corporate form, but also its purposes and its accountability to each of the relevant constituencies. A basic goal of this article is to examine the changing nature of the business enterprise and its implications for the theory and practice of corporate governance across the range of corporate constituencies.

Meaning, objective and importance of corporate governance

Corporate governance is the acceptance by management of the inalienable rights of shareholders as the true owners of the corporation and of their own role as trustees on behalf of the shareholders. It is about commitment to values, about ethical business conduct and about making a distinction between personal and corporate funds in the management of a company². Corporate governance is defined as the process that “deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment”³. It is susceptible to both broad and narrow definitions. Perhaps the simplest and most common definition of this sort is that provided by Cadbury Report (U.K.)⁴, which is frequently quoted or paraphrased: “Corporate governance is the system by which businesses are directed and controlled.” Thus to put it simply corporate governance relates to the issue of the framework of values under which an enterprise performs. The basic objective of corporate governance is to build up an environment of trust and confidence amongst those having competing and conflicting interest to enhance shareholders’ value and protect the interest of other stakeholders by enhancing the corporate performance and accountability.

A corporation is a congregation of various stakeholders, namely, customers, employees, investors, vendor partners, Government and society. Unless a corporation embraces and demonstrates ethical conduct, it will not be able to thrive, and it is where the role of the concept of corporate governance becomes prominent. Corporate governance looks at the institutional and policy frame for corporations—from their very beginning, in entrepreneurship, through their governance structures, company law, privatisation, to market exit and insolvency.⁵ The integrity of corporations, financial institutions and markets is particularly central to the health of our economies and their stability.

Global corporate failure and its impact on Indian governance code

Recent corporate failures of once mighty corporates such as Enron have proved to be a huge wake up call for all constituents of corporate governance process including the Governments and the regulators. They were the result of trespassing ethical and legal limitations by businesses. As a result, the discussions in the boardrooms today focus on issues of governance, accountability and disclosure. The US Securities and Exchange Commission was the first to swiftly and severely respond to these challenges and enacted the Sarbanes Oxley Act⁶ with a reach even to the corporations incorporated beyond the borders. This Act was the aftermath of the Enron debacle which was the result of the non-compliance with corporate governance principle by the company. This response indicates the urgency for capital market regulators to put in place systems to avoid the recurrence of distasteful incidences of questionable corporate events, which not only leave the investors high and dry and erode their trust in the institution of business, but also affect the national economies and public at large.

The Securities and Exchange Board of India, which has been actively engaged in evolving, setting and enforcing the standards of good corporate governance, has taken steps towards benchmarking governance norms with those of international standards.⁷ The revised Clause 49 of the Listing Agreement sets out a number of measures to raise the standards of corporate governance in listed companies.⁸

The Indian business landscape and need for effective corporate governance

Prominent features of the Asian business landscape include the predominance of family-run firms, the informal nature of stakeholder relations and the legal and economic diversity of the region. In India, most of the listed companies, and substantially all billion dollar companies, are family-run for example Tata, Birla, Reliance. Over the last several decades, the collective talents and efforts of these family business owners have resulted in strong economic growth and substantial increases in living standards.

A particular characteristic of the Asian corporate landscape, however, is a tendency for such individuals (and their families) to establish large interlocking networks of subsidiaries and sister companies that include partially-owned, publicly-listed companies. On the one hand, the use of such subsidiaries and sister companies permits investors not only to place their money with the management team of their choice, but to direct this money to the markets and industries in which particular subsidiaries specialise and which investors believe hold the greatest potential for profits. On the other hand, such pyramidal structures can lead to severely inequitable treatment of shareholders. By conducting operations through a complex network of subsidiaries, controlling shareholders acquire control of operations and/or cash flows disproportionate to their equity stake in individual companies. The extent of this disproportionate control is frequently opaque to outsiders and undisclosed by insiders. A particular need for effective corporate governance in India is, therefore, to encourage the dynamism and growth of family businesses while channelling their energies and operations into structures that are more transparent and, consequently, more clearly equitable for non-family investors.

Evolution, development and contemporary set-up of corporate governance code in India

Dramatic transformations are underway in at least five crucial areas that characterise the internal organisation and external environment of the public corporation: (1) The nature of work; (2) The capital market; (3) Product-market competition; (4) Organisational forms; and (5) Regulatory environment.

