Weaknesses of Corporate Governance in India

By S. Chaitanya Shashank, Nilika Kumar, School of Law, KIIT University

Editor’s Note: In recent years, the relations between the ownership and management have become the basis of Modern Corporation. While corporate governance essentially lays down the framework for creating long term trust between companies and the external providers of capital, it would be wrong to think that its importance lies solely in better access of finance. The key aspects of good corporate governance include transparency of corporate structures and operations, the accountability of managers and the boards to shareholders; and corporate responsibility towards stakeholders. While companies around the world are realizing that better corporate governance adds considerable value to their operational performance, India still needs to improve its standard of the same and cover up for the weaknesses.

INTRODUCTION

Corporate governance involves a set of relationships amongst the company’s management, its board of directors, its shareholders, its auditors and other stakeholders. These relationships, which involve various rules and incentives, provide the structure through which the objectives of the company are set, and the means of attaining these objectives as well as monitoring performance are determined. Thus, the key aspects of good corporate governance include transparency of corporate structures and operations, the accountability of managers and the boards to shareholders; and corporate responsibility towards stakeholders.  While corporate governance essentially lays down the framework for creating long term trust between companies and the external providers of capital, it would be wrong to think that the importance of corporate governance lies solely in better access of finance. Companies around the world are realizing that better corporate governance adds considerable value to their operational performance:

  • It improves strategic thinking at the top by inducting independent directors who bring a wealth of experience, and a host of new ideas
  • It rationalizes the management and monitoring of risk that a firm faces globally.
  • It limits the liability of top management and directors, by carefully articulating the decision making process

Good corporate governance system also gives due recognition to the Stakeholder’s theory.  The main intention of the stakeholder’s concept as theory is to affirm and show that the company together with its executive board is responsible not only for shareholders but also for individuals or groups that have a stake in the actions and decisions of such organization. [i]

CADBURY COMMITTEE ON CORPORATE GOVERNANCE – 1992

The stated objectives of the Cadbury Committee was “To help raise the standards of corporate governance and the level of confidence in financial reporting and auditing by setting out clearly what it sees as the respective responsibilities of those involved and what it believes his expected of them.” The committee investigated the accountability of the board of directors to shareholders and to society. It submitted its report and associated “Code of Best Practices” in 1992 wherein it spelt out the methods of governance needed to achieve a balance between the essential power of the board of directors and their proper accountability. Its recommendations were not mandatory. The Cadbury code of best practices had 19 recommendations. The recommendations are in the nature of guidelines relating to the board of directors, non-executive directors, executive directors and those on reporting and control. The stress in the Cadbury committee report is on the crucial role of the board and the need for it to observe the Code of Best Practices. It is important recommendations include the setting up of an audit committee with independent members.[ii]

CORPORATE GOVERNANCE IN INDIA: HISTORY

There have been several major corporate governance initiatives launched in India since the mid-1990s. The first was by the Confederation of Indian Industry (CII), India’s largest industry and business association, which came up with the first voluntary code of corporate governance in 1998. The second was by the SEBI, now enshrined as Clause 49 of the listing agreement. The third was the Naresh Chandra Committee, which submitted its report in 2002. The fourth was again by SEBI — the Narayana Murthy Committee, which also submitted its report in 2002. Based on some of the recommendation of this committee, SEBI revised Clause 49 of the listing agreement in August 2003. Subsequently, SEBI withdrew the revised Clause 49 in December 2003, and currently, the original Clause 49 is in force.[iii]

The CII Code

More than a year before the onset of the Asian crisis, CII set up a committee to examine corporate governance issues, and recommend a voluntary code of best practices. The committee was driven by the conviction that good corporate governance was essential for Indian companies to access domestic as well as global capital at competitive rates. The first draft of the code was prepared by April 1997, and the final document[iv], was publicly released in April 1998. The code was voluntary, contained detailed provisions, and focused on listed companies.

Kumar Mangalam Birla Committee Report and Clause 49

The second major corporate governance initiative in the country was undertaken by SEBI. In early 1999, it set up a committee under Kumar Mangalam Birla to promote and raise the standards of good corporate governance. In early 2000, the SEBI board had accepted and ratified key recommendations of this committee, and these were incorporated into Clause 49 of the Listing Agreement of the Stock Exchanges. This report pointed out that the issue of corporate governance involves besides shareholders, all other stakeholders. The committee’s recommendations have looked at corporate governance from the point of view of the stakeholders and in particular that of shareholders and investors. The committee report establishes a set of recommendations. These recommendations are expected to be enforced on listed companies for initials disclosures. This enables shareholders to know, where the companies are in which they have involved. The committee recognized that India had in place a basic system of corporate governance and that SEBI has already taken a number of initiatives towards raising the existing standards.

