CGVE/U1 Topic 1 Issues, Need of Corporate Governance Code
Good governance is an ideal which is difficult to achieve in its totality. For the implementation of a rigorous corporate governance code, companies and institutions must come together regionally and internationally to draft corresponding guidelines. One of the main issues, at least in the U.S., is that plenty of well-intentioned people have brought their ideas and experiences to the policy-making table but it hasn’t resulted in any clear-cut framework.
To give this context, countries such as the U.K. have had powerful codes of conduct since the 1990s – the position in the U.K. is that every company listed on the London Stock Exchange must comply with the national corporate governance code or explain why it would not. Noncompliance serves as a massive red flag to investors. Generally, this code is considered as the benchmark for sound corporate governance in operations of all sizes.
In the U.S., stock exchanges compete for listings and imposing rigorous corporate governance responsibilities might lose them business. The Securities and Exchange Commission, the primary regulator of listed companies, is hot on the issue of transparency and comes down hard on companies that don’t prepare their financial reports properly or disclose information to stakeholders in the appropriate way. However, it doesn’t look beyond the issue of disclosure.
So, for example, a company might defy shareholders’ wishes and offer a large cash bonus to an unpopular and under-performing director. On the face of it, the decision is an example of poor governance as there’s no consensus, inclusion or stakeholder accountability in the decision-making. But the SEC would allow it as long as the company made full disclosure in its reports. This type of regulation has been likened to a stop sign – useful to prevent serious accidents, but in no way a substitute for skillful and judicious driving.
What Are the Challenges of Corporate Governance?
The main problem with corporate governance is that it doesn’t stand alone; it has to work in conjunction with a company’s mission and values statement to give directors and stakeholders a clear guide about how they should behave. There are several problems that a business might struggle with as follows:
Conflicts of interest: A conflict of interest occurs when a controlling member of the company has other financial interests that could influence his decision-making or conflict with the objectives of the company. For example, a board member of a wind turbine company who owns a significant amount of stock in an oil company is likely to be conflicted, because she has a financial interest in not representing the advancement of green energy. Conflicts of interest erode the trust of stakeholders and the public and potentially open the business up to litigation.
Governance standards: A board can have all the equitable rules and policies it likes but if it can’t propagate those standards throughout the business, what chance does the company have? Resistant managers can subvert good corporate governance at the operational level, leaving the business exposed to state or federal law violations and reputational damage with stakeholders. A policy of corporate governance needs a clear enforcement mechanism, applied consistently, as a check and balance against the actions of executive staff.
Short-termism: Good corporate governance requires that boards should have the right to manage the company for the long-term, to create sustainable value. This is problematic for a couple of reasons. First, the rules governing a listed company’s performance tend to prioritize short-term performance for the benefit of shareholders. Managers face an unrelenting pressure to meet quarterly earnings targets, since dropping the earnings per share by even a cent or two could hit the company’s stock price. Sometimes a company has to go private to achieve the kind of sustainable innovation that cannot be achieved in the glare of the public markets.
The second problem is that directors only sit on boards for a brief period and many face re-election every three years. While this has some benefits – there’s an argument that directors cannot be considered independent after 10 years of service – short tenures could rob the board of long-term oversight and critical expertise.
Diversity: It’s common sense that boards should have an obligation to ensure the proper mix of skills and perspectives in the boardroom, but few boards take a hard look at their composition and ask whether it reflects the age, gender, race and stakeholder composition of the company. For example, should workers be given a place on the board? This is the norm across most of Europe and evidence suggests that worker participation leads to companies having lower pay inequalities and a greater regard for their workforce. It’s a balancing act, however, as companies may focus on protecting jobs instead of making tough decisions.
Accountability issues: Under the current model of corporate governance, the board is positioned squarely between shareholders and management. Authority flows from the shareholders at the top and accountability flows back the other way. In other words, it’s shareholders – not stakeholders generally – who are most protected by corporate governance and shareholders – not stakeholders – who get to withhold critical votes unless certain reforms are implemented.
While it’s certainly not undesirable to have the actions of the board checked by shareholders in this way, the future of corporate governance is perhaps more holistic. Companies can and do have ethical obligations to their communities, customers, suppliers, creditors and employees, and must take care to protect the interests of non-owner stakeholders in the company code of conduct.
Need of Corporate Governance Code
The need for corporate governance has arisen because of the increasing concern about the non-compliance of standards of financial reporting and accountability by boards of directors and management of corporate inflicting heavy losses on investors.