The development of information, communication, and automation technologies has fundamentally changed the nature of work inherited from the eighteenth century beginnings of the industrial revolution. Three broad areas of change stand out when considering the innovations in financial instruments and institutions: (a) The emergence of an international capital market; (b) The rise of the institutional investor; and (c) The unprecedented proliferation of financial products.

The most profound change in the capital market over the past two decades has been its transformation from a conglomeration of regionally and nationally segmented markets into one integrated, international market. Corporate product market has increased leaps and bounds since the economic liberalisation in India. The volume of both cross-border mergers and acquisitions (“M&A”) and strategic alliances—two of the important means by which firms implement their product market globalisation strategies—saw impressive increases during the last two years. Thus Clause 49 of listing agreement becomes all the more important because it reminds the corporation about maintenance of their ethical conduct while earning profit.

The Companies Act, 1956

Ever since the beginning of the “nineties, attempts are being made to revamp the Companies Act, 1956 to reduce its complexity, reduce bureaucratic interference and discretion, and to transfer the decision-making authority to companies themselves. The experience of amending/recodifying the Act, however, has been that changes favourable to company managements went through smoothly, at times even through an ordinance. Those seeking to restrict their freedom have been subjected to examination by Expert Committees, working groups, discussions, debates, and so on. The important changes that had taken place through amendments, relevant for Clause 49 include: permitting buy-back of shares; freeing inter-corporate investments from government control; relaxing the limits on managerial remuneration; introduction of postal ballot; non-voting shares; representation for small shareholders, etc.

Provisions of the Companies Act, 1956 with respect to corporate governance Disclosures on remuneration of Directors

The specific disclosures on the remuneration of Directors regarding all elements of remuneration package of all the Directors should be made as a part of corporate governance. Section 299 of the Act requires every Director of a company to make disclosure, at the Board meeting, of the nature of his concern or interest in a contract or arrangement (present or proposed) entered by or on behalf of the company. The company is also required to record such transactions in the Register of Contract under Section 301 of the Act.

Requirements of the Audit Committee

The Audit Committee has a critical role to play in ensuring the integrity of financial management of the company. This Committee add assurance to the shareholders that the auditors, who act on their behalf, are in a position to safeguard their interests. Besides the requirements of Clause 49, Section 292 A of the Act requires every public having paid-up capital of Rs 5 crores or more shall constitute a committee of the Board to be known as Audit Committee. As per the Act, the committee shall consist of at least three Directors, two-third of the total strength shall be Directors other than managing or whole-time directors. The annual report of the company shall disclose the composition of the Audit Committee. The recommendations of the committee on any matter relating to financial management including audit report, shall be binding on the Board. In case Board does not accept the recommendations so made, the committee shall record the reasons thereof, which should be communicated to the shareholders, probably through the Corporate Governance Report. The committee shall act in accordance with the terms of reference to be specified in writing by the Board. The committee should have periodic discussions with the auditors about the internal control systems and the scope of audit including the observations of the auditors. If the default is made in complying with the said provision of the Act, then the company and every officer in default shall be punishable with imprisonment for a term extending to a year or with fine up to Rs 50,000 or both.

Director’s remuneration

The Companies Act, 1956 requires that the remuneration payable both to the executive as well as non-executive Directors is required to be determined by the Board in accordance with and subject to the provisions of Section 198 either by the articles of the company or by resolution or if the articles so require, by a special resolution, passed by the company in a general meeting.⁹ Further, Schedule VI of the Act requires disclosure of Director’s remuneration and computation of net profits for that purpose.

Corporate democracy

Wider participation by the shareholders in the decision-making process is a pre-condition for democratising corporate bodies. Due to geographical distance or other practical problems, a substantially large number of shareholders cannot attend the general meetings. To overcome these obstacles and pave way for introduction of real corporate democracy, Section 192 A of the Companies Act, 1956 and the Companies (Passing of Resolution by Postal Ballot) Rules provides for certain resolutions to be approved and passed by the shareholders through postal ballots.