Naresh Chandra Committee Report

The Naresh Chandra committee was appointed in August 2002 by the Department of Company Affairs (DCA) under the Ministry of Finance and Company Affairs to examine various corporate governance issues. The Committee submitted its report in December 2002. It made recommendations in two key aspects of corporate governance: financial and non-financial disclosures: and independent auditing and board oversight of management. The committee submitted its report on various aspects concerning corporate governance such as role, remuneration, and training etc. of independent directors, audit committee, the auditors and then relationship with the company and how their roles can be regulated as improved. The committee stingily believes that “a good accounting system is a strong indication of the management commitment to governance.  Good accounting means that it should ensure optimum disclosure and transparency, should be reliable and credible and should have comparability.  According to the committee, the statutory auditor in a company is the “lead actor” in disclosure front and this has been amply recognized sections 209 to 223 of the companies act.

Narayana Murthy Committee Report On Corporate Governance

The fourth initiative on corporate governance in India is in the form of the recommendations of the Narayana Murthy committee. The committee was set up by SEBI, under the chairmanship of Mr. N. R. Narayana Murthy, to review Clause 49, and suggest measures to improve corporate governance standards. Some of the major recommendations of the committee primarily related to audit committees, audit reports, independent directors, related party transactions, risk management, directorships and director compensation, codes of conduct and financial disclosures.[v]

WEAKNESSES OF CORPORATE GOVERNANCE

 1. No Proper Structure

It is true that the ‘corporate governance’ has no unique structure or design and is largely considered ambiguous. There is still lack of awareness about its various issues, like, quality and frequency of financial and managerial disclosure, compliance with the code of best practice, roles and responsibilities of Board of Directories, shareholders rights, etc. There have been many instances of failure and scams in the corporate sector, like collusion between companies and their accounting firms, presence of weak or ineffective internal audits, lack of required skills by managers, lack of proper disclosures, non-compliance with standards, etc. As a result, both management and auditors have come under greater scrutiny.

But, with the integration of Indian economy with global markets, industrialists and corporate in the country are being increasingly asked to adopt better and transparent corporate practices. The degree to which corporations observe basic principles of good corporate governance is an increasingly important factor for taking key investment decisions. If companies are to reap the full benefits of the global capital market, capture efficiency gains, benefit by economies of scale and attract long term capital, adoption of corporate governance standards must be credible, consistent, coherent and inspiring. Individual shareholders, who usually do not exercise governance rights, are highly concerned about getting fair treatment from controlling shareholders and management. Creditors, especially banks, play a key role in governance systems, and serve as external monitors over corporate performance. Employees and other stakeholders also play an important role in contributing to the long term success and performance of the corporation. Thus, it is necessary to apply governance practices in a right manner for better growth of a company.[vi]  There are two types of mechanism that resolve the conflicts among different corporate claim-holders, especially, the conflicts between owners and managers, and those between controlling shareholders and minority shareholders. The first type consists of various internal variables, e.g.

(1) the ownership structure,

(2) board of directors

(3) executive compensation and

(4) financial disclosure.

The second includes external mechanism with variables, e.g.

(1) effective takeover market,

(2) legal infrastructure and

(3) product market competition.

2. No Government Support

Strong  governance  standards  focusing  on  fairness,  transparency, accountability and responsibility are vital not only for the healthy and vibrant  corporate  sector  growth,  as  well  as  inclusive  growth  of  the economy. Recent corporate scandals have led to public pressure to reform business practices and increase regulation. The public outcry over the recent scandals has made it clear that the status quo is no longer acceptable: the public is demanding accountability and responsibility in corporate behavior. It is widely believed that it will take more than just leadership by the corporate sector to restore public confidence in our capital markets and ensure their ongoing vitality. It will also take effective government action, in the form of reformed regulatory systems, improved auditing, and stepped up law enforcement. These responses make clear that the governance of corporations has become a central item on the public policy agenda. The recent scandals themselves demonstrate that lax regulatory institutions, standards, and enforcement can have huge implications for the economy and for the public. Of course, government responses to scandals should be well considered and effective.[vii]