The collapse of international giants likes Enron, World Com of the US and Xerox of Japan are said to be due to the absence of good corporate governance and corrupt practices adopted by management of these companies and their financial consulting firms.
The failures of these multinational giants bring out the importance of good corporate governance structure making clear the distinction of power between the Board of Directors and the management which can lead to appropriate governance processes and procedures under which management is free to manage and board of directors is free to monitor and give policy directions.
In India, SEBI realised the need for good corporate governance and for this purpose appointed several committees such as Kumar Manglam Birla Committee, Naresh Chandra Committee and Narayana Murthy Committee.
Importance of Corporate Governance:
A good system of corporate governance is important on account of the following:
- Investors and shareholders of a corporate company need protection for their investment due to lack of adequate standards of financial reporting and accountability. It has been noticed in India that companies raised capital from the market at high valuation of their shares by projecting wrong picture of the company’s performance and profitability.
The investors suffered a lot due to unscrupulous management of corporate that performed much less than reported at the time of raising capital. “Bad governance was also exemplified by allotment of promoters’ share at preferential prices disproportionate to market value affecting minority holders interest”.
There is increasing awareness and consensus among Indian investors to invest in companies which have a record of observing practices of good corporate governance. Therefore, for encouraging Indian investors to make adequate investment in the stock of corporate companies and thereby boosting up rate of growth of the economy, the protection of their interests from fraudulent practices of corporate of boards of directors and management are urgently needed.
- Corporate governance is considered as an important means for paying heed to investors’ grievances. Kumar Manglam Birla Committee on corporate governance found that companies were not paying adequate attention to the timely dissemination of required information to investors in by India.
Though some measures have been taken by SEBI and RBI but much more required to be taken by the companies themselves to pay heed to the investors grievances and protection of their investment by adopting good standards of corporate governance.
- The importance of good corporate governance lies in the fact that it will enable the corporate firms to (1) attract capital and (2) perform efficiently. This will help in winning investors confidence. Investors will be willing to invest in the companies with a good record of corporate governance.
New policy of liberalization and deregulation adopted in India since 1991 has given greater freedom to management which should be prudently used to promote investors’ interests. In India there are several instances of corporate’ failures due to lack of transparency and disclosures and instances of falsification of accounts. This discourages investors to make investment in the companies with poor record of corporate governance.
- Global Perspective. The extent to which corporate enterprises observe the basic principles of good corporate governance has now become an important factor for attracting foreign investment. In this age of globalisation when quantitative restrictions have been removed and trade barriers dismantled, the relationship between corporate governance and flows of foreign investment has become increasingly important.
Studies in India and abroad show that foreign investors take notice of well- managed companies and respond positively to them, capital flows from foreign institutional investors (FII) for investment in the capital market and foreign direct investment (FDI) in joint ventures with Indian corporate companies will be coming if they are convinced about the implementation of basic principles of good corporate governance.
Thus, “International flows of capital enable companies to access financing from a large pool of investors. If countries are to reap the full benefits of the global capital markets, and if they are to attract long-term capital, corporate governance arrangements must be credible and well understood across borders”. The large inflows of foreign investment will contribute immensely to economic growth.
- Indispensable for healthy and vibrant stock market. An important advantage of strong corporate governance is that it is indispensable for a vibrant stock market. A healthy stock market is an important instrument for investors protection. A bane of stock market is insider trading. Insider trading means trading of shares of a company by insiders such directors, managers and other employees of the company on the basis of information which is not known to outsiders of the company.
It is through insider trading that the officials of a corporate company take undue advantage at the expense of investors in general. Insider trading is a kind of fraud committed by the officials of the company. One way of dealing with the problem of insider trading is enacting legislation prohibiting such trading and enforcing criminal action against violators.
In India, insider trading has been rampant and therefore it was prohibited by SEBI. However, the experience shows prohibiting insider trading by law is not the effective way of dealing with the problem of insider trading because legal process of providing punishment is a lengthy process and conviction rate is very low.
According to Sandeep Parekh, an advocate (Securities and Financial Regulations), the effective way of tackling the problem is by encouraging the companies to practice self regulation and taking prophylactic action. This is inherently connected to the field of corporate governance.
It is a means by which the company signals to the market that effective self-regulation is in place and that investors are safe to invest in their securities. In addition to prohibiting inappropriate actions (which might not necessarily be prohibited) self-regulation is also considered an effective means of creating shareholders value. Companies can always regulate their directors/officers beyond what is prohibited by the law”.