Concept of Corporate Governance

By Sahil Kumar 18 Minutes Read

Introduction

• Corporate Governance refers to the system by which a corporation is directed and controlled. It involves the methods through which companies are guided and overseen, aligning business operations with the expectations of stakeholders.
• This governance is carried out by the Board of Directors and relevant committees for the benefit of the company’s stakeholders. It seeks to balance personal and societal objectives, alongside economic and social goals. Directors have a fiduciary obligation to act with the highest level of care and diligence, prioritizing the interests of the company and its shareholders.^[1]
• Corporate Governance encompasses the interactions among various participants—such as shareholders, the Board of Directors, and the company’s management—influencing the corporation’s performance and direction.
• A healthy relationship between the owners and managers is essential, avoiding any conflicts, with owners ensuring that actual performance aligns with expected standards.
• Corporate Governance also addresses how providers of finance ensure a fair return on their investment. It clearly differentiates between the roles of owners and managers, with managers holding decision-making authority. In modern corporations, the roles of owners and managers must be clearly defined and harmonized.
• Corporate Governance is concerned with establishing effective strategies and decisions, giving the Board of Directors ultimate authority and responsibility. In today’s market-driven economy, corporate governance is increasingly necessary due to the pressures of efficiency and globalization. It is crucial for adding value to stakeholders.
• Corporate Governance promotes transparency, which supports strong and balanced economic development. It ensures that the rights of all shareholders, whether majority or minority, are protected and fully exercised, and that the organization acknowledges these rights.
• Corporate Governance has a wide-ranging scope, encompassing both social and institutional dimensions. It fosters an environment of trust, integrity, and ethical conduct.

Definition

The most commonly accepted definition of corporate governance is “the system by which companies are directed and controlled”^[2]. It is more precisely described as the framework through which the interests of various stakeholders are balanced.

As the International Finance Corporation (IFC) puts it, it involves the relationships among management, the Board of Directors, controlling shareholders, minority shareholders, and other stakeholders. The Cadbury Committee provided the following definitions:

• “Corporate governance is the system by which companies are directed and controlled. It encompasses the entire mechanism of a company’s operations, aiming to establish a system of checks and balances among shareholders, directors, employees, auditors, and management.”
• “Corporate governance is the system by which business corporations are directed and controlled. The corporate governance structure defines the distribution of rights and responsibilities among different participants in the corporation, such as the board, managers, and shareholders. It outlines the rules and procedures for making decisions on corporate matters, providing the framework through which the company sets its objectives, achieves them, and monitors performance.”
• The Institute of Company Secretaries of India defines corporate governance as follows: “Corporate Governance is the application of best management practices, compliance with the law in its true spirit, and adherence to ethical standards for effective management and distribution of wealth, as well as the discharge of social responsibility for the sustainable development of all stakeholders.”

OECD on Corporate Governance

The Organisation for Economic Co-operation and Development (OECD) is an international organization dedicated to developing better policies for improved living standards.

In 1999, the OECD released the Principles of Corporate Governance, which have since become a global standard for policymakers, investors, and companies. The OECD defines corporate governance as a system of relationships between a company’s management, its board, shareholders, and other stakeholders.

It also provides the structure through which the company’s objectives are established, and the means for achieving and monitoring these objectives are determined.

While traditional definitions of corporate governance acknowledge the role of ‘other stakeholders,’ they often focus on the conventional debate regarding the relationship between disconnected owners (shareholders) and self-interested managers. Corporate governance is often viewed as comprising two key elements:

1. The long-term relationship, which addresses checks and balances, incentives for management, and communication between management and investors.
2. The transactional relationship, which involves issues of disclosure and authority.

This perspective suggests an adversarial relationship between management and investors, characterized by mutual suspicion. This view underpinned much of the rationale behind the Cadbury Report, which emphasized consistency and transparency towards shareholders, prescribing detailed guidelines on how the board should conduct itself.

Benefits of Corporate Governance

• Effective corporate governance is crucial for ensuring corporate success and fostering economic growth.
• It strengthens investor confidence, enabling companies to raise capital more efficiently and effectively.
• Additionally, good corporate governance reduces the cost of capital, positively influences share prices, and incentivizes both owners and managers to pursue objectives aligned with the interests of shareholders and the organization.
• Furthermore, it minimizes waste, corruption, risks, and mismanagement, contributing to brand formation and development.
• Overall, sound corporate governance ensures that the organization is managed in a way that serves the best interests of all stakeholders.