3. Insider Trading

Corporate insiders like officers, directors and employees by the virtue of their position have access to confidential information about the corporation and may misappropriate that information to reap profits. In most countries, trading by corporate insiders such as officers, key employees, directors, and large shareholders may be legal, if this trading is done in a way that does not take advantage of non-public information. However, the term is frequently used to refer to a practice in which an insider or a related party trades based on material non-public information obtained during the performance of the insider’s duties at the corporation, or otherwise in breach of a fiduciary or other relationship of trust and confidence or where the non-public information was misappropriated from the company. Such corporate insiders use these information in such a way to reap profits or avoid losses on the stock market, to the detriment of the source of the information and to the typical investors who buy or sell their stock without the advantage of “inside” information.[viii] The term insider trading is popularly used in the negative sense as it is perceived that the persons having access to the price sensitive and unpublished information used the same for their personal gains. However insider trading per se does not mean any illegal conduct. It encompasses both legal as well as illegal conduct. The legal version is when corporate insider’s officers, directors, and employees buy and sell stock in their own companies. In order to legalize their transactions, the directors and employees of the company should inform about their dealing with the securities to the SEBI. Insider trading is defined as-“The use of material non public information in trading the shares of the company by a corporate insider or any other person who owes a fiduciary duty to the company”.[ix] SEBI is the watchdog of all the stock exchanges in India. It has been obligated to protect the interest of the investors in the securities market and to regulate the stock market through such other regulations as it deems fit. It is due to the very fact that the investors invest on the shares being speculative, but when the prices of the shares could be predicted well before in hand then they may take a decision accordingly. Hence, pre determined price may result in undesired consequences as people may buy huge amount of shares whose value may appreciate.

Section 17 Securities Exchange Act, 1933 contained prohibitions to deal with the fraud in the sale of the securities in the most stringent manner possible. The Act addressed insider trading directly through Section 16(b) and indirectly through Section 10(b). Section 16(b) of the Securities Exchange Act, 1934 prohibits the purchase and sale of the shares within six month period involving the directors, officers, stock holders owning more than 10% of the shares of the company. The rationale behind the incorporation of this provision is that it is only the substantial shareholders and the persons concerned with the decision and management of the company who can have access to the price sensitive information and therefore there should be bar upon them to transact in securities.[x]

In the case of Samir.C.Arora vs. SEBI[xi], Mr. Arora was prohibited by the SEBI in its order not to buy, sell or deal in securities, in any manner, directly or indirectly, for a period of five years. Also, if Mr. Arora desired to sell the securities held by him, he required a prior permission of SEBI. Mr. Arora contested this order of SEBI in the Securities Appellate Tribunal. SAT set aside the order of SEBI on grounds of insufficient evidence to prove the charges of insider trading and professional misconduct against Mr. Arora.

This case testifies the fact that the SEBI lacks the thorough investigative mechanism and a vigilant approach due to which the culprits are able to escape from the clutches of law. In most of the cases, SEBI failed to adduce evidence and corroborate its stance before the court. Unlike the balance of probabilities that is required in proving a civil liability, a case involving criminal liability requires the allegations to be proved beyond reasonable doubts. Therefore there should be thread bare investigation and all the loopholes if any should be properly plugged in.

4. Basis of Indian Model

The problem in the Indian corporate sector is that of disciplining the dominant shareholder and protecting the minority shareholders. Clearly, the problem of corporate governance abuses by the dominant shareholder can be solved only by forces outside the company itself. In an environment in which ownership and management have become widely separated, the owners are unable to exercise effective control over the management or the Board.

The central problem in Indian corporate governance is not a conflict between management and owners as in the US and the UK, but a conflict between the dominant shareholders and the minority shareholders. The problem of the dominant shareholder arises in three large categories of Indian companies. First are the public sector units (PSUs) where the government is the dominant (in fact, majority) shareholder and the general public holds a minority stake. Second are the multinational companies (MNCs) where the foreign parent is the dominant (in most cases, majority) shareholder. Third are the Indian business groups where the promoters (together with their friends and relatives) are the dominant shareholders with large minority stakes, government owned financial institutions hold a comparable stake, and the balance is held by the general public. It is important to bear in mind that the relation between the company and its shareholders and the relation between the shareholders inter-se is primarily contractual in nature.