Securities and Exchange Board of India (SEBI)

In India, while companies in general have to function within the provisions and rules specified under the Companies Act, 1956, administered by the Ministry of Company Affairs, publicly traded companies, in addition, have to comply with the norms and regulations prescribed by the Securities and Exchange Board of India (SEBI), the market regulator. In line with international developments, India has also been gradually moving in the direction of introducing significant changes in corporate governance by amending/introducing appropriate measures in the relevant legislations and rules. Following the recommendations of Kumar Mangalam Birla Committee’s Report¹⁰, SEBI specified principles of corporate governance which listed companies have to follow. Provisions were introduced through Clause 49 of the Listing Agreement which required companies, among others, to have certain minimum proportion of independent Directors depending upon whether the Chairman was also the chief executive or not and to have Board sub-committees to deal with audit, remuneration and investor grievances. These were to be implemented in a phased manner. Some of the provisions like the constitution of a Remuneration Committee were not mandatory. But since the inclusion of Clause 49 there have been a series of amendments made to it in order to plug the loopholes and to make it more comprehensive and effective. Some major amendments like (i) criteria for an independent Director ¹¹; (ii) responsibilities of independent Directors¹² ; (iii) Audit Committee functioning ¹³; (iv) monitoring of subsidiaries¹⁴ ; (v) disclosure in respect of related party transactions ¹⁵; and (vi) putting in place a whistle-blower policy, have provided a whole new paradigm to Clause 49. Apart from this there were many important changes made in Clause 49 to make it effective and efficient. Major changes have been made to the definition of “independent Directors”; strengthening the responsibilities of Audit Committee; improving the quality of financial disclosures and finally; the Board as a whole has been tasked with the adoption of a formal code of conduct for senior management and the certification of financial statements issued by the CEO or the CFO.

Accordingly, companies are now required to form various committees like a “Nomination Committee”, “Compensation Committee”, “Governance Committee” and other committees likely to adhere to corporate governance. Ultimately, corporate governance is the net result of the individual sense of values, the values held in society or part of a society like professional bodies or business associations and finally the system of public governance.

Lacunas in existing Clause 49

Clause 49 of Listing Agreement has changed the structure and working of the companies to a great extent. Introduction of corporate governance has infused enhanced transparency and ethics into the structure and working of the companies. But it is still a tough and long road ahead. There are many loopholes and lacunas that have to be taken care of in order to ensure better performance and implementation of corporate governance. For example the present Code allows the promoters to gain/retain control over companies. The main implication of the shareholding pattern is that leaving decision making to companies’ shareholders and their Boards in effect means giving full freedom to the promoters. In the present ownership pattern there is hardly any threat to incumbent managements of vast majority of companies. In most companies institutional investors, who could have played the monitoring role, have either no presence or are only marginal players. The problem appears to be more severe in case of smaller companies which are generally avoided by institutional investors. There is also the possibility of the liberalised Companies Act encouraging inter-corporate investments which reduce the risk borne by the promoters while increasing their hold. It may seem that India has missed an opportunity to build an ownership structure which while making the promoters genuinely interested, also would have kept them on tight leash.

Private managements probably did not oppose the induction of independent Directors initially because first, it was difficult for them to openly oppose the international trend and secondly, they had the freedom to decide on a Director’s independence. Instances have been found where companies overlooked obvious linkages to confer independence on individuals probably taking advantage of this freedom. Promoters being firmly in saddle, the slim possibility of genuine independent Directors getting elected to corporate boards have receded even further. It should be kept in mind that companies are being rather forced to introduce such Directors. As a result of this companies have found out a way to avoid the probable problems faced by the induction of independent Directors. In many companies the promoter redesignated themselves as the non-executive Chairmen so that the company does not have to reserve half of the Board seats for independent Directors. But this is only a part of the problem, the major problem is that some companies are designating the promoter’s father in-law, mother’s brother or wife’s brother as non-executive Chairman as they are not regarded as relatives under the company law. SEBI had to make the Corporate Governance Code somewhat more palatable to them. It is, therefore, debatable to what extent the efforts at improving corporate governance would succeed in the face of high promoter stakes. In fact, the prescribed minimum public shareholding is so low that managements can get through even special resolutions without any hindrance. It is easy to let promoters accumulate their holding but difficult to force them to bring it down. Effective steps should be taken at the entry point itself to curb the problem.

If the objective is to have genuine independent Directors and constraining the promoters, the recommendations of Asian Development Bank such as placing restrictions on promoter voting and making cumulative voting and representation of minority shareholders mandatory need a fresh look. On certain matters promoters should be denied the voting rights. Make provisions relating to election of Directors more restrictive so that diverse shareholder interests could get representation on corporate boards. For instance, small shareholder representation on company boards could be made mandatory rather than voluntary.