Need for Corporate Governance

The importance of corporate governance is underscored by several factors:

1. Widespread Shareholding

Modern companies often have a vast number of shareholders, dispersed across the nation and even globally. Many shareholders are unorganized and exhibit indifference towards corporate affairs. Although shareholder democracy is embedded in law and the Articles of Association, its practical implementation requires adherence to a corporate governance code of conduct.

2. Changing Ownership Structure

The ownership landscape has significantly shifted, with institutional investors, both foreign and domestic, and mutual funds becoming the largest shareholders in major private sector corporations. These investors present a substantial challenge to corporate management, compelling them to adhere to established corporate governance standards to maintain a positive societal image.

3. Corporate Scandals

Scandals, such as the infamous Harshad Mehta case, have deeply shaken public confidence in corporate management. The need for corporate governance is crucial in restoring investor trust and supporting economic development.

Principles of Corporate Governance

The key principles of corporate governance includes:

1. Transparency

Transparency involves the clear, accurate, and timely disclosure of relevant information about a company’s operations to its stakeholders. It is the cornerstone of corporate governance, essential for building public confidence in the corporate sector. To ensure transparency, companies should regularly publish information about their corporate affairs in leading newspapers on a quarterly, half-yearly, or annual basis.

2. Accountability

In corporate governance, accountability signifies the responsibility of the Chairman, Board of Directors, and Chief Executive to use the company’s resources effectively and in the best interest of the company and its stakeholders.The board is responsible for maintaining transparency and accountability in financial disclosures while adhering to corporate governance standards.^[3]

3. Independence

Effective corporate governance requires the independence of top management, particularly the Board of Directors. The board must be a strong and impartial body capable of making decisions based on sound business judgment. Without independence at the top management level, good corporate governance remains an unfulfilled aspiration.

SEBI on Corporate Governance

To foster good corporate governance, SEBI (Securities and Exchange Board of India) established a committee under the chairmanship of Kumar Mangalam Birla. Based on the committee’s recommendations, SEBI issued guidelines on corporate governance, which are required to be included in the listing agreement between companies and stock exchanges. An overview of these guidelines is provided below:

1. Board of Directors

• The Board should have a balanced mix of executive and non-executive directors.
• The proportion of independent directors depends on the chairman’s role
• If the chairman is non-executive, at least one-third of the Board should be independent directors.
• If the chairman is executive, at least half of the Board should be independent directors.
• Independent directors are those who, aside from receiving directors’ remuneration, have no significant financial ties to the company.
• Directors are responsible for ensuring that financial statements accurately reflect the company’s true financial position, and they must remain vigilant and accountable for the company’s operations.^[4]

2. Audit Committee

The company must establish an independent audit committee composed of:

• A minimum of three members, all non-executive directors, with the majority being independent and at least one member having financial and accounting expertise.
• An independent director as the chairman, who should be present at the Annual General Meeting to address shareholders’ questions.

  The audit committee’s powers include:

• Investigating any activity within its scope.
• Seeking information from any employee.
• Obtaining external legal or professional advice.
• Inviting external experts when necessary.

  The committee’s role includes:

• Overseeing the company’s financial reporting and disclosure to ensure accuracy and credibility.
• Recommending the appointment and removal of external auditors.
• Reviewing the adequacy of the internal audit function.
• Discussing audit scope and concerns with external auditors.
• Reviewing the company’s financial and risk management policies.

3. Remuneration of Directors

The Annual Report’s corporate governance section should disclose:

• All components of directors’ remuneration, including salary, benefits, bonuses, stock options, and pensions.
• Details of fixed compensation and performance-linked incentives, along with performance criteria.

4. Board Procedure

• The Board must meet at least four times a year, with no more than a four-month gap between meetings.
• A director should not be a member of more than 10 committees or chair more than five committees across all companies where they serve as a director.

5. Management

A Management Discussion and Analysis Report should be included in the annual report, covering:

• Opportunities and threats.
• Segment-wise or product-wise performance.
• Risks and concerns.
• Financial performance in relation to operational performance.
• Significant developments in human resources or industrial relations.