The memorandum and articles of association of the company constitute the core of this contract and the corporate law provides the framework within which the contracts operate. The essence of this contractual relationship is that each shareholder is entitled to a share in the profits and assets of the company in proportion to his shareholding. Flowing from this is the fact that the Board and the management of the company have a fiduciary responsibility towards each and every shareholder and not just towards the majority or dominant shareholder. Shareholder democracy is not the essence of the corporate form of business at all. Shares are first and foremost ownership rights – rights to profits and assets. In other cases, shares also carry some secondary rights including the control rights – rights to appoint the Board and approve certain major decisions. The term shareholder democracy focuses on the secondary and less important part of shareholder rights. Corporate governance ought to be concerned more about ownership rights. If a shareholder’s ownership rights have been trampled upon, it is no answer to say that his control rights have been fully respected.[xii]

OTHER WEAKNESSES

  • Family-owned business- Family-owned companies are characterized as organizations in which the shareholders belong to the same family and participate substantially in the management, direction, and operation of the company. A family business refers to a company where the voting majority is in the hands of the controlling family; including the founder(s) who intend to pass the business on to their descendants.[xiii] Many Indian businesses are old family establishments and while controlling shareholders may welcome cash infusions by outside investors, but they may hesitate to relinquish control. It becomes difficult for outsiders to track the business realities of individual companies. As the family and its business grow larger, this situation can lead to many inefficiencies and internal conflicts that could threaten the continuity of the business. Family control also brings governance problems – not least of which are a lack of checks and balances over executive decision making and behavior, and a lack of transparent reporting to the outside world.[xiv]
  • Noncompliance with disclosure norms and even the failure of auditor’s reports to conform to the law attract nominal fines with hardly any punitive action. The Institute of Chartered Accountants in India has not been known to take action against erring auditors.
  • While the Companies Act provides clear instructions for maintaining and updating share registers, in reality minority shareholders have often suffered from irregularities in share transfers and registrations – deliberate or unintentional.
  • Sometimes non-voting preferential shares are used by promoters to channel funds and deprive minority shareholders of their dues.
  • Minority shareholders have sometimes been defrauded by the management undertaking clandestine side deals with the acquirers in the relatively scarce events of corporate takeovers and mergers.
  • Misleading financial statements- There are many ways to present factually accurate information on a financial statement in a manner that is misleading to investors . By, for example, selling property from a parent company to a subsidiary to maximize parent company revenues.
  • The Harshad Mehta stock market scam[xv] of 1992 followed by incidents of companies allotting preferential shares to their promoters at deeply discounted prices as well as those of companies simply disappearing with investors’ money. These concerns about corporate governance stemming from the corporate scandals as well as opening up to the forces of competition and globalization gave rise to several investigations into the ways to fix the corporate governance situation in India.[xvi]
  • One of the big problems with Indian corporate governance is that too many listed companies and directors follow the letter of the law, rather than the spirit. Clause 49 of the country’s listing rules sets out a series of corporate governance regulations. For example, a listed company must have a non-executive and one-third of its board should be non-executive directors. The nonexecutives should be on the board to challenge management, but in reality they tend not to.
  • ‘Good people are very few’ partly because there is a legal limit on the amount companies can pay non-executives. They are not allowed to receive a salary and can only be paid for attendance at board meetings That gives the non-executives little incentive to fulfill their obligations properly.
  • Directors’ remuneration needs a rethink, as does the process of appointing directors. Currently, non-executives are generally selected by the board, with little input from shareholders – they should become more active. An independent agency should also rate the standards of corporate governance at listed companies.[xvii]

THE SATYAM SCAM

The failure of corporate governance and of misleading accounts is a failure of both the management and of the auditors. The promoters decided to inflate the revenue and profit figures of Satyam. In the event, the company has a huge hole in its balance sheet, consisting of non-existent assets and cash reserves that have been recorded and liabilities that are unrecorded.

This episode has led to debates in India, about some of inadequacies in the corporate governance norms. Questions have been raised about the performance/ effectiveness of board of directors, roles of auditors, the impact of regulations, disclosures, etc

It is one such great opportunity to reassess some of the existing framework on corporate governance, systems for better enforcements of regulations; effective roles and duties of directors, executives, regulators; ethics in businesses and empowerment of minority shareholders.