Induction of independent Directors is only the first step. For the mechanism to be effective, one needs to continually monitor the characteristics of such Directors and a change must be brought about in the definition of “relatives” so as to enlarge it to include the in-laws of promoters also.

But excessive regulation stifles innovation and growth, which is also a major risk. Shareholder activism needs to be encouraged, or at least not stifled. They are the nest check on fraudulent practices of managers and Directors. The art of corporate governance lies in establishing convergence between interests of managers and other stakeholders and selecting Boards that provide this crucial link, ensuring that Managers do not abuse their authority nor feel cramped to such an extent that they feel rusted.

Conclusion

“Law without loyalty cannot strengthen the bonds of Empire .¹⁶” In an energetic and lively environment, systems of corporate governance need to be continually evolved. The following lines from Narayan Murthy Committee Report aptly put it—

“Corporate governance is beyond the realm of law. It stems from the culture and mindset of management, and cannot be regulated by legislation alone. Corporate governance deals with conducting the affairs of a company such that there is fairness to all stakeholders and that its actions benefit the greatest number of stakeholders. It is about openness, integrity and accountability. What legislation can and should do is to lay down a common framework—the ‘form’ to ensure standards. The ‘substance’ will ultimately determine the credibility and integrity of the process. Substance is inexorably linked to the mindset and ethical standards of management.”

The companies must realise its responsibility towards its shareholders in general and towards society at large. Since the 1997 financial crisis, Asian regimes have made considerable progress in raising awareness of the value of good corporate governance. More work remains. Public sector institutions (including governments) need to understand the role good corporate governance plays in promoting national competitiveness, economic/financial stability, growth, job creation, poverty alleviation and higher living standards. Private sector institutions need to understand how good corporate governance facilitates better corporate performance, management succession (particularly inter-generational succession within family-run firms), access to (and lower cost of) capital, diversification of wealth and informed entrepreneurial risk-taking.

To a large degree, raising awareness means convincing people that corporate governance is in their self-interest. Many Asian business leaders and controlling shareholders are thus being challenged to rethink their relationships with their companies and with the minority shareholders who lay claim to partial ownership in them. Such reorientation in thinking requires not only a strong national commitment to corporate governance, but one that is also broad-based.

Development and maintenance of a robust corporate governance framework therefore calls for the commitment of numerous persons and institutions throughout society. Legislatures, regulatory bodies, courts and self-regulating professional organisations must establish, monitor and enforce legal norms actively and even-handedly. Private associations and institutes must develop and promulgate codes of conduct, particularly with respect to corporate Directors, that raise expectations for behavior and generate formal and informal sanctions for failure to meet these expectations. Educational institutions should promote research on, and the teaching of, professional and managerial ethics. Institutions throughout Government and society must educate and train persons ranging from judges to regulators to managers to retail investors. Investment advisors and business media must constantly weigh information provided by companies and probe for additional information of interest to investors. This would not only benefit the society but would also be beneficial for the companies as well. Both in India and abroad there have been outstanding companies, which stand for ethics. These are the companies which are more than 50 to 100 years’ old and which had survived over the years, in spite of the changing environment. In fact, when compared in terms of market capitalisation from 1950-1990, their market capitalisation was 15 times that of the normal companies. In terms of longevity also they were more than 50 years’ old compared to the average life of 15-20 years of a company. As they analysed the causes of the success of these companies, one of the issues that came up was that these visionary companies had some values to which they stuck through thick and thin. It is these values which had probably given them sustenance and helped them to develop a corporate culture and the requisite focus over the superordinate goals which probably in the long run helped the company to overcome the challenges which an enterprise has to constantly meet.¹⁷

Despite all the benefits enshrined in the concept of corporate governance and allstringent norms prescribed by the Government, adherence to corporate governance is poor. As of 1-4-2007, the Directors database covers 2447 of the 4782 BSE listed companies, where investor interest is maximum. So far, only, 1928 BSE listed companies have filed information about their compliance with Clause 49 of Listing Agreement.¹⁸ It is required that the Government must step in and ensure the effective implementation of Clause 49 so that the interest of the investors must be protected as well as transparency in the corporate functioning may be maximised. But it is imperative that governmental intervention must also be regulated i.e. it should be done sparingly and with utmost care and caution so as to ensure that corporate autonomy must not be sabotaged. Thus in the end it can be said

“A nation’s well being, as well as its ability to compete, is conditioned by a single, pervasive cultural characteristic: the level of trust inherent in the society.”