6. Shareholders

When appointing or reappointing a director, shareholders should be provided with:

• A brief resume of the director.
• Details of the director’s expertise.
• Information on the number of directorships and committee memberships the director holds.
• A Board Committee, chaired by a non-executive director, should be formed to address shareholder and investor complaints, such as issues with share transfers, non-receipt of balance sheets, or dividends. This committee should be known as the ‘Shareholders/Investors Grievance Committee.’

7. Report on Corporate Governance

The Annual Report must include a separate section with a detailed report on corporate governance.

8. Compliance

The company must obtain a certificate from its auditors confirming compliance with corporate governance requirements. This certificate should be attached to the Directors’ Report sent to shareholders and the stock exchange.

Issues in Corporate Governance

Corporate governance involves several key issues that are deeply interconnected, each holding varying degrees of priority depending on the specific corporate context. These issues are crucial for ensuring effective governance within organizations:

1. Value-Based Corporate Culture

A strong ethical foundation is essential for any organization. Value-based corporate culture embodies a set of inviolable beliefs, principles, and ethics that guide the company’s operations, such as a unique motto, vision, mission, and objectives that drive long-term success.

2. Holistic View

This perspective encompasses a broader, often philosophical approach to management, fostering qualities like nobility, tolerance, and empathy within the organization. Adopting a holistic view helps in developing a positive organizational culture that aligns with good governance practices.

3. Compliance with Laws

Companies aiming for sustained progress and ethical business practices must comply with relevant legal frameworks, including SEBI regulations, the Competition Act 2002, cyber laws, and banking laws. Compliance ensures the organization’s legitimacy and promotes long-term stability. A coherent legal framework for corporate governance is essential, especially in insolvency situations, to ensure that stakeholders’ interests are adequately considered during resolution processes.^[5]

4. Disclosure, Transparency, and Accountability

Timely and accurate disclosure of financial and operational information is vital. Transparency builds trust with stakeholders, including the government, which has historically reduced corporate tax rates as a result. Maintaining transparency helps companies retain customers in competitive markets.

5. Corporate Governance and Human Resource Management

Employees are central to a company’s success, and effective human resource management is critical. HRM should foster respect, recognize achievements, and provide opportunities for personal and professional growth, directly linking to strong corporate governance.

6. Innovation

Taking calculated risks through innovation in products and services is essential for staying competitive. Innovation plays a pivotal role in corporate governance by driving growth and adaptation in a rapidly changing business environment.

7. Necessity of Judicial Reform

The judicial system, while historically effective, requires reforms to meet the demands of globalization and liberalization. Speedier and cost-effective dispute resolution is necessary for a robust economy and improved corporate governance.

8. Globalization Helping Indian Companies

Globalization has enabled Indian companies to become global giants, an achievement heavily reliant on good corporate governance practices. By adhering to these practices, Indian companies can compete on the global stage.

9. Lessons from Corporate Failure

Failures, whether internal or external, provide valuable lessons for corporate bodies. Learning from these failures is essential for improving governance and steering the organization toward future success.

Conclusion

Corporate Governance is essential for the effective management and success of modern corporations, particularly in an increasingly globalized economy. It establishes a framework of accountability, transparency, and ethical standards, ensuring that companies operate in a manner that aligns with the interests of all stakeholders. By defining clear roles for owners and managers, corporate governance minimizes conflicts and fosters trust, thereby enhancing investor confidence and corporate reputation. Moreover, adherence to corporate governance principles, such as those outlined by SEBI and the OECD, supports sustainable development, economic growth, and the protection of shareholder rights. Companies that prioritize good governance practices are better equipped to navigate challenges, maintain compliance with legal frameworks, and adapt to market changes through innovation. Ultimately, corporate governance is not merely a regulatory requirement but a strategic tool that drives long-term value creation, reinforces corporate integrity, and contributes to the overall stability and prosperity of the business environment.

^[1] A P Jain v. Faridabad Metal Udyog, C.P. no. 111 of 2006.

^[2] Report of the Committee on the Financial Aspects of Corporate Governance, 1992 (Cadbury Committee Report), Gee & Co. Ltd., London (1992).

^[3] Yashodhara Shroff v. Union Of India 2019 SCC ONLINE KAR 682

^[4] N. Narayanan v. Adjudicating Officer, Securities And Exchange Board Of India 2013 SCC ONLINE SC 396

^[5] Essar Steel India Limited v. Satish Kumar Gupta, (2020) 8 SCC 531.

Sahil Kumar