One must, however, understand that no matter how strong a regulatory system is, it cannot always prevent frauds. Despite the enormous increase of disclosures and stringent risk management systems scams do take place. Moreover, strong measures often lead to expensive regulations and defiance. There are limits to legislations as a lot depends on the integrity and ethical values of various corporate players such as directors, promoters, executives and shareholders. The key lies in management decisions and its commitment to establish and follow rigorous governance systems. The implementation must be in the letter and spirit, and one should recognize the responsibility of the company towards its stakeholders.[xviii] In particular, non-executive directors are supposed to give an independent assessment of the quality of management. But time and time again, failures of corporate governance suggest that they do not. The infractions of law have arisen despite independent directors which were stopped by external forces. There are several reasons pointing to these anomalies-
First, it is difficult to appoint truly independent directors. This is particularly hard to achieve in countries such as India where family ownership is widespread and there is a close-knit group of corporate leaders. It is difficult for non-executive directors to perform a scrutiny objective at the best of times.
Next, the very idea of independent directors is to ensure commitment to values, ethical business conduct and about making a distinction between personal and corporate funds in the management of a company. Yet, most independent directors have become sidekicks for the management, eying their commission and fees, forgetting their very purpose of appointment. In contrast, the problem in the Indian corporate sector is disciplining the dominant shareholder and protecting the minority shareholders, vindicated in the recent Satyam case. After successfully working over the decades separating ownership and management, owners, realized that they have lost control over the management or the board.[xix]

IMPROVING STANDARDS

  1. Preventing insider trading by devising an internal procedure for adequate and timely disclosures andspecific rules for the conduct of insiders and the power to punish offenders. SEBI should show seriousness about checking insider trading and there should be a separate code by itself.
  2. Organisation for Economic Co-operation and Development (OECD) lays down certain principles for reforming corporate governance. They are-
  • The right of shareholders- These include a set of rights including secure ownership of their shares, the right to full disclosure of information, voting rights, participation in decisions.
  • The Equitable Treatment of Shareholders- Here the OECD is concerned with protecting minority shareholders rights by setting up systems that keep insiders, including managers and directors, from taking advantage of their positions.
  • The Role of Stakeholders in Corporate Governance- the OECD recognizes that there are other stakeholders in companies in addition to shareholders whose rights needs to be protected on being associated with the company. For instance, if we take the example of an employee who invests their human capital in the firm as compared to share holders who invest their financial capital, shareholders can diversify their investment, whereas employees can make limited investment of their capital. For this purpose employees risk their entire investment in one field so their rights need to be protected.
  1. The N.R Narayan Murthy Committee report also made some mandatory recommendations:-
  • Strengthening the responsibilities of audit committees.
  • Improving the quality of financial disclosures.
  • Requiring corporate executive boards to assess and disclose business risks in the annual reports of companies.
  • Introducing responsibilities on boards to adopt formal codes of conduct.
  • Striving to ensure that the code of conduct is understood and adhered to by all members of the organization.
  • The performance management system should recognize and reward ethical behavior.[xx]

Edited by Kanchi Kaushik

[i] http://www.nfcgindia.org/library/cgitp.pdf

[ii] http://www.authorstream.com/Presentation/tafseerahmad771-1600150-institute-business-management/

[iii] http://shodhganga.inflibnet.ac.in/bitstream/10603/1558/15/15_chapter%206.pdf

[iv] Desirable Corporate Governance: A Code

[v] http://shodhganga.inflibnet.ac.in/bitstream/10603/1558/10/10_chapter1.pdf

[vi] http://business.gov.in/corporate_governance/future_prospects.php

[vii] http://www.hks.harvard.edu/m-rcbg/research/rpp/reports/RPPREPORT8.pdf

[viii] http://works.bepress.com/pankaj_singh/2/

[ix] Black’s Law Dictionary.

[x] http://airwebworld.com/articles/index.php?article=1264#sdfootnote18anc

[xi] (2002) 38 SCL 422..

[xii] http://www.iimahd.ernet.in/~jrvarma/papers/iimbr9-4.pdf

[xiii] http://www.ijimt.org/papers/23-C050.pdf

[xiv] http://www.ibanet.org/Article/Detail.aspx?ArticleUid=4BBCD91B-ADC0-466A-9B17-29071AE06FC0

[xv] ILR 1993 Delhi 274.

[xvi] http://eravandi.blogspot.in/2009/10/corporate-governance-2.html

[xvii] http://www.ibanet.org/Article/Detail.aspx?ArticleUid=4BBCD91B-ADC0-466A-9B17-29071AE06FC0

[xviii] http://pushkarchandna.sulekha.com/blog/post/2010/02/satyam-lessons-and-corporate-governance-reforms.htm

[xix] http://eravandi.blogspot.in/2009/10/corporate-governance-2.html

[xx] http://business.gov.in/corporate_governance/narayana_murthy.php